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Chasing dividends often overlooks growth

Five Forces

I have mentioned to you the bubble in stocks (and inevitably property) inflated by the baby boomer’s desperate search for yield.  We described the pursuit of yield as a fad.  We were not surprised to watch investors rushing into higher yielding banks and Telstra but we were shocked to hear of investors buying BHP for its ‘progressive’ dividend.

The bubble has burst but the fad lives on, and now that the banks have wiped billions from retirees wealth and BHP has backed away from its progressive dividend position, I wonder what will be the next mistake investors will repeat en-masse.

A year ago, we said:  “The pursuit of yields through dividend-paying shares is analogous to a mindless heard of bison stampeding towards a cliff. Wall Street will sell what Wall Street can sell. Right now selling yield and income is the easiest game in town. Investors are predisposed to hearing the siren song of income and advisers and product issuers are rushing to feed the hoards. There are only a few who are willing to question the conventional thinking about pursuing yield at all costs. 

My belief is that the pendulum will swing back and this time is no different to other periods of unbridled optimism…”

Of course much has changed - BHP has fallen 35 per cent, CBA has declined 26 per cent from its interim peak to trough, NAB 28 per cent and Telstra 23 per cent. What has not changed is the need of retirees for income.  But is there a better way to generate income that suffers less from the massive tides associated with mass investor hype and hysteria?

I believe there is and some basic arithmetic can demonstrate what we practice at Montgomery and what we believe is a superior choice even for those requiring income.

Table 1. High ROE company paying out 100% of earnings


Let’s start with the company described in Table 1.  We make some minor assumptions; The first reflects our practice of investing in businesses with economics that are attractive.  By definition they are companies that can sustain attractive returns on equity capital.  In Table 1 you can see we assume the business is able to generate a return on equity of 20 per cent sustainably.

The second assumption is that we buy and sell the shares on an unchanged price earnings ratio of 10 times.  The final assumption is a payout ratio of 100 per cent.

Note that I have assumed no increases in debt (which increases the risks) and no dilutionary share issues.  The company’s only source of growing equity is retained profits.

The point of Table 1 is to demonstrate that an investor who purchases and sells shares in a company, in this case with an attractive rate of return on equity, at a constant P/E, and where the payout is 100%, will receive as their return an internal rate equivalent to the dividend yield at the time they purchase their shares.  You will note this represents the upper bound of their return – the dividend yield is the best outcome, unless they speculate successfully on an expansion of the P/E ratio.  For that to occur, sentiment or popularity towards the company’s shares would have to change and be correctly predicted.

In more simple terms, if you chase a high yield and the company pays all of its earnings out as a dividend, the high yield is about all you should expect.  Perhaps that is what investors who chased the banks, Telstra and BHP for their yields are now finding out.

Turning to Table 2., you will notice that the only item that has changed is the payout ratio, which is now zero.  Of course this has a major impact on everything else. 

Table 2. High ROE company paying out 0% of earnings

This company pays none of its earnings out as a dividend.  As a result an investor who buys and sells the shares on the same p/E will receive no income from dividends, but because capital and earnings grow by the rate of the retained return on equity, the constant P/E ratio means the IRR to the investor will equal the return on equity of, in this case, 20 per cent.

My proposal is that investors who chase higher yields, especially from companies that pay the bulk of their earnings out as dividends, are missing out on major financial benefits that would otherwise accrue.  The corollary is that company boards who acquiesce to shareholder demands for higher dividend payout ratios – especially where they are able to employ retained earnings at high rates of return – are ultimately doing their shareholders and their share price a disservice.

How much of a disservice can also be seen in the following Table 3.

Table 3. Power of true blue-chips (not Telstra)
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Investors in 2005 who invested $100,000 in the higher, 5.9%-yielding Telstra shares could have alternatively invested $100,000 in M2 Telecoms.  The major difference between these two companies was not just their yield.  Telstra’s management elected to pay the bulk of the company’s earnings out as a dividend.  Indeed under Solomon Dennis Trujillo Telstra’s dividend exceeded earnings over a number of years. While Telstra’s payout ratio was near 100 per cent, M2 Telecommunication’s payout ratio was much lower.  Table 2 revealed the desirable impact on returns from investing in a company that can retain earnings and reinvest those earnings at a high return on equity.  Table 3, puts that into practice.

Remembering our previous example in Table 1. that when the payout ratio is 100% the bulk of the returns come from yield, unless the P/E expands, Table 3 now reveals the growth in wealth as well as income from a ten-year investment in Telstra.

Investing $100,000 in Telstra in 2005 for ten years has produced an investment of about $117,000 or an average annual compounded capital return of 1.5%p.a. 

Many of you will immediately jump to the defense of Telstra and point out that I have excluded the dividends from the calculations.  Firstly I note, that I have not assumed a reinvestment of dividends.  This article is about retirees who have been chasing income to spend on food and clothing and other essentials like BMWs and annual overseas holidays.

In 2005, the yield on Telstra shares was 5.9% and this equates to $5,900 of fully franked income.  Of course Telstra has increased the dividend since then from 28 cents to 30 cents per share and the low level increase reflects that fact that profits have not grown markedly.  In any event, the income on your $117,000 investment in Telstra currently would be about $6400.

Contrast this will M2 where the ability to generate high returns on large amounts of capital have turned $100,000 into $3m and importantly for those desperate for income, turned $3900 of dividends in 2005 into almost $100,000 of fully franked dividends in 2015.

To reinforce the point, and show that M2 is not an isolated example of the power of high rates of return on equity and the ability to retain profits, I have also listed the metrics for CSL.  A company that also displayed a less attractive dividend yield than Telstra in 2005, but was able to retain capital and compound it at an attractive rate, ultimately producing more wealth AND more income.

Investors chasing the highest yielding blue chips shares are missing out on the returns and income available from true blue chips – the type that we prefer to fill our portfolios with. Investors are making an expensive mistake by eschewing those companies with lower yields today but are able to grow their income.

Perhaps that’s the best summary of all; go for growing income not the highest yield.

Roger Montgomery is CIO at The Montgomery Fund and author of – how to value the best stocks and buy them for less than they’re worth.
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!