Episode #12: “Why ‘Shareholder Yield’ Beats ‘Dividend Yield’”
Guest: Episode #12 has no guest, but is co-hosted by Meb’s co-worker, Jeff Remsburg.
Topics: If you’re a dividend investor, Episode 12 is for you. Yes, historical market data tells us that dividend stocks outperform the broad market. But that’s where too many investors stop. That same historical market data suggests we can improve our dividend-strategy returns—significantly—by a few tweaks. What are they? Well, paying dividends is just one of several ways that corporate managers can return profits to shareholders. They can also buy back stock and pay down debt (a subtler form, but valuable nonetheless). Together, we call these three returns “shareholder yield.” Shareholder yield provides investors a more holistic perspective on the degree to which corporate managers are sharing profits with investors. So when an investor limits his or her analysis simply to dividends, he/she runs the risk of overlooking companies that might be returning major profits to shareholders—but in less visible ways than dividends. That’s a problem because it turns out, when we combine these three yields, this “shareholder yield” strategy has posted better historical returns than dividends alone. How much better? Find out in Episode 12.
Episode Sponsor: Soothe
To listen to Episode #12 on iTunes, click here
To listen to Episode #12 on Stitcher, click here
To listen to Episode #12 on Pocket Casts, click here
To listen to Episode #12 on Google Play, click here
To stream Episode #12, click here
Comments or suggestions? Email us Feedback@TheMebFaberShow.com
Links from the Episode:
- Shareholder Yield – Meb Faber
- How to look up fund valuations on Morningstar
- The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success– Thorndike
- “The High Dividend Return Advantage” – Tweedy Browne
- 2011 Global Investment Returns Yearbook
- “The Importance of Dividend Yields in Country Selection” – Michael Keppler
- “Dividends, Share Repurchases, and the Substitution Hypothesis” – Grullon and Michaely
- “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?” – French Fama
- “Taxation, Dividends and Share Repurchases: Taking Evidence Global,”—Jacob and Jacob
- “The Importance of Dividends and Buybacks Ratios for Gauging Equity Values” and “When Will Apple and Google Start Paying Dividends” – Jeremy Schwartz
- “Share Repurchase From All Angles” – Michael Mauboussin
- What Works on Wall Street – James O’Shaughnessy
- “Enhancing the Investment Performance of Yield-Based Strategies” – Gray and Vogel
- “The Dividend Challenge” – Faber
- “What You Don’t Want to Hear About Dividend Stocks” – Faber
- “The Case for Global Dividends” – OSAM
- “Buybacks Beat the Market” – Hulbert
- Here is a discussion summarizing Buffett’s thoughts on dividends in his 2012 letter to shareholders
- “When Measures Become Targets: How Index Investing Changes Indexes” – OSAM
- “Will Dividends go the way of the Dinosaur?” – Skinner
- Free Cash Flow and Shareholder Yield – William Priest
- “On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing” Griffin
- “Asset Growth and the Cross-Section of Stock Returns” – Schill, Gulen, and Cooper
- “How Tax Efficient are Equity Styles?” – Israel and Moskowitz
Transcript of Episode 12:
Welcome Message: Welcome to Meb Faber Show where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Sponsor Message: This podcast is sponsored by the Soothe app. We all know how stressful investing and volatile markets can be. That’s why I use Soothe. Soothe delivers five-star certified massage therapists to your home, office, or hotel in as little as an hour. They bring everything you need for relaxing spa experience without the hassle of travelling to a spa. Podcast listeners can enjoy 30 bucks to their first Soothe massage with the promo code MEB. Just download the Soothe app and insert the code before booking. Happy relaxation.
Meb: Hey, everybody. It’s Meb. It’s summertime here in Los Angeles. So we thought we would do another topical research chat today, again, with Jeff. Welcome, Jeff.
