Why (also) bet on small dividends

Traditionally, when you start looking at dividends, you do what most people do: you look for stocks that pay the most. This seems logical at first glance. But savvy investors know that this approach is risky and counterproductive, because companies that pay out juicy dividends relative to their share price are very often in difficulty. So there is a good chance that the income for which you bought a stock will be reduced or even eliminated altogether.

With this in mind, dividend-oriented investors turn to a tried-and-true approach: stocks that pay slightly lower dividends but that grow on a regular basis, usually every year. This strategy works well because it forces them to focus on companies that are profitable over the long term. These companies have certain characteristics that allow them to produce abundant cash flow.

That said, there are also plenty of well-managed companies that know how to generate a lot of free cash flow and pay little or no dividends. The best-known example is undoubtedly Warren Buffett's holding company, Berkshire Hathaway. The fresh cash left in the coffers can be used by these companies to finance expansion, pay down debt, or buy back stock. The dividend is just one of many choices available to managers to create value for owners.

The universe of dividend-paying stocks can be roughly broken down into three categories:

• Those who display a distribution ratio greater than 2/3. This is typically the category of high yields that are expensive and/or risky. Most of the time these stocks appear cheap because of their attractive dividend yield, while the price is actually high relative to earnings, free cash flow, sales and/or assets. The dividend growth potential is low (there is even a chance that it will decrease). Swisscom is a good example of this type of business.
• Those with a distribution ratio of between 1/3 and 2/3. Here we enter a world well known to investors oriented towards increasing dividends. The distributions are rather in line with the market average. Since they are not excessive, they offer companies a certain margin of safety, which prevents them from having to lower or suspend them in the event of a drop in profits. Better still: if the cash generated is sufficient, they can even increase them each year. Allianz is a good example of this type of business.
• Finally, those that display a distribution ratio of less than 1/3. These companies pay little, very little, or even no dividends at all. There are many reasons. The company may be growing and needs cash to finance its expansion, organically or through acquisitions. It may also want to clean up its debts. Or it may have decided to buy back its own shares. Sometimes it is a tax-related choice. Often, it is a mix of all of that. The dividend growth potential is very significant. We have already cited Berkshire Hathaway as an example of a company that does not pay any dividends, we can also talk about Mory Industries which pays very modest distributions and is a good example of this type of company.

But what is the interest of securities that belong to the third category for an income-oriented investor? Indeed, he should rather try to maximize the dividends he receives from his shares.

The big advantage is that these securities are often cheaper and less risky than others. The formula distribution ratio = yield * PER in fact tells us that the distribution ratio is proportional to the PER (price to earnings), for a constant yield. Securities with low distribution ratios therefore not only have a margin of safety in relation to earnings to be able to ensure and even increase their dividend in the future, but they are also often traded at more affordable PERs than those of other categories.

As an illustration, among companies around the world that pay dividends and are currently trading at a PER less than 15 :

• 58.8% have a distribution ratio less than 1/3;
• 27.8% have a distribution ratio between 1/3 and 2/3;
• 9.2% have a distribution ratio between 2/3 and 100%
• 4.2% have a higher payout ratio than 100%.

Yet in the global dividend-paying stock market, there are only 44% currently paying dividends. a distribution ratio of less than 1/3. PERs below 15 are therefore over-represented among companies that pay out less than a third of their profits:

• 50.3% have a PER less than 15;
• 34.9% have a PER between 15 and 30;
• 14.8% have a PER greater than 30.

For comparison, there are fewer than 40% stocks worldwide that are currently trading at a P/E below 15.

These examples prove to us that the theory suggesting that stocks with low payout ratios are cheaper than others is often found in reality. Of course, it is possible to find companies that are still affordable in the other two categories, but it becomes increasingly difficult, especially after applying qualitative filters. By ruling out modest payout ratios from the outset, we unfortunately deprive ourselves of a very important choice.

If companies in this category also manage to create net free cash flows on a regular and progressive basis, they are then candidates to later become payers of generous increasing dividends. Once they have finished paying down their debt or financing their expansion, they will be able to reward their shareholders in hard cash.

Buying these companies is a bet on juicy future dividends. In the worst case, even if it were to be delayed, the company's ability to generate free cash flow and therefore finance its expansion, buy back its shares, etc. would in any case translate into value for the shareholder, by an increase in the share price. For investors who are lucky enough to reside in Switzerland, this is also an opportunity since stock market capital gains are not taxed.