How dividend growth signals steady compounding

All investment strategies have the potential for profit and loss, your or clients capital may be at risk. This paper is intended solely for the use of professional investors and should not be relied upon by any other person. It is not intended for use by retail clients.

Companies that can compound their earnings at steady rates for long periods are relatively unusual. It’s one thing for a company to deliver 10 per cent growth for a couple of years. But to deliver that rate for a decade or more? That’s rare.

These durable compounders are worth searching for. Stock markets tend to be good at discounting the next one or two years of earnings, but less good at taking the long-term view. The result is that steady compounders are often a source of excess returns. The question is, how do we find them?

After many years of searching, I’ve come to the belief that one of the strongest signals we receive as investors is also one of the oldest: dividend growth. This paper is all about why dividend growth signals steady compounding.

Before we start, it’s vital to remove a potential source of confusion. Dividend growth is not the same as dividend yield. Stocks with high dividend yields (think British Telecom, with a 6 per cent yield) are targeted by value managers who try to generate returns by buying companies with low price-earnings (PE) multiples and high yields. 

Dividend growth, by contrast, is pursued by growth managers targeting companies with strong prospects for growing their cashflow across the ups and downs of economic cycles. These are companies like L’Oréal and Atlas Copco, with durable competitive advantages and high returns on capital, which are reinvesting a portion of their earnings for future growth while consistently paying dividends to shareholders.

As the name suggests, dividend growth is very much a growth strategy, albeit ‘core-growth’ rather than ‘high-growth’. It’s about long-term steady compounding.

This style is probably best-known in the US, where there are long-established funds such as Vanguard’s Dividend Growth Fund, launched in 1992, which has almost $50bn of assets under management today. 

The dividend growth wish list

The connection between dividend growth and long-term compounding can be summarised in a few short sentences:

If a company is willing and able to commit to growing its dividend for many years into the future, across the ups and downs of economic cycles, it must possess several attributes. These same attributes significantly raise the odds of it delivering long-term compounding in its earnings. This compound growth in earnings and dividends is likely to drive outperformance of the wider market over time.

Below I’ve spelled out several of these attributes in more detail. I like to think of them in three groups, each of which has characteristics that allow a company to pay dividends today, through downturns and into the future:

1. Today
   This group includes a return on invested capital (ROIC) well above the cost of capital, generating the profits required to pay shareholders. Those profits must then be converted into genuine free cash flow, and managers must display capital allocation discipline when deciding how much the company will reinvest and how much it will allow for dividends.
   
   
2. Through downturns
   If a company’s pay-outs are too high and profits subsequently fall, the dividend will have to be cut. A commitment to paying out during tough cycles, therefore, requires a prudent pay-out ratio. Companies also need a strong balance sheet to remove the risk of cash calls threatening the dividend. They should remain solidly profitable at the trough – even in a deep recession they should not make losses.
   
   
3. Into the future
   To support continued increases in its dividend, the company should have a long runway for growth. It must also be reinvesting at good returns and working well organisationally – it should be confident in its ability to execute on opportunities in the long term, with its flywheel humming, so to speak. And it should be managed with a
   long-term mindset.

Attributes required for a company to commit to dividend growth

Look down this list and you’ll realise it is a compelling set of signals for long-term compounding of earnings, as well as dividends. Essentially then, when a company commits to paying a growing dividend for the long-term, it is sending shareholders a strong signal that it could also be a long-term ‘steady compounder’.

This wish-list might make it seem like picking these companies is a tick box exercise; that is not the impression I want to give. Although commitment to dividend growth is a strong signal of steady compounding, it is not an outright guarantee. 

Some companies commit to paying a dividend they can’t afford, or which they can’t realistically hope to grow. As experienced stock pickers, we need to make a judgment about whether a company genuinely possesses the qualities outlined above. Assuming our analysis is thorough, this will help us maximise the chance of long-term returns.

Examples from experience

We can point to multiple companies that we have owned for our clients which have been willing and able to commit to growing their dividends for a long time and gone on to grow their earnings per share (EPS) very nicely.

One such company which displays our desired attributes is L’Oréal, the beauty conglomerate. Our analysis of and meetings with the business over the years have consistently reinforced our conviction in its ability to pay out dividends and thus compound. It even pays a bonus to shareholders that have been on its register for
a long time.

The company earns a return on invested capital well above its cost of capital: typically, in the percentage range of mid-to-high-teens. It converts an average of 100 per cent of earnings into free cash flow and has a prudent payout ratio of around 50 per cent of earnings. Indeed it meets every attribute on our wishlist.

The graph below shows its outperformance compared to global equities (MSCI ACWI):

As we can see, L’Oréal’s compound annual growth rate (CAGR) has been four points higher than MSCI ACWI since 2000. By compounding its earnings at this rate for the past 22 years, it has delivered total returns well above global equity markets.

Interestingly, an investor could have paid a PE multiple of 101 for L’Oréal in 2000 and it would still have outperformed; such is the power of its long-term compounding.

What about research?

Aside from company examples, one important reason for our faith in this idea is that it’s backed up by academic research. 

One commonly cited example is a paper by Harvard Business School professor John Lintner, written in 1956 but still relevant today. Lintner studied nearly 200 dividend decisions by American companies and interviewed management boards to understand their motivations for raising or cutting pay-outs. He observed that companies were careful to increase their dividends only if they believed earnings had permanently increased. 

This finding supports the argument that dividends contain important information about a firm’s prospects – signalling strongly that earnings can be expected to grow in the years ahead.

Another noteworthy study in this area is by University of Pennsylvania professor R. Richardson Pettit, carried out in 1972. 

Pettit researched more than 600 dividend announcements by US companies and calculated the relationship between those and their share price performance. After adjusting for market moves, he found a strong positive correlation between dividend increases and outperformance. 

These results have been replicated by numerous studies over the years and are a foundation stone of the investment style.

What’s our edge?

So, there’s plenty of research supporting the argument outlined above. But what can the Global Income Growth (GIG) team bring to the table that’s different from other dividend growth managers?

The first string to our bow is that we are active managers. Passive managers targeting dividend growth are effectively screening for companies that have provided steadily growing dividends in the past – this leaves room for howlers. Take General Electric, for example. This company had a long track record of increasing shareholder
pay-outs… until it died. 

A backward-looking approach also ignores up and coming dividend growth stocks. Apple has been one of our biggest winners since we bought it for clients a decade ago, shortly before it started paying dividends. It wouldn’t have shown up in passive analysis because it didn’t have a historic record of dividend growth.

As active managers, we should be able both to avoid the howlers and identify future winners. We can add value both ways. 

Another string to our bow is our repeatable investment process, honed over the past decade-plus. We also benefit from working at a firm dedicated to growth investing. But the strongest advantage, I would argue, is our unusually long time-horizon. Many of our investments have been portfolio holdings for more than a decade.

Dividend growth requires patience. It’s about long-term compounding at 10 per cent per annum or more, rather than bursts of quarterly earnings. As long-term investors, Baillie Gifford’s institutional advantages are deeply relevant to this investment style. 

Read more from James in his companion article, How steady compounding outperforms in the long term.

Past performance is not a guide to future returns.

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