Meb: You know, I thought today we’d talk a little bit, this could probably be a short one, on the topic of shareholder yield, which is our second book, our first self-published book, because there’s a lot of misconception going on about yield investing. Before we start, I’m gonna say this one more time. T-Rex arms, alligator arms, listeners out there, take 10 seconds. Go leave us a review. Again, it’s anonymous. I’m not gonna know who you are. Go to iTunes. Just click the number of stars. You can write something if you want or not. I’d really appreciate it. It makes all of our effort worthwhile. So, Jeff, I’m just gonna start and start jabbering. You feel free to interject at any point, ask questions, stop me, repeat something at any time.
Meb: So dividends, you know, people love dividends. We’ve been talking about dividends a little bit on other podcasts. We talked a little bit about them in tax efficiency, inefficiency. But let’s take a step back. And the way that we started this book was with an old Buddhist/Hindu parable. And it was about the five blind men and the elephant. It exists in many different traditions, and the names change or whatnot. But usually, it’s a wise man or a king or someone who’s having five blind people or blindfolded people touch an elephant describe what they’d feel. And the blind man may feel the elephant’s tail and say, “I feel a rope.” And the other may feel the elephant’s leg and say, “I feel a tree trunk,” or whatever it may be. The takeaway from the story was always that while you may think you know what you’re describing or understanding, it’s really only part of an overall picture.
And this is what we kind of led into the topic of the book with dividends, because most people when they think about companies and stocks, they think about the operations. That’s the sexy part, right, where Tesla makes this incredible car or Facebook, you know, the operations of the actual company. And while it’s certainly important, equally important is the role of capital allocation. In many cases, the future success of the company that capital allocation plays is often overlooked. So there’s a really good book that Buffett actually recommended a few years ago that talks all about this, called “The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success.” It’s by Thorndike. And I’m gonna read a long quote here, so stick with me.
And he says, because it’s so accurate, he says, “CEOs need to do two things well to be successful, run their operations efficiently and deploy the cash generated by those operations. Most CEOs and the management books they write or read focus on managing operations, which is undeniably important. Basically, CEOs have five choices for deploying capital, one, investing in an existing operations, two, acquiring other businesses, three, paying down debt, four, repurchasing stock, and three alternatives to raising it, tapping internal cash flow, issuing debt, or raising equity. Those are the tool kit. That’s all you can do. Over the long term, returns for shareholders will be determined largely by the decisions the CEO makes in choosing which tools to use and which to avoid among these various options. And in fact, this role just might be the most important responsibility any CEO has. And yet, despite its importance, there are no courses in capital allocation at the top business schools.”
All right, that was along quote. But let’s review that for a second. There’s only five things a company can do with its cash, all right? Again, it can reinvest in the business. So Tesla can do R&D to build new cars. It can pay down debt to the extent it has any. It could acquire another business, like Tesla and SolarCity just did. It could pay a dividend or can buy back stock. That’s it. That is only things a company can do with its cash.
And so if you’re thinking about investing, historically, dividends focusing on one of those, a company paying dividends, has been a great way to invest. So if you go back to 1900, there is a huge stack of research on dividends. I mean we’re talking about French-Fama, you know, took dividend stocks back to the ’20’s. They outperformed high-dividend new orders, outperformed low-dividend new orders by about 3 percentage points a year. There’s a great Tweedy, Browne study called the High Dividend Returned Advantage that has a lot of dividend studies. One of my favorite groups of professors, Dimson, Marsh, Staunton, they have the “Triumph of the Optimist” book. They looked at UK stocks back in 1900, same thing. In almost every scenario, it’s even better if you compare countries based on dividend yield, they all outperform by a few percentage points a year and, depending on the time frame, could be even higher than that.
And so dividends have been a wonderful way to invest [inaudible 00:06:22] on dividend stocks for as long as we can remember. One of the challenges in markets is always asking the question is this time different? Has something changed? In many cases, the answer is no, that, really, people are looking at a certain time frame and thinking that it’s different. But something has already occurred in history. But in dividends, there was actually a structural change that happened in the early ’80’s.There’s a couple of clues to this. One is if you look at the payout ratio of dividends, it’s been declining ever since the early 20th century. If you look at dividend yield, has been declining. Fewer companies are paying out less and less in dividends. So it used to almost be 100% of S&P 500 companies pay dividends. Now, it’s declined to about 75%. NASDAQ, it’s down I think to around 30%.
