The Myth of Dividend Payout Ratio Part I: Is Lower Necessarily Better?

Everywhere I look for dividend investing commentary I always read the same "absolute truth": a lower dividend payout ratio is better. It's almost a dogma among dividend investors.

Intuitively, it makes sense.

The payout ratio is the portion of earnings that a company pays out as dividends. So, if you expect your dividends to be paid consistently and to not be cut or shrink over time, a low payout ratio makes sense: there's a margin of safety; if the company earns less one year, it will still be able to pay its dividend if the payout ratio is low.

The idea of "low payout is better" then is that companies can smooth their dividends if they retain cash for a rainy day and allow ample room for earning shrinkage by paying out less of their earnings in dividends.

So what's wrong then?

Well, two things. One is a principle thing and the other one is a historical fact:

• In principle, all money not needed to be reinvested in the business (to keep the business afloat, such as replacing inventory, fixing up plant and equipment, etc) belongs to shareholders. So, management has no moral right to keep more than they should of shareholders money.

This can be debatable, especially if each dollar retained by the company gets translated to an extra dollar of appreciation of their share price.

As for the the historical fact:

• Historically, smoothing out earnings hasn't provided any evidence that it can prevent or reduce the likelihood of dividend cuts. Consistent dividend growth and reliable payouts are the exception, not the rule.

At least that's what Ben Graham's investment company found out after many years of market research. The results are in Graham's book, Security Analysis. Consider this passage:

The typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself. No instances are on record in which the withholding of dividends for the sake of future profits has been hailed with such enthusiasm as to advance the price of the stock. The direct opposite has invariably been true. Given two companies in the same general position and with the same earning power, the one paying the larger dividend will always sell at the higher price.
(Security Analysis, 4th edition, Benjamin Graham and David Dodd, 1940)

The authors go on to explain that the theory of lower payout ratio may sound good, but that it fails to provide adequate protection regarding dividend cuts, and that therefore dividends should just be paid out as much as possible and it's the investor who should worry about smoothing his earnings over time.

This smoothing can be achieved by investors by them not relying on a fixed and increasing income stream from a dividend portfolio but instead relying on a fraction of it and saving the rest for a rainy day.

If the investor is not depending on the income stream for a living, then it's even better to get the maximum dividend now instead of later since an intelligent investor will have an easier time allocating the income proceeds into the most interesting investment opportunities at any given time than would individual companies.

In the book, Graham shows a few examples of companies that attempted to smooth out their dividends just to cut them some years later.

In another post, I will go over a current example where the smoothing out of dividends was detrimental to shareholder's returns.

Free Market Commentary Usually as Good as Its Price

Don't believe everything you read out there. Errors, omissions and mistakes abound. Here's is this week's example. Consider this news article by Zacks, "Brazilian Manufacturers Slightly Relieved".

The news piece claims that some Brazilian companies should benefit from consumer spending, "These include home appliances retailer Companhia Brasileira de Distribuicao (CBD), [...] cement maker CEMEX S.A. de C.V. (CX) [...] and state-owned steel producer Companhia Siderurgica Nacional (SID) ".

Wait a second.

CBD is not a "home appliances retailer". It's a supermarket chain.

CEMEX is not a Brazilian company either. It's Mexican.

SID is not state-owned and hasn't been since 1994.

And this comes from a "respectable" market and security research company.

Is this even relevant to the article's point? Probably not. But these errors are so simple and straightforward to catch that they show no editorial quality control whatsoever.

If this were the only example where errors, bad data or bad advice happen on the Internet (or on TV or other media in general) we'd probably be okay. But beware, it's out there. This one was only too obvious not to comment.

A Good Company in a Poor Industry

Even though management is crucial for the success of a company, the type of industry and business it is in is also very important. Warren Buffett once said that he prefers to buy companies that are so easy to run that they can be operated by a fool, "because someday a fool will". He also said that "when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact".

