Corporate Finance Topics Issue No A Crowded Field: Dividend Strategies That Differentiate

Transcription

1 Corporate Finance Topics Issue No A Crowded Field: Strategies That Differentiate

2 A Crowded Field: Strategies That Differentiate This is not an equity research publication. Corporate Finance Topics is a publication of Bank of America Merrill Lynch s Corporate Finance Group. We are committed to helping our clients create shareholder value by delivering innovative, strategic solutions to address their most complex financial needs. We deliver the power of the firm to our clients through a team of experts who draw upon the broad capabilities of our global, integrated platform.

3 Introduction The ability of a company to attract more capital and at better prices than its competitors is a significant competitive advantage. Over the long term, this advantage should translate into a higher stock market valuation, a lower cost of equity and overall cost of capital, and deeper access to capital markets. Achieving this requires building a robust investor base by attracting a diverse set of shareholders. Even if a company thinks its profile naturally appeals to a certain type of investor, knowing what other types of investors look for is valuable. This knowledge can allow a company to make better capital allocation decisions at the margin regarding dividends and share repurchases, and maximize the impact of its investor relations program. Every incremental dollar of capital a company attracts in this way is a dollar not going to its competitors in a zero-sum game. -focused funds are frequently an underappreciated potential source of incremental investor demand. We define this category of funds as mutual funds that incorporate one or more aspects of a company s dividend policy into their stated investment criteria. The universe of dividend-focused funds is quite broad. Traditional yield-based equity income funds that emphasize current yield represent only a fraction of it. Many large mutual funds pursue a blended investment style in which they seek to maximize long-term returns while taking into account a company s ability and willingness to grow its per-share dividend over time. Knowing what drives ownership by dividend-focused funds provides a foundation for a company to assess the effectiveness of its current dividend program and to make any necessary adjustments to better appeal to these funds. In A Crowded Field: Strategies That Differentiate, we take a closer look at both the current dividend policies of U.S. companies and at the growing universe of dividend-focused funds. We also highlight markets-based analyses that management teams and boards can use to predict the impact of capital allocation policy changes on stock ownership by dividend-focused funds. Performing these analyses is critically important as setting dividend policy based only on cash flow projections or target payout ratios overlooks the fact that dividend yields and other markets-based considerations can be just as important to investors. The right policies and investor outreach can allow a company to better attract dividendfocused funds and to get the most bang for its dividend buck. 1

4 1 Corporate return of capital programs have maintained more balance between dividends and share repurchases than headlines suggest Today, both share repurchases and dividends are at record levels. Share repurchases seem to have received the bulk of press coverage over the last several years at the expense of dividends, however. This would seem to suggest outsized growth in repurchases versus dividends. In reality, corporate return of capital programs have maintained a remarkably consistent balance between dividends and share repurchases, as shown in Figure 1. s have consistently represented approximately 40% of total return of capital in each of the last five years, with only small annual variations. Additionally, companies have been disciplined in adhering to relatively constant dividend payout ratios (ratio of dividends to net income), which have remained at around 35%. Companies have also grown dividends at approximately the same rate as share repurchases and stock price increases. Aggregate dividends have grown at an 11% compounded annual rate since the start of This closely matches the 13% compounded annualized growth in both share repurchases and price appreciation of the S&P 500 Index over the same period. One direct result is that the dividend yield offered by the S&P 500 Index has remained in the 2% area despite the stock market nearly doubling since early Overall, companies and investors continue to think about capital allocation the same way today as they did five years ago, in spite of what headlines may seem to suggest. Figure 1. Historical dividends and share repurchases by S&P 500 companies $ bn (bars) $1,000 $900 $800 $700 $600 $500 $400 $300 $200 $100 $0 s 50% $553 45% $476 40% $399 $405 35% $299 30% $350 $312 $281 $206 $240 25% 20% Buybacks Payout Ratio s as % of Total Percentage (lines) Source: S&P Dow Jones Indices 2

5 2 Special dividends can be a useful addition to a company s return of capital toolkit Many U.S. management teams perceive that investors only give credit for regular quarterly dividends and share repurchases, and not for special dividends. Tradition and this perception explain the conformity among dividend program structures in the United States. In 2014, almost 85% of S&P 500 companies paid a dividend, and of these companies, 95% had their dividend programs structured to provide regular quarterly dividends of equal amounts, as shown in Figure 2. Special dividends are unusual and somewhat misunderstood as a result. A common misconception is that special dividends must be one-time or irregular in nature. Actually, special dividends can be incorporated into a return of capital policy and be paid on regular schedules, just like regular quarterly dividends. PACCAR, Diamond Offshore and HollyFrontier are among the companies whose capital allocation policies historically have allowed them to supplement regular quarterly dividends with ongoing special dividends at regular intervals. These dividends reflect available cash flow and the perceived attractiveness of competing investment opportunities. Investors understand that these special dividends can be changed or even turned off as opportunities present themselves, or as business conditions change. A key benefit of this type of policy is that shareholders retain a regular quarterly dividend, but the company has more flexibility in how it returns additional excess cash beyond the regular dividend rather than having to repurchase share regardless of price. 401 Only Pay Regular s Pay Special s in Addition to Regular s 79 Figure 2. How S&P 500 constituents structure No s Quarterly Semi-Annual Annual Quarterly Frequency of Regular s 0 Semi-Annual 2 Annual their dividend programs Source: Company filings for calendar year