And so you take a step back and say, “Is that just companies’ preference, or is there a reason for that? And SEC passed a rule in 1982 called 10b-18. They gave companies safe harbor for purchasing their own stock. And there’s a good paper on this called “Dividends Share Repurchases and the Substitution Hypothesis. We’ll certainly link to all these again as we always do in the show notes.
Finance 101, Investing 101, many people get this wrong is the dividends and buybacks are the exact same thing if a company’s trading at intrinsic value, and there’s no tax differences. It’s literally the same equation. And most people don’t really understand that. But what happens is if you incentivize companies to buy back stock by having different tax rates, which we’ve had over time… So in half of the past 40 years, dividends have been taxed at higher rates than long-term capital gains. And so if you look at charts during tax periods, dividends were disadvantaged for most of the ’80s. And so fewer companies started paying out less in dividends.
Then a similar tax rate for the early ’90s, disadvantaged again till ’04, and it changes how company behave. And that’s not just in the U.S. There’s a paper, one called…let’s see…it’s called “Disappearing Dividends: Changing Firm Characteristics.” There’s another one called “Taxation Dividends and Share Repurchases.” And they find that, you know, if you look at dividends and share repurchases across countries, depending on the tax regime, changes absolutely how they behave. And that makes sense.
And so what you’ve seen, particularly the U.S. starting the early ’80s but really ramping up in the late ’90s, is buybacks become a much, much bigger part of how a company distributes its cash. So, really, when it happened, I think, for the first time in the late ’90s, buybacks surpassed dividends as a route for companies to distribute cash to the shareholders and, I believe every year since, have surpassed dividends as the amount that people have paid out.
Jeff: Let me cut you off real quick on that. So what are your thoughts on whether or not you truly believe that that is altruistic versus companies realizing that “Hey, yeah, we can return some cash to shareholders. But it doesn’t hurt that we’re also potentially manipulating earnings per share by buying back our own shares here.” I mean is that really…
Meb: I used to be much more negative on CEO’s ability and their reasoning for buying back shares. So, yes, there is some share-based common s–… And it’s also important, by the way, to look at net buybacks. So one easy way to do this is just simply look at shares outstanding, change, because if you look at simply how many shares a company’s buying back, it’s ignoring how many shares they’re issuing. And a lot of tech companies, a lot of companies that issue a lot of options-based compensation are serial diluters, meaning they’re diluting their shareholders. And so that’s much worse than a company buying back stock, in my opinion. So as a shareholder, you don’t wanna get diluted. So you have to look at net buybacks or net issuance.
So I used to be much more pessimistic on the CEOs, because, in general, buybacks and mergers and acquisitions are much more volatile than dividends and reinvesting in business capital expenditures. So both of those are very low-volatility. But acquisitions and buybacks tend to follow the business cycle a little more. So you see them peak when times are good. You see them kind of bottom out during recessions as well as big bear markets. And so my thoughts of if you take a look at aggregate buybacks, you often say, “Huh, it looks like they’re buying a lot at the top and selling at the bottom. What a bunch of morons!”
But a buddy of ours, Patrick O’Shaughnessy, is often looking…and we’ll get to this in a minute…is looking at when the CEOs buy back stock based on their conviction levels, meaning the guys that are buying back, say, 1% of their stock per year versus the guys that are buying back 5% versus the guys that are buying back 10%. And you find some really interesting takeaways. And the guys that are buying back the stock that’s really cheap tend to be the high-conviction ones. The ones that are buying back most stock, the stocks are actually cheap. The ones that are issuing the most stock, the stocks are actually expensive. So takeaway is that they’re no dummies. However, are there a bunch of perverse incentives? Absolutel, you know, the share-based compensation being one as well as the options.
