Wherefore art thou Dividends?

The question of dividends when it comes to mutual funds is a tricky one, so let me try and share some perspective that I have gained over the last 18 years in the financial business.  I will try to explain the role and importance of dividends paid by individual companies and why this is a different issue at the mutual fund level.

First I’d like to say that the reinvestment of dividends by of business typically forms a large part of the total return that comes to investors in the business. The total return is composed of capital gains and reinvested dividends and if we look at the market indexes then we can clearly see that the gain attributed to dividend reinvestment is the largest part of the total return. What this means is that the owners of the shares have not spent the income produced by the shares but have bought more shares using that income.

The same thing takes place when a business conducts a share buyback. For example, a number of companies these days have excess cash on their hands that they don’t need for continuing business operations and they have to choose what to do with it.  They may:

a) invest it in new capital projects to improve the production of the company;

b) acquire other businesses that they think can be run more efficiently;

c) pay it out as a dividend to shareholders;

d) see that the shares of their own company are significantly undervalued and go out into the marketplace and buy back shares from the market and put them back into the treasury of the company.

This last strategy concentrates the future earnings of the company in fewer shares and so increases future returns. For example the family of Sam Walton, the founder of Walmart, has recently been buying back shares from the market because they see that their own business is one of the best investment opportunities available today.

Most money managers that I have recommended are what I would call active dividend seekers. In other words, with other things being equal they have a preference for companies that have paid dividends reliably over the past years and appear to have a sustainable dividend payout policy. However, this is not universal. For example, the Cundill Value Fund has often made investments in companies that pay little or no dividends and sometimes this is in fact preferred.  Since the Cundill team seeks companies that are priced very significantly below their intrinsic value, this may mean that the shares are viewed as distressed by the financial markets and in fact sometimes the companies are experiencing significant short-term distress.  A company in distress may seek to preserve its cash on hand by reducing or even eliminating dividends.  In some cases, the  Cundill team prefers that the company is not paying dividends so that they can keep their eyes on the cash and it stays inside the company where the business owners (and through them the fund managers) can see how it is being used.

This has happened with American financial companies over the last few years and also with European financial companies that have recently dominated headlines. For example, banks maintain a capital reserve that forms part of their financial stability. In several circumstances, regulators have required that banks increase their capital reserve and so the banks have been building their cash while paying less dividends than they could have. As an example, the managers of the AGF Global Value Fund have significant experience with and exposure to European banks and have been monitoring not only what the companies actually pay out in dividends, but the changes in their capital reserve ratios and the stream of income that they are earning that could be used to pay out in dividends as soon as they reach the new target reserve level. They have thus found that there are many companies that could increase their dividends by very large amounts on very short notice when they reach their target reserve. In a similar fashion, the Cundill team has made some significant investments in a few large American financial companies where the share prices have declined so significantly that they now represent what the Cundill team describes as the opportunity of a lifetime to own companies like this.  In cases like this the current dividends do not tell nearly the full story.

In other cases, the payment of dividends does not form a significant part of the investment policy of the fund manager. This is normally the case for fund managers that describe themselves as having a growth style. These managers are seeking companies that are using their cash flow to grow the company at above average rates and so the most efficient use of that cash is internal business growth.  When a company reaches a very large size it gets more difficult to find ways to continue to grow the business at the previous rate and this is often when companies will start paying  dividends or will increase their dividends instead of reinvesting inside the company. Microsoft is an example of a company that has grown so large that it has very little room to continue growing and so has become a cash and dividend generator instead of a business growth machine.  The Cundill Value Fund owns Microsoft because the managers believe the market does not fully recognize the strong cash flows the company can generate in the years ahead and its strong current position.  Inside the Mackenzie Universal American Growth Fund the manager has had tremendous success in identifying companies that are able to grow their business through good and bad economic times at a rate that is well above average.  While I am not sure about the average dividend rate of the companies in this fund I expect that it would be very low. Despite this, the fund has had higher than average returns and has held its value well during market declines.

Now let’s consider dividends in the context of a mutual fund. There is a category of mutual fund called dividend funds, which generally indicates that the funds are actively seeking a high dividend yield, but this is not exclusively true.  There are cases where most of the total return of the fund comes from capital gains, with a small portion attributable to dividends paid out to investors and then reinvested in the fund. In order to minimize the tax liability of the fund for all investors, the normal accounting policy of funds is to deduct the expenses of the fund against the income of the fund and in the case of equity funds dividends represent the bulk of the taxable income.  Expenses cannot be written off against capital gains.  Note that this is an accounting procedure and does not change the total return of the investment.  In all cases, the dividends earned by a fund are part of the total return of the fund and it does not matter whether those dividends are, for accounting or marketing purposes, paid to investors and then reinvested.

There are a number of funds where the distribution that the fund pays to investors is composed of both income and a return of capital. The return of capital portion is paid out by the fund to reflect the managers’ expectation of the sustainability of a long-term income stream.  For example, the manager may expect to earn a total return of 7% over the years after deducting expenses, but will almost  never have a 7% dividend net of expenses available to pay out to investors.  In a case like this the fund may set a distribution policy of 7% but the composition of that 7% will vary depending on the net dividends available for payment.  In a number of cases these days, investors can choose multiple versions of the very same fund that have different distribution percentages.  For example you may opt to receive no distributions and have perfect tax efficiency or to have 4%, 5% or 6% distributions from the fund.

When you change perspectives from dividends at the level of an individual company to dividends at the level of mutual fund you are looking at quite different  things. The one that counts for investment returns is the one that takes place at the level of business ownership.  When a fund manager examines the financial statements of a business he can see what the company is doing with its cash flow. Depending on the circumstances of the company it may make sense to pay dividends or not to pay dividends and there is no single right answer.  I think it is fair to generalize that most successful long-term money managers have a preference for companies that pay significant dividends over the long term.

Let’s take the case of the Trimark Fund, where we will find only a couple of dozen companies, many of which are currently paying very healthy dividends. The dividends are received by the mutual fund and form part of its total assets and its total return. Whether the dividends are retained by the fund and used to buy more shares by the fund manager or are paid out to the investors and then automatically reinvested to buy more shares of the fund has no impact at all on the total return of the investor who does not spend the money but reinvests it, but may impact the investor’s tax return.

I believe that many investors do not fully understand the potential effects when examining the dividend policy of an individual company and the policy of the mutual fund that owns that company.  I hope this little essay adds to your investment knowledge.