Dividends and Duration

Dividends reduce the duration of an investment. This was something I thought about after hearing a friend compare a successful investment he’d made in the mid-1990s with some of the growth stocks which have become today’s market darlings. His point was that dividends brought forward his return and thereby reduced his risk.

I’m going to build this article up in blocks to give a quick framework for capital allocation and to show that I understand how seemingly expensive stocks can offer compelling value thanks to the high rates of return they earn on re-investment. This will hopefully give context when I return to my friend’s comparison at the end and thus make his point more clear.

When to pay dividends:

Good capital allocation recognises that capital has a price, and calls on companies to think carefully about how to source and use capital. Generally speaking, capital should be raised from the cheapest source, be it equity, debt or float. Surplus capital should only be re-invested in projects with expected returns higher than the company’s hurdle rate, and returned when none can be found, either by repaying debt, dividends or share buy-backs.

Ben Graham said, “Investing is most intelligent when it is most businesslike”. When thinking about capital allocation, it helps to turn this around: business is most intelligent when it is most investing-like. Why? Because good investors are always thinking about their cost of capital and opportunity set. Company managers should do the same. Businesses can always grow earnings by investing more. But they shouldn’t when the expected return isn’t attractive on a per share basis.

So not every company should pay a dividend. But then not every company should invest in growth either. The right decision will be different at every point in time depending on the company’s opportunity set.

Deferring earnings to maximise value:

To repeat: sometimes a company’s best choice is not to pay a dividend. In fact, sometimes it’s best not to even report a profit at all. How could that be?

Buffett has long talked about the difference between companies maximising short-term and long-term returns. The classic example is how GEICO takes market share because it’s willing to sign on new customers with an attractive lifetime value, even though the cost of acquiring those customers will depress earnings when expensed in the current year. Tom Russo calls this “the capacity to suffer”.

Many of the best performing investments of the last two decades have been in companies run by managers who get this. It can take an enormous upfront investment to build competitive advantage. But once complete, marginal costs become negligible and businesses can grow with minimal additional capital. This has been most obvious with internet companies like Facebook, Netflix and Amazon. But it’s just as true for old-line companies. For example, how much more did Boeing have to invest in R&D to make its 10,000th 737 jet last year? How much does it cost Mastercard to process one more payment after building its global network? What did it take for Abbvie to make one more dose of Humira after decades of R&D? The answer to all three questions is virtually nothing. Moreover, the large upfront investment itself makes it more likely these businesses become natural monopolies if successful.

In these situations, it can make sense for investors to stick with a company even as it reports losses over an extended period – and foregoes dividends – so long as incremental returns on investment are positive. Josh Tarasoff and John McCormack illustrated this thinking in 2013 with an analysis of Amazon.

I’d qualify this by asking too for favourable odds that the company will indeed enjoy a natural monopoly one day and indeed see a return on its investment. Many high growth businessses I see in China are facing intense and well-funded competition, for example, and I’m sceptical that their growth will ultimately translate into sustainable earnings.

Dividends and duration:

Back now to the conversation I had with my friend and the comparison he made between some of today’s market darlings and the successful investment he made in the mid-1990s.

Along the same lines as what Dan Sheehan asked, he felt that some of today’s market darlings had taken this good idea of deferred earnings to an extreme, stretching their hoped for profits out into an indefinite future. Does this leave investors any margin of safety? He didn’t think so, at least at recent prices.

What was really interesting though was that my friend was humble enough to recognise that for regulatory reasons, his successful investment had also had a much greater risk of permanent capital loss than he’d normally accept. Had he strayed from the straight and narrow and just gotten lucky?

After a lot of reflection, he concluded he had not: his investment had decades of operating data showing stable market shares, was very profitable and offered close to a 20% dividend yield at the time of purchase. Knowing the axe might fall, its managers were doing everything in their power to return as much capital to shareholders as they could. So even if the business failed in three years when a critical regulatory decision was due, my friend’s downside would have been limited to 40% of his original investment.  Dividends brought his returns forward.

We can link this to the concept of duration, which in a narrow sense measures the sensitivity of a security’s value to interest rates and in a broad sense to assumptions about the future. The further into the future we make assumptions – such as the size of future cashflows – the higher the duration. And the higher the duration, the more sensitive the value of the security to changes in those assumptions. Thus a thirty-year bond will have a higher duration than a one-year bond. And equities – with our implicit assumption that their underlying businesses will be going concerns forever – will have the highest duration of all.

If we think about it this way, investing in a stock which doesn’t pay dividends is like investing in a zero-coupon bond with an infinite duration.  Its value is entirely determined by the price in the future at which we hope to sell. As a result, the range of possible outcomes we should consider must be wider than a stock which does pay dividends and hence has a lower duration. Dividends front-load our return whereas growth back-ends it.

Dividends also give us a clearer handle on valuation. Seth Klarman framed this as an important psychological benefit in his 2018 letter, which I’m going to quote in full (and will stretch to include dividends as a “corporate event”):

We believe another key element in portfolio management is curtailing the duration (the weighted average life) of one’s portfolio through exposure to investments with catalysts for the realization of underlying value. Catalytic events shift the outcome of investments from a reliance on future market multiples and macroeconomic developments (which are not at all under your control) to a dependence on your assessment of the outcomes, probabilities, and implications of announced or anticipated corporate events, including mergers and acquisitions, bond maturities, debt restructurings, bankruptcies, major corporate asset sales, spinoffs, and tender offers. No strategy can avoid all risk of loss. But we believe our approach should increase the likelihood of achieving sustainable gains with limited downside risk over the long-run. To put it differently, a portfolio of near infinite duration (such as an all equity portfolio without catalysts) can trade just about anywhere. With such exposures, if stock prices plummet, the odds go up that an investor will feel pressure to do the wrong thing and sell into market weakness. A limited duration portfolio, both because of the hopefully truncated downside in a bad market as well as the beneficial cash inflows (buying power) that catalysts usually generate, is hugely advantageous in navigating through turmoil.

So in sum:

  1. Companies should be opportunistic with capital allocation. Sometimes it makes sense to invest and forego earnings today for greater earnings in the future. And sometimes it makes sense to return capital, e.g. through dividends.

  2. Growth can be a margin of safety but without dividends, we’re entirely dependent for our returns on the price at which we hope to sell in the future.

  3. Dividends bring returns forward and lower duration.

I’d long considered dividends as just another way to earn my returns (the others being earnings growth and multiple expansion).  But it’s fair to argue that dividends alone can also reduce risk by lowering duration.

So while a company could go on to compound its earnings for years to come, without a dividend it has a relatively high duration, leaving me as an investor more vulnerable to adverse outcomes in the future.