But in general, the whole point of kind of that intro is saying, look, the distribution method by which companies distribute cash has changed. The old John Maynard Keynes quote, he says, “When the facts change, I change my mind. What do you do, sir?” Right? So, all right, if you are just looking at dividends at this point, you’re literally missing half of the coin. If you just look at buybacks, you’re missing the other side of the coin. If you do either one of those alone, you’re making the same very basic investing mistake. And it’s a very basic one. And you see this happen all across the industry.
And so what a good takeaway is that if you look at the aggregate amount, you know, while dividend yields are low on the S&P, if you include buybacks, then the actual distribution amount isn’t so bad. So it’s what we call shareholder yield. In the academic, there’s a lot of different phrases for this. So we call it shareholder yield, which is dividends and net buybacks. We actually include debt paydown. But because most of the world doesn’t, we’ll just call it dividends and buybacks, makes it a little easier
And so that theoretically makes sense. So if you’re looking at buybacks, you know, Buffett says for companies trading… And this is the whole key with the buybacks is where does the stock trade? Buffett always says, “If a company’s trading below intrinsic value, there’s no better use for that company’s cash than to buy back their stock.” And Buffett’s an interesting example, because Berkshire’s never paid out a dividend, and that’s not quite right, because they paid out a 10 cent one in 1967. And he famously jokes that he must have been in the bathroom when they authorized that dividend. But they never paid out a dividend. But he said many times, he said, “I am ready to buy back stock. But you have to have an objective measure that it’s undervalued.” So with Berkshire, he used to say 1.1 times book will be buying stock hand over fist. I think he bumped that up to either 1.2 or 1.3 times book. And it’s gotten pretty close over the years. But you need to have an objective measure.
Most CEOs are always gonna think their stock’s cheap, because a lot of CEOs have that sort of Empire Building kind of approach on markets. But in general, if you have an objective methodology which to buy back a dollar’s worth of assets for 80, 70, 60 cents, then it’s a wonderful way to invest.
Jeff: So do you suggest any specific objective measures like that in your book, anything tangible to look at?
Meb: We do. And if you’re looking at value in general, remember all the value indicators are similar. They have different flavors. So we like to use a value composite, meaning we’ll look at like five, six, seven of the value indicators, blend them, so you get a good idea across a number of them if something’s cheap or if something’s expensive. And the value is the big sort of lever in this equation where the last thing you want as a company buying back 5% of their shares is it’s expensive. That makes no sense. And so a lot of the buyback funds don’t have a value filter. Same as a lot of the dividend funds don’t have a value filter. So it’s a moronic idea in my mind to buy high-dividend stocks or high-buyback stocks that are expensive. In O’Shaughnessy, there’s some good research here too. This talked about putting it into quadrants of shareholder yield where you’re buying back shareholder yields, companies that are cheap stocks versus expensive. And obviously, the cheap ones do much better.
Jeff: So your value screen would start any discussion before we even get to this?
Meb: Yes, you can do value first then shareholder yield or shareholder yield first then value. You kind of end up in the same place. You know, you get rid of the bad stuff eventually. But let me let me take a step back, and then we’ll talk a little bit more about the investing side.
And so one of our favorite researchers, Michael Mauboussin, has a great paper called “Share Repurchases From All Angles.” And I’ll read his quote just to give you a little more color. And he says, “The purpose of a company is to maximize long-term value. As such, the prime responsibility of a management team is doing best financial, physical, and human capital at a rate in excess of the opportunity cost of capital. Operationally, this means identifying and executing strategies that deliver excess returns. Outstanding executives assess the attractiveness of various alternatives and deploy capital where value is highest. This not only captures investments, including CapEx, working capital and acquisitions, but also share buybacks. There are cases where buying back shares provides more value to continuing shareholders than investing in the business does. Astute capital allocators understand this.”
And at a certain size, a lot of companies… You know, when you’re the Apple size, how many projects are you gonna be able to build that are gonna be able to generate the return they need for it to move the needle on their stock? You know, and so in many cases, a lot of companies, when they get that size, they have to start distributing their cash flows. Otherwise, they can’t use it.
