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Cutting Dividends to Create Value


There are a variety of recipes for making a 100 bagger, but the most reliable uses just two ingredients like a kind of financial martini: High returns on capital plus an ability to reinvest again and again at those high rates. Stir. Add olives, if desired. (Valuation matters, too, but these two are essential…)


But what if a company can reinvest but at lower rates of return than it does currently? Should it follow such a path, even if it means they have to cut the dividend?


There are cultural hurdles and biases at work that make it difficult for most people to get these decisions right. People are wed to their dividends for one thing. And lowering returns doesn’t sound good.


Which is partly why Mark Leonard’s latest shareholder letter is such a remarkable document. [Link]


Leonard, as you know, is the CEO of Constellation Software, Inc. (Disclosure: We own it at Woodlock House). Constellation has been a compounding machine for years and earns returns on capital employed of 30%+. Leonard and his team are widely regarded as among the best capital allocators around.


In his latest letter, a succinct, power-packed 2-pages, Leonard makes two important announcements that most companies would have a hard time making.


To begin, he talks about Constellation’s historical commitment to a high return on capital. Such a high bar invariably means they’re going to let some good deals pass by. And so, unable to find enough deals to meet this high bar, they pile up cash. And what they do with that cash is pay it out to shareholders in the form of dividends.


But, is that the way it should be done? At least one director has made a different case, as Leonard says in his letter:


“One of our directors has been calling me irresponsible for years. His thesis goes like this: [Constellation] can invest capital more effectively than the vast majority of [Constellation’s] shareholders, hence we should stop paying dividends and invest all of the cash that we produce, even if it means lowering our hurdle rates.”


Leonard finally has come to agree with that director. Now Constellation will look to invest more capital by lowering their previous high hurdle rate and, as a result, they will cut the dividend.


“I anticipate that [Constellation’s] return on investors’ capital will decrease,” Leonard writes, “but we will not have to return any of our free cash flow to shareholders.”


I wonder how many CEOs could say such a thing. It doesn’t sound good, but it is great news.


Why?


Focus on “Economic Profit”


If, as I often say, the key to 100 baggerdom is high returns on capital, why sacrifice them? Shouldn’t a company maximize its return on capital?


The answer is: If you can invest more capital at a lower return on capital, but still earn a good return, then you should do it. I like to use an extreme example to make the point: Say you invested $10,000 and earn 100% returns. Now you have the opportunity to invest another $10,000 that will earn a 50% return. Do you pass on the opportunity because it will lower your overall return on capital?


No, you wouldn’t. Because you still realize that a 50% return is attractive. And you’d rather put another $10,000 to work than sit on it.


Of course, in the real world, it’s not so obvious and our returns are never certain. But the logic is clear. You prefer to invest as long as the returns are good.


In their book Valuation, authors Koller, Goedhart and Wessels (KG&W) go through a case study where Lilly and Nate, who run a chain of clothing stores, have a similar decision. They can close under-performing stores to raise their return on capital. Should they do it?


KG&W say Lily and Nate should focus on “economic profit,” which they define as the difference, or spread, between your return on capital and your cost of capital multiplied by the amount of capital invested. You can think of the cost of capital as your opportunity cost. If you didn’t invest it, this is what you’d get. (That’s not exactly right, but it’s okay for our purposes here). So when I say a return is “good” what I mean is that the return is above the cost of capital.


In the KG&W example, Lily and Nate have a business with an 18% ROIC. They can improve it to 19% by cutting under-performing stores and freeing up $2,500 in capital. Should they do it? KG&W say no, because it will lower their economic profit.


Here’s the table they use to make the point:

(Another way to think about it is: If you had $2,500 back in capital, you could only reinvest it at 10%, your cost of capital. Obviously, you’d prefer 18%.)


KG&W’s advice to Lily and Nate is, I think, counterintuitive to a lot of people. Most people would instead cheer for a company that closed under-performing stores, freed up capital and increased its ROIC. But it may not be the right call. This table gives you the math, or logic, you have to think through to figure it out.


Back to Constellation and Dividend Cuts


In Constellation’s case, they are earning such high returns on capital, they can stand a little degradation to put more capital to work. I’m confident that the opportunities they are letting slide by are good opportunities, though lower than their current return on capital.


If you can’t trust this team to make the right call on future deals, then you don’t want to own Constellation’s stock. Given their track record allocating capital over many years, I’m delighted with their decision.


And that means I also love the idea of cutting the dividend.


As you know from my last post, I was doing some work on “Swedish compounders” and one annoying thing I found is that most mindlessly declare how they promise to pay a certain percentage of their profits as dividends. It’s like a badge of honor for them. Here are firms with high returns on capital and who seem to have plenty of opportunities to reinvest, yet they’re automatically giving one-third to one-half of their cash profits back to shareholders instead of reinvesting it.


The cultural bias in favor of dividends is widespread. When I wrote 100 Baggers some readers protested the section where I basically tell people they shouldn’t be looking for dividends. Thomas Phelps, the author of the first book on 100 baggers, also saw dividends as costly. He wrote “dividends are an expensive luxury” because they slow down the potential rate of compounding capital.


Ideally, as an investor, you want a firm that reinvests as much of its profits as possible at high rates of return. Any payout to you is a leak in that compounding cycle.


Note, this only applies to those rare and wonderful businesses that can mix that classic financial martini of 100 baggerdom. A lot of mediocre businesses with marginal returns and no reinvestment opportunities should pay dividends. But I’m not interested in those kinds of opportunities. I’m interested in businesses like Constellation Software.


Leonard’s letter just upped my conviction on the stock. I think there is a long runway yet and I’m excited to see what Leonard and his team do.


Thanks for reading!


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Published: February 18, 2021

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