Chapter five of “Why Moats Matter: The Morningstar Approach to Stock Investing” looks at the complex relationship between moats and dividends.
It was written by Josh Peters, the director of equity-income strategy for Morningstar and editor of the firms’ “DividendInvestor” newsletter. Lead authors for the book as a whole were Heather Brilliant and Elizabeth Collins.
The authors argued the relationship is not only complex, but also very important. To start, however, they addressed the old issue of dividends versus buybacks; the former provides income and the latter produces higher capital gains (both in theory, at least). The authors take an agnostic position, giving no extra weight to either, as they focus on total return.
Why do dividends matter? When Morningstar analyzes moats (or their absence), they estimate future free cash flows and discount them back to present-day dollars. That establishes a value for the shares, and “As that future unfolds, though, it’s rare—and generally undesirable—for those future free cash flows to simply pile up on the company’s balance sheet.”
As cash from retained earnings and other sources pile up, a company has five ways to respond:
- Hoard the cash, something that was relatively common after the crash of 2008; and perhaps in 2019 it might be done to take advantage of an expected stock market decline and cheap acquisition opportunities.
- Companies can reduce their debt, particularly if it leaves shareholders better off.
- Acquisitions, provided they do not involve “empire building,” with benefits accruing to senior management rather than shareholders.
- Buybacks, or as they are more formally known, share repurchases. The authors reported the practice was growing when the book was published in 2014. Five years on, it apparently is growing even more quickly.
- Dividends: The only direct and tangible way to send capital back to shareholders.
While dividends usually cannot directly add or reduce values, they can perform several positive functions:
- Signal to investors that the company wants to reward shareholders and is a sign of “corporate maturity.”
- Force managers to be disciplined, since shareholders expect dividends to be maintained or increased in coming years.
- Make shareholders less likely to dump their holdings during short-run fluctuations; in a related vein, it may also make it possible for management to focus on long-term possibilities.
- The shares of companies with high dividend yields, and perceived to be sustainable yields, tend to be more less volatile, which can lead to better risk-adjusted returns.
The authors also pose this provocative question: How is a company’s value to be recognized by the market if it does not pay a dividend? Take the case of Google, now Alphabet GOOGGOOGL, which in 2014 had become too big to be bought out by another company. If it never pays a dividend, then investors who want to take their profits must depend on the daily vagaries of the market.
In the second half of the chapter, the focus shifts to dividend cuts, those reductions that lessen investment income. Both investors and analysts should ask three questions when eyeing a dividend-paying stock:
- Is the dividend safe?
- Will it grow in coming years?
- How much total return can be inferred from future dividend prospects?
Following up, the authors wrote, “Although these three questions don’t specifically deal with a company’s economic moat or lack thereof, the moat is the essential context when evaluating the safety of a company’s dividend and its ability to grow over time.”
For example, Clorox CLX had an economic moat; but if it did not, then its dividend could not be considered sustainable, nor would it be expected to grow in the future. Without a moat that protects its strong margins, its earning power would be expected to decline and match its cost of capital in the near future.
The company did have a moat, however, thanks to several prominent brands, efficient manufacturing plants and a strategy of sticking to its niches. Morningstar also expected that moat to play a role in the future, as the company invests 2% of revenue in research and development as well as 4% of revenue in capital investments. With those commitments, it can continue to develop new products and improve its manufacturing efficiency; smart reinvestment will widen its moat. With ample excess cash left after capital expenditures, it paid a healthy dividend, one that grew by an average of more than 11% per year between 2003 and 2013.
Pitney Bowes PBI, on the other hand, was a company going in the wrong direction. Its once wide moat was shrinking in the first decade of this century as postal volumes declined. In addition, management tried to buy its way out of the problem by purchasing other businesses that were somewhat related, but did not have the protection of moats.
For each of the 30 years leading up to 2012, the company had consecutively increased its dividends, though the hikes kept getting smaller (what Morningstar called a “rapidly eroding” moat). In 2012, it did not increase the dividend and in 2013, cut it in half. All the while, its stock price was swooning.
How can you tell if a dividend is in trouble? Payout ratios go up, the balance sheet becomes less robust and short-term earnings look weak. Behind all of that is erosion of the moat, in fundamental terms. In fact, the Morningstar analysts draw a direct line between moat width and the likelihood of dividend cuts. That’s illustrated in this table from the book:
The message is clear: The wider the moat, the lower the likelihood of dividend cuts.
The authors wind up the chapter with these observations:
“The lesson here: If you’re focused on income, we urge you to pay close attention to economic moats in your analysis. By itself, no dividend—regardless of size—can turn a bad business into a good long-term investment. But a dividend can turn a moat-protected, financially healthy business into a sound provider of income and total returns.”
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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