So what else? Let’s see. So we talked about intrinsic value. So how does this work, you know? And so there’s a lot of academic studies that have looked at dividends and buybacks and shareholder yield. One comment just for color, like the S&P today, to give you an example. S&P yields about 1.57%, somewhere around there, 2% maybe, I think. Russell’s even less. But if you look at the median stock in Russell, it’s like .3%. If you look at the median stock in the S&P, 1.7% dividend, so low. If you look at the median buyback of those companies in those indexes, for the Russell, it’s negative. So you’re actually owning companies that are issuing stock. And for the S&P, depending on if you look at average or median, but it’s basically zero. So you end up with a shareholder yield and net payout yield that’s really no different from the dividend yield. And in many cases, that’s the case.
If you were to sort by shareholder yield, so if you sorted the Russell and bought the top quartile, top 25% of stocks, you end up with a higher dividend yield than the S&P, so it’s around 2. But you tack on about a 3% to 4 % buyback yield. And so you end up with a shareholder yield, what we’d call around 6.7%[SP]. If you include debt, you get up to around 9%. So you end up with a much higher cash distribution.
And one of the cool studies from SocGen was that they showed this actually correlated very highly with free cash flow characteristics. So a company that was cheap on price of free cash flow, because… And that makes sense. So for these companies to be distributing 7% percent of their cash and using it, they must have the cash in the first place.
Jeff: Yeah, are we in essence really just…these are screens to sniff out companies that are operationally doing a lot of good things with their cash. I mean, it’s really, we’re finding good value here, right?
Meb: Yeah, you end up with higher-quality companies. So if you go back and test this… So O’Shaughnessy’s taking it back to the ’20s. We took it back to the ’70s in our book. And we said, for example, here’s the numbers back… Oh, sorry, we took it back to 1982, which is the modern era of buybacks. But again, O’Shaughnessy took it back to the ’20s. Since ’82, S&P did 11% a year, rounding up pretty awesome. This is ’82 to 2011. And we’re actually gonna update this book probably in the next year. Dividend yield, 13.4. Buyback yield, 13.2. So both of them beat the S&P by about 2 percentage points a year, that’s great, a little over 2 percentage points. Shareholder yield did 15%.
And so it’s kind of this holistic way of looking at it. And the example I used to give in talks was if you went up to your niece or nephew and said, “Look, I’m gonna give you a couple of choices. I’ll give you $20 cash, choice A. Choice B, I’ll give you a $20 dollar Amazon gift card. Choice C, I’ll give you a $20 Amazon gift card, but you give me $20 cash. Or choice D, I’ll give you a $20 gift card and give you $20 cash. Every child on the planet is gonna take D, right? You get $40 instead of getting $20 through various payments or C getting a netted out zero. And that’s the way I look at dividends and buybacks. So you know dividends or buybacks, how you pay them out, everyone would always choose the higher distribution in my mind. But people, for whatever reason, are preconditioned to not like buybacks and to much prefer dividends.
Jeff: It’s less visible. So many investors are sort of preconditioned to need that income generation.
Meb: And it is hard too. So you go to a lot of websites. You can’t find buyback yield as easily as you can find dividend yield. You know, it requires you to dig around, have a little extra calculation. YCharts is a good site for this. And part of it’s the brand. So we did an article called “The Dividend Challenge” where we were basically talking about the old school, if you remember, the Pepsi taste tests where Pepsi would do these blind taste tests with Pepsi and Coke, almost always found that people preferred Pepsi. And then Coke would do the same tests and, much to their dismay, also found that people preferred Pepsi. And if you remember, if you then told people what they were ahead of time and did the blind taste…well, you show them, “Hey, this is Coke. This is Pepsi,” then they preferred Coke. And Coke vastly outsold Pepsi.
You know, so a lot of it has to do with the brand. So is it the association you have of the Coke commercials and the polar bear or Santa Claus or drinking Coke as a kid or whatever it maybe? It’s the brand of Coke. If you remember it, it actually led to the disastrous decision where the blind taste test Coke said, “Well, crap, it’s clearly because Pepsi is sweeter. We’re now gonna launch New Coke.” So that led to the abomination known as New Coke. But really, it was about the brand.
