3 principles for finding dividend sustainability

A recent podcast with Robert Millner, Chairman of Washington H Soul Pattison & Company Ltd (ASX:SOL) provided valuable insights into the mindset of a long-term investment conglomerate. What started as a chemist on Pitt St in the 1870s has turned into what some would argue is the closest thing Australia has to a Berkshire Hathaway.

Today, as a conglomerate with only 10 people in head office and a market capitalisation of over $6 billion, SOL has delivered dividends to shareholders every year since 1903 and is one of only two companies listed on the ASX to deliver a growing stream of dividends over the past 20 years.

SOL is likely the ‘gold standard’ of income stability and consistency for investors. Whilst there are only a handful of companies on the ASX that can come even close to the 20-year dividend track record of SOL, one can never rely on past performance when looking ahead.

At NAOS we invest in small and microcap industrial companies. Whilst the concept of small stocks and dividends does not typically go hand in hand, there are plenty of companies in our universe which have demonstrated dividend success.

The principles which create an environment for stable to growing dividends are not company size dependent. For any of the principles below, we recommend looking at a medium to long term performance record as results can vary from year to year.

Principle 1 – free cash flow

The quality of any company’s operations can be measured by the amount of free cash it generates. The ability of a company to ‘compound capital’ comes down to how a company utilises and reinvests a portion of its free cash. This can include activities such as acquisitions, debt reduction, or building a bigger cash balance.

Whilst companies can pay dividends without free cash flow in the short term, over the long term, it is not conducive to sustainable capital management. A company that is extracting cash at the expense of reinvestment capital is likely to be going backwards. We like to see capital-light businesses that allocate a portion of free cash to both strategic and balance sheet initiatives whilst paying a portion to their shareholders.

A basic way to look for sustainability is to compare the total dividend amount to the total free cash flow amount. For this exercise, we define free cash flow as operating cash flow less ongoing capital expenditure. A company that is generating sustainable income for investors would have higher free cash flows than dividends paid.

Principle 2 – payout ratio

As a dividend hungry market, payout ratios of ASX-listed companies have been rising to become an ever-increasing percentage of total shareholder returns.

A dividend payout ratio measures the dividend per share versus the earnings per share. Inverting the payout ratio shows how much profit the company plans to retain. There may be industry-specific or ownership-specific factors which vary results, but as a general principle, a high payout ratio can be a sign that dividends may not be sustainable over the longer term.

Earnings that are retained within the business should be a buffer for future expectations, therefore a high payout ratio is likely to provide an understanding of the intentions of directors. Businesses which do not reinvest will likely face headwinds in the future.

Over the medium term, a capable board is one which prudently builds the retained earnings balance at a rate greater than the dividend payments. It gives a buffer against unexpected losses or impairments and may allow a more consistent dividend profile.

Often a company can be valued by its dividend yield, therefore a high yield can artificially inflate a share price. But if this payout ratio drops, it can have a serious negative impact on a share price.

The numerical increase in dividend per share often doesn’t tell us enough. We believe a better approach is that a company should ‘earn the right’ to increase its payout ratio. If previous investment decisions are compounding capital faster than a payout ratio increases, it demonstrates sustainability.

It could be a red flag if a company’s retained earnings balance is consistently diminishing whilst dividends remain steady or increasing.

Principle 3 – financing cash flows

It may be best to read a company’s financials back to front: the cash flow statement first and the income statement last. A company can’t muddy the waters of a cash flow statement. The bottom section of the cash flow statement shows how a company ‘keeps its lights on’ during a reporting period.

A warning sign is a continual entries in the ‘proceeds from borrowings’ line of the cash flow statement, without any entry in ‘repayment of borrowings’. There are short-term reasons such as acquisitions when this is acceptable (which in turn should hopefully generate further free cash flow) but there are other, more worrying reasons.

If a company is living on debt and not generating the free cash to pay it off, any dividends will eventually suffer and a capital raising may occur. A quick way to interpret sustainability of the funding of dividends is to compare dividend growth to debt growth. Artificially ‘holding up’ a dividend through debt is likely not sustainable.

These principles are a good start

The above three principles should not be solely relied upon, rather be considered as part of a wider analysis of a potential investment. The principles give a grasp of what might happen down the tract to a dividend, which in theory should be the most predictable part of total shareholder returns.

At NAOS, we invest in businesses where the earnings today are not a fair reflection of what we consider the same business will earn over the longer term, and over time the business can pay dividends. We do not invest solely for income, and avoiding ‘yield traps’ is just as important as finding a good sustainable dividend.

Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529 and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.