The pay-out ratio of companies listed on Johannesburg’s stock exchange has been rising steadily, with roughly half of company earnings being declared as dividends, notes investment expert Ian de Lange of Seed Investments. But he asks whether this is a good thing. After all, this could be an indication companies are finding fewer opportunities for business expansion – which could, in turn, result in lower profitability in future.
Before you choose a share on the basis of its dividend pay-out record, pay close attention to its long-term prospects. As Ian notes in his blog: “This is something that needs to be looked at very carefully on a company per company basis.” – JC
Profits: Retain or pay out?
Ian de Lange
We recently looked at the history of pay-out ratio of all listed JSE companies over the last 50 years and is displayed in the chart below. The pay-out ratio is the percentage of company earnings that a company declares out as a dividend. This will naturally differ from industry to industry and then down to the specific company.
All things being equal, at the early phase of a business’s life it will tend to require higher levels of capital for growth and as it generates profit, management will want to accumulate that capital in order to invest back into the business for expansion.
As a business or the industry it is in matures, it will have a reduced requirement to reinvest retained profits and so be in a position to pay out a higher percentage of profits as a dividend.
Many investors have as their main focus the divided that they receive on an annual basis. But just as important, if not more so, for investors are the retained earnings, which is that portion of the profit left after paying the dividend and forms part of the available capital. How a company puts this retained capital to work over the years will be a big factor in determining future profitability.
The portion of annual profits retained by a company each year and not paid out is essentially added to the capital of the company to be used for business expansion and therefore to generate higher profitability.
So, while there is always a focus on the earnings and dividends announced by a company each year, what is often of more importance is how adept management is at allocating the available capital at their disposal in order to generate future profit. In general, where a company has profitable opportunities to deploy available capital on which it can earn a superior return, it should be doing this as opposed to distributing too much of its profits to its shareholders.
Obviously it’s not always easy to compare one business with another. Some are more capital intensive and some far less capital intensive. Heavy industry type businesses, for example Sasol, normally require a much higher portion of yearly profits to be retained and invested into new plant in order to be able to grow future profits.
Other less capital intensive business such as Coronation, have the ability to pay out almost all of their annual earnings as dividend to shareholders and because they have low capital requirements, can still grow their annual earnings. In 2012 they had earnings per share of 217 cents and paid a dividend of 206 cents per share. This year are set to grow earnings by 100%.
A key factor that investors should look for, therefore, is how management have allocated capital and the returns that they have made. In many instances management have destroyed shareholder value by investing into sub optimal businesses. Conversely others like the management of Naspers have utilised the cash from their more mature businesses and invested it into other high growth businesses, earning a superior return on capital for the benefit of all shareholders.
Looking back at the overall payout ratio of all JSE companies then, while this ratio reduced in the 1960s and 1970s from above 50%, more recently that percentage has climbed from 35% to around 50%. It could be an indication that companies are finding fewer opportunities to which to allocate capital, which could in turn result in lower company profitability in the years to come. This is something that needs to be looked at very carefully on a company per company basis.
Ian de Lange is director at Seed Investments, an asset management company with about R1,2bn under management. It offers multi-manager portfolios as well as its Smart Beta fund, which was launched recently with R50m in seed capital. It has a strategic alliance with about 100 brokers and 15 wealth managers through Hereford Wealth Managers and acts as advisor for the Prescient Fund of Hedge Funds.