So dividends, you could say they have a great brand. This becomes dangerous, though. So a couple of things, one, if you look at dividends stock valuations now…and we’ve talked about it a lot before, so it’s probably the last I’m gonna mention this on the podcast…and you take dividends that have worked historically because they’re a value tilt and dividends that historically traded at a 20% to 40% discount to the overall market based on valuations. And this goes going back to the ’60s. For the first time in the past few years, dividend stocks, not only don’t trade at a discount, they trade at a premium to the overall market. This hasn’t occurred in the 50, 60 years prior and really until the last few years. And a lot of this has to do with the chase for yield and the chase for people looking for income anywhere.
Now, no one wanted dividend stocks in ’99 when they traded the biggest valuation discount ever to dividends. Again, you don’t have to believe me. Go to Morningstar. Type in any of the top five largest dividend, ETFs, or mutual funds. And the caveat is if they have a valuation filter, it’s a little different, but particularly the biggest, which manages over $20 billion. Type that in. Look at the holdings. And look at the valuation. And it has, I believe, I have to recheck, in every case, it’s more expensive than the S&P 500 and ironically has a lower dividend yield than the S&P 500.
So [inaudible 00:22:35] these very expensive companies, they’re having a monster year. If you look at utilities, they’re up 20%.But they have a P/E over 20. And we’re talking about utilities here. You know, this is much higher than they normally have been. And we’re seeing this echo in other places where money is flowed into. It’s echoing in their low-vol stocks. It’s echoing in certain other areas, the smart beta. Its problematic. So it’s problematic, one, because dividends are expensive. It’s problematic, two, if and when rates ever go up…that could be 2016. It could be 2018. It could 2020. Who knows? If and when we have an interest rate rising cycle, dividends historically underperform in a rising rate environment. And so I think O’Shaughnessy takes it back to 19…
Jeff: 1920s, I think.
Meb: 1927, and found that in the average rising rate environment, U.S. dividend stocks underperform the broad market by two and a half percent a year where shareholder yield strategies outperform by one and half percent a year and shareholder yield outperforming 12 out of 16, rising rates for dividends were only half.
Jeff: Okay, so this is a little red flaggish. So does that mean then that you have to wait these various yields differently rather than to look at the total net payout ratio? I mean it could be you have two different companies with the same that payout ratio but different mixes of how you got there.
Meb: McKinsey did a study that showed that people didn’t care about the mix. All they care was the aggregate amount. And so if you look at buyback indexes right now, so shareholder yield strategies look more similar to a buyback index, because a buyback index has a reasonable dividend yield, but not much. But it has a big fat buyback yield, because companies have been buying back stock hand over fist. So it ends up looking more like a shareholder yield index currently. That doesn’t mean it always will. So in bad times, big bear market companies stop buying back stock. So then what are you gonna do with the buyback index? If all the sudden, companies, they aren’t buying back stock, what happens to your index? I have no idea.
You know, literally, it’s the most nonsensical investment approach I think I could ever think of. You know, a lot of people talk about backtests. And they’ll say, “Well, you know, I think Vanguard did a study that showed back tax returns for how many? over ten years prior to publication and then post-publication of that index.” Actually, for the shareholder yield, I mean we’ve been writing about this since I think ’08. But the shareholder yield strategy post-publication of the book actually had its best year after publication. I think 2014 shareholder yield had a monster year. Anyway, you know, we vastly prefer the strategy. We think it makes a lot more sense than traditional dividend strategy and particularly right now.
Jeff: I haven’t heard you talk too much about the debt part of all this. Do you give that equal weight?
Meb: Well, so there’s been a lot of papers. There’s another paper called, I think something like, “Total Assets.” That might not be the name of the paper. But what it’s basically saying is if you look at total assets of the firm…because, historically, mergers and acquisitions have not helped stock returns or companies. So in general, they destroy value. Basically, any sort of adding of assets in empire building is not something you want with a company. But Charlie Munger famously says, “Look for the cannibals,” meaning look for the companies that are eating themselves, the share account. You know, the debt side is you get a lot more correlation with high quality, low leverage. This helps you during bear markets. When times are good, it’s the opposite. You know the more leverage companies work better but low leverage low debt is something that’s easier to live with usually has lower vol lower drawdowns. Particular during a bear market which we haven’t seen in going on almost ten years now. You know eight years so the debt pay downside is a similar metric. It’s a little squishier for a number of reasons but I think it’s an important component. Again it’s shown to add value over time but it’s not the two biggest ones to me are dividends and buybacks.