Why am I saying this? Well, because I think I've found a great company with great management but in an industry with relatively poor economics. And I'm not talking about airlines.

Consider SYSCO (SYY), a food distributor company. SYSCO sells prepared and raw food and food-related products to restaurants, healthcare and educational facilities, lodging establishments and other food service customers.

SYSCO's results over years have been pretty good. In the last 10 years SYSCO has:

• Increased its dividend by an annualized 17%.
• Increased earnings-per-share by an annualized 13%.
• Reduced outstanding shares to 600 million from 670 million.
• Had an average ROE of 31.9% (with an average leverage of 2.91).
• Grown sales an annualized 8%.
• Grown free cash flow by an annualized 14.6%.

A pretty impressive achievement for a company of its size, $12 billion market cap.

On the other hand, consider the difficulty of achieving these results. This company depends heavily on commodity prices (fuel and food), has limited pricing power, achieves only minimal differentiation from competitors based on services since its products are very similar to those of competitors, and is highly dependent on the North American market for the bulk of its earnings.

Food Prices and Pricing Power. SYSCO buys food to sell to customers. Therefore it's exposed to food prices. In its most recent 10Q report, they say "Sysco attempts to pass increased costs to its customers; however, because of contractual and competitive reasons, we are not able to pass along all of the product cost increases immediately".

Considering that their products are similar to that of the competition, they must compete on higher-quality services and price. Therefore, the economics of this type of industry are not great. Compare that with products such as J&J's Band-aid, P&G's Gillette razors, WD-40 and Coca-cola. No one will choose a cheaper brand, even if the difference in price is 10, 20 or 30%. But customers of SYSCO do care if prices are 5 or 10% lower, especially if the product is very similar.

Fuel Costs. SYSCO is also exposed to fuel costs, since they deliver the food using their own trucks. SYSCO attempts to hedge fuel costs by entering forward diesel contracts. About 70% of their fuel expenses are on the basis of fixed-price agreements. However, this means they need to make bets on the direction of oil prices. In 2008, the company entered forward-contracts when oil prices were high and thus had to pay higher prices for diesel than spot market prices during the year. Management says

We periodically enter into forward purchase commitments for a portion of our projected monthly diesel fuel requirements to lessen the volatility of our fuel costs due to changes in the price of diesel. In the first 39 weeks and third quarter of fiscal 2009, our forward purchase commitments resulted in an estimated $50,000,000 and $22,000,000, respectively, of additional fuel costs as the fixed price contracts were higher than market prices for the contracted volumes.

(emphasis mine).

On the flip side, now that oil has dropped form last year's peak, SYSCO is enjoying lower fuel costs and is thus immune to increases for the duration of the current contracts. Over the long run, I expect such agreements to have no positive effect on earnings, as the ups and downs in the price of the contracts serve only to smooth volatility in fuel costs, but does not reduce fuel costs (to understand why, just think of the investor on the other end of these contracts).

Hence, SYSCO is squeezed between higher food prices that can't be passed on to customers automatically and higher fuel costs that are hard and expensive to manage. This means an investment in SYSCO is probably a bad hedge against inflation.

In fact, management recognizes this much: "Prolonged periods of high inflation, such as those we have recently experienced, have a negative impact on our customers, as high food costs and fuel costs can reduce consumer spending in the food-prepared-away-from home market".

SYSCO's net earnings as a percentage of sales has recently been in the 2.6 to 2.8% range. Compare that with Coca-cola's 18% and J&J's 23%.

Conclusion. SYSCO is a well-run company, in a stable and somewhat profitable market with large and stable demand. The company has a 16% share of a $231 billion a year market. However, the economics of this industry are not appealing and a fool could not run this company successfully for very long. Therefore, investing in SYSCO is making a bet in its management and in a deflationary to mild-inflationary times ahead.

At reasonable prices, SYSCO is an appealing buy. But it's a company one needs to watch the fundamentals very closely and be ready to sell when fundamentals deteriorate.

Disclosures: I own SYSCO at the time of writing.