Are high dividend yielding stocks good investments?

Dividends are a recurring question from investors. You know, “XXX is a company with a high dividend yield. Should we invest?” This is not the real question. The question is whether high dividend yielding stocks make good investments. We believe that when investing in stocks, we should focus on the total return. That means share price appreciation and dividends received. If the underlying dividend yield and price appreciation has a good chance of exceeding 20%, we’d be excited. Alas, most high dividend yielding stocks rarely cross the double-digit percentage range. Whenever we come across these candidates, we end up in dying business with an unsustainable yield.  

Return on Capital matters

8VantEdge focuses on good quality businesses. Beyond discussing its competitive advantages, a marker of quality businesses is that they generate high returns on capital. This means numbers in excess of 20, even 30%. In layman terms, the company takes a dollar of capital and generates a return of 20 to 30 cents every year.

A derivative of return on capital that many investors, including our peers, miss is incremental return on capital. What matters to the stock market is the return a company can generate on every NEW dollar of capital that is invested. After all, the market is forward looking. It’s funny how many otherwise smart, insightful investors may make simplistic assumptions on a business.

Retail example

For example, a luxury shop operating in Marina Bay Sands in Singapore may generate a return of $ 1 mm per annum, on capital invested of $2 MM ($1 MM in stock inventory and $1 mm in store fittings). That’s a Return on capital of 50%. It’s very tempting for investors to assume that the same company will continue generating a return on capital of 50% forever. The problem here is that there’s only one Marina Bay Sands in Singapore. The company could invest another $2 mm of capital in Macau and generate similar returns. But the company quickly runs out of such high return opportunities. The second store planted in Singapore must be in a location where foot traffic is inferior to Marina Bay. Even if the store was planted in Orchard Road, returns for the Orchard store is not likely to match Marina Bay Sands. A superior store paired with a less superior store must generate lower blended returns for investors.

A similar analogy can be made for planting factories that make widgets. The investor must focus on growth opportunities available to the business and the return opportunities on that incremental dollar. High return businesses almost always struggle to redeploy capital in HIGHER returning projects than the original cash cow businesses. Scale effects play a role in mitigating the drop in return on capital, but we can discuss scale effects in a later post.’

Where do dividends fit in?

In the ideal situation, the quality company shouldn’t pay dividends. If the business was able to redeploy its incremental dollar in projects that yield in excess of 20%, we should let the company do so. The return is far superior to any investment opportunity that investors have for the same dollar distributed as dividends.

In fact, shareholders demanding dividends are preventing the company from compounding its capital. Dividends are distributable only after the company has paid tax due on earnings. Whereas when the company re-invests the capital in new projects, there are many ways of deferring or delaying the tax that is due. The dollar of tax that is retained in high return projects further compounds the wealth of shareholders, since shareholders get to keep the upside from every dollar of tax deferred.

Sell stocks rather than collect dividends

If the shareholder required cash, they could exit a portion of their holdings. The company should be busy doing what they do best, which is to identify profitable projects and use the cash flow thrown off by their existing businesses to invest. Berkshire Hathaway is a wonderful example of a compounding machine over the past 5 decades that has never paid a dividend.

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