Jeff: I mean I think they’re clearly the biggest.In today’s low rate environment if you’re able to buy back $100 million with a debt that you know 6% and reissue the same amount at 3%. I mean that’s….
Meb: It goes back to the equation of where does the C.E.O. find the best return on the capital? Maybe you have an early stage tech company that’s just crushing and they have a high return on capital. Well they shouldn’t be paying out dividends and buybacks So there’s a couple of the things you can do to the strategies.So one we show in the book the adding a momentum sort on the final shareholder yield works great. Add some performance. You know we look at it in foreign markets and foreign markets in general how they don’t have the same culture of buybacks in the developed an emerging market as much as the U.S. does. That’s changing. So you’re seeing it more in Japan. You’re seeing it more in places as are becoming more shareholder activism,more shareholder friendly to where the buybacks are becoming more commonplace. But up till now it’s been a more US centric phenomenon.Any more thoughts before we wind up?
Jeff: Yeah. If you initially I think the quote you gave us talked about the five ways that managers could allocate their capital. Shareholder yield we’ve really focused on three the dividend yield, the net buyback yield in the debt yield. So I haven’t really heard you talk much about using money to reinvest in the business as much and I wonder if you know reinvestment really is needed to I guess grow future returns your future cash flows. So if you’re really looking only at how you’re using money for the returns to shareholders is that inherently backward looking. Whereas you wanna be involved with companies that are fueling their future growth in their future cash flows.
Meb: Sure if you can to tell you if you can tell me the future growth. Accurately and you know what these companies are gonna invent five years from now.But no I think earnings growth there’s a lot of metrics that I think would correlate nicely with a with a growing company. You know but you’ve got to balance that historically.Some of the better metrics is values. You wanna be buying cheap companies that are high quality. So in our screens that we use for our funds we incorporate a number of variables.It’s not just shareholder. Yet although I think that’s fine but we include measures through quality. We include measures for value and then a final sort on momentum as well. But yeah I mean you wanna great company that has a great business I mean ideally that’s the trifecta where you have a company that’s crushing it on the operational side.
You know they’re not doing as much as stupid M& A and they’re distributing lots of free cash flow which means they have a lot of free cash flow in the first place. They kind of all come together and if you look at a laundry list of shareholder yield companies.A lot of companies you would expect to be very high quality companies. If you look at a lot of high dividend companies. The high it’s often poorly understood the highest quartile or quintile of dividend yield isn’t the highest performer. It’s actually the next 20% down and it’s because the top dividend yield. You don’t realize that dividend yield so you may have an 8,9,10 % dividend yield or they very rarely pay that out. And on top of that they’re crappy companies they typically have a high leverage. So they’re paying out way too much of their cash flow as earnings and so traditionally they’re not the best performers whereas in shareholder yield the highest fractile is the best performer which is the way you wanna see it kind of happen.
Jeff: I can see total shareholder yield being very valuable on a relative basis. For instance look at the net payout of Apple compared to Tesla and you would assume Apple is gonna be significantly more than Tesla’s. On an absolute basis do you find it’s helpful to use this looking to Apple’s I guess historical net payout and comparing where they are now to where they were three years ago ?
Meb: The buybacks tend to be a little more transient.You have people that will announce buy backs.Then what they actually do and we always do what they do rather than what they say. And so we’ll look at share shares outstanding over the past year. You could average over the past three years but you wanna see someone that’s consistently buying back stock or has a methodology for it and there’s research has shown there’s a white paper that says there’s basically a buyback echo. So the buyback effect this year continues for the next four years. I think four or five years but it but it can be more transient which makes it tough and then be one of which is one of the biggest kind of Illuminations I think for a lot of people. You can have a company that has say a 3% dividend yield what is actually issuing four percent shares per year which means you actually have a negative yield. So you may think you have this great company 3% dividend yet again this fat dividend yield but you know on the right with the right hand there picking your projects I missed which is so if your dividend like like look fun. I don’t care. Ignore buybacks to your peril.
But at least take a take a look at share issuance because a lot of these companies are just serial diluters. So there’s about 80% of companies we call shareholder friendly which means they have a positive yield of some sort but about 20% have negative yields. We call these the capital destroyers. That’s not a trivial amount and so just being able to get rid of you know we talk about Factor screening in value where we screen off. We pick the best stuff the cheapest stuff with the best cash flows or whatever. We’re also avoiding the really crappy stuff and by having a market cap weighted index or equal weighted you’re guaranteed to own the stuff that serially diluting you by 3%.You’re guaranteed on the expensive stuff. You’re gonna own the over leveraged stuff and in general I don’t think that’s you know a smart approach to investing. So for a lot of people that do just dividends and they’re ignoring not only buybacks but also valuation.I think it’s a very very sub par way to go about investing.
Jeff: So if your listeners are listening to this and they’re looking for a way to act on it and invest according to it.It seems like it’s kind of cumbersome. They have to go through all the 10K.’s and 10Q by hand looking to sort of add up all this stuff.Is there an easier way to do it?
Meb: No it’s not simple. You know we run a fund based on it. Epic runs a few funds there’s I believe a sharehold fund in Canada now but if you wanna if you want the actual data. You can do it by your hand. Ned Davis tracks some of it.Y charts is a good one. One of the only ones they require subscription.There’s a European site called Value Dash investing dot eu .Wes’s site at Alpha architects and there’s a handful of these kind of individual investor retail level screeners. So AAII has been a famous one historically Portfolio 123 which I think they include dividends now they used not to Zack’s.
They used to be survivor bias. I think they’re fine now of course Bloomberg and then there was one I wrote about a few years ago but haven’t looked at recently called blood hounds system or blood hounds something.So but itself is not as it is not as easy and that’s one of the reasons I think that it’s not as popular. Here’s another example we used to look at dogs of the Dow which is buying the ten highest yielding stocks in the dogs which is out of 30 and was a hugely popular strategy back in the 90’s and before but once that. O’Higgins published I believe the initial research.
Once that published it also coincided early with when companies started buying back more stock. And so that strategy hasn’t worked since. But if you look at what we call the cash cows of the Dow or the cows or the Dow instead of the dogs. It’s worked wonderfully since and for the same reasons because you’re getting the high shareholder you know it’s not just dividends and avoiding the issues as well
Meb: We’re cool look we’re probably in our time limit. You know we forgot last time but will add at this time on something beautiful useful and magical Jeff said he’s tapped out officially on all of his ideas.
Jeff: I will go think about it for next time.
Meb: We won’t pressure him into it but mine is insight I learned a few years ago that was kind of like a aha moment that almost embarrassed not to know but I query people on this. Every once in a while now and usually the people that know it be like yeah you idiot.Everyone knows that but at least half the room when I say this says oh man I didn’t know that that’s really cool and so this is it’s pretty simple one. But if you’re driving. And this is probably in the last 20 years so I don’t thing on older cars and you look down at the fuel gauge. There’s an arrow that points to which side the gas tank is on and I didn’t know that in most people don’t know.
Jeff: I don’t know that either.
Meb: I can’t tell you how many times I’ve driven in a rental car or even my own car which is even more embarrassing but there’s a little bit of a personality going into a gas station and not knowing which side on the net to back out and reverse and and move so that points to which side the gas tank is on so try it out. Take a look. Unless you have a car from the seventy’s. It’s probably updated. So again friends leave us a review. Thanks for taking the time to listen we welcome feedback we did our Q& A episode last week which we have lots of great questions but please send more feedback at the Mebfabershow dot com .You can always find the show notes another up mebfaber.com/podcast. Thanks for listening friends and good investing.