6 Other companies have supplemented their regular quarterly dividend programs through sizeable, irregular special dividends. Costco, for example, has paid two special dividends in the last three years, more than doubling its regular dividend payout. Stock price reaction to both announcements was positive. Publicly listed private equity firms are paying dividends of variable amounts based on underlying fund cash flows. This can make sense for other companies with lumpy cash flow profiles. Additionally, Wynn Resorts and Brown-Forman, among others, have historically paid significant special dividends to benefit shareholders ahead of proposed tax rate changes. Tradition will result in regular quarterly dividends continuing to dominate dividend program structure in the United States for the foreseeable future. Other countries, like Germany and the UK, have different but equally ingrained traditions. This could change as more companies consider the flexibility benefits of introducing special dividends into their return of capital programs. 3 focused mutual funds are larger than many companies may realize A typical company s institutional shareholder base contains a mix of index funds, growth funds, value funds and dividend-focused funds. We define a dividendfocused fund to be a mutual fund that incorporates one or more aspects of a company s dividend policy into the fund s stated investment objective. Each type of fund mentioned above is important in developing a diversified and robust shareholder base. -focused funds manage a larger pool of assets than many public companies may realize. We estimate that dividend-focused funds constitute approximately 20% of mutual fund assets under management. Two of the five largest mutual funds in the United States include dividend income among their stated investment objectives. Collectively, the 10 largest dividend-focused mutual funds manage approximately $400 billion. -focused funds can be a substantial source of incremental demand for a company s stock if accessed properly. The current interest rate environment has contributed to the growth of dividendfocused funds by making equity yields more competitive with fixed income alternatives. Figure 3 shows that today, income-oriented investors can for the first time in recent history replace a portfolio of 10-year Treasuries with the S&P 500 Index without giving up yield, and yields on long-term corporate bond funds also have shrunk to within 2.5% of the S&P 500 Index. Generally higher tax rates on interest income versus qualified dividends make the after-tax differential even smaller for many retail investors. This may help to explain why since the start of 2010, U.S. equity income funds (a subset of dividend-focused funds) have received net inflows of $190 billion as compared to only $8 billion for U.S. government bond funds. 4

7 8% 7% 6% 5% Figure 3. Pre-tax excess yields of long-term bond funds over the S&P 500 dividend yield Spread 4% 3% 2% 1% 0% (1%) Long-Term Corporate Bond Index Yield Minus S&P 500 Yield 10-Year Treasuries Yield Minus S&P 500 Yield Source: FactSet Even in higher interest-rate environments, dividend-focused funds have outperformed the broader stock market. We calculate that the S&P Aristocrats Index, which includes approximately 50 large-cap companies that have consistently raised their dividends over the last 25 years, has outperformed its S&P 500 Index benchmark on total return basis by 2.1%, 2.8% and 2.8% on a compounded annual rate over the last one, five and 10 years, respectively. 4 A company s ability and willingness to grow its dividend can be just as important as its current dividend yield to many dividendfocused funds Traditional equity income funds, dividend growth funds and blended funds all constitute dividend-focused funds under our broad definition. Traditional equity income funds place meaningful focus on current yield and the sustainability of the dividend. growth funds focus on companies that have the ability and willingness to grow per-share dividends over time. They often target stocks with earnings per share growth potential that have a history or stated policy of returning capital to shareholders via dividends. Blended funds are growth or value funds that also have the additional stated investment objective of seeking dividend income or dividend growth. A stock s current dividend yield is an important driver of ownership among dividend-focused funds. Generally, the greater the yield, the greater the ownership. Figure 4 shows a typical progression in ownership levels using fund-level data from five large-cap companies operating in the same sector. The ownership style categories in the diagrams have been simplified to, and, and exclude index and sector-specific funds. Credit for blended funds is allocated equally among a given fund s styles. 5

8 Peer 1 Peer 2 Peer 3 Peer 4 Peer 5 Figure 4. Higher dividend yields generally drive greater ownership by dividendfocused funds NM 98% NM 17% 10% 73% 18% 23% 59% 12% 35% 53% 19% 54% Yield 0.0% 1.5% 2.0% 2.6% 3.0% Ownership 1% 10% 23% 35% 54% 27% Source: Bank of America Merrill Lynch analysis based on FactSet ownership data and fund filings yield is not the only ownership driver, however. Many dividend-focused funds actually have yields not meaningfully greater than that of the overall S&P 500 Index. The stated investment objectives of most dividend-focused funds highlight that long-term growth of capital and increases in per-share dividends are equally important to the funds. Figure 5 provides examples of several large-cap companies that offer dividend yields generally well below the S&P 500 Index s 1.9% average, yet still attract significant dividend-focused fund ownership as compared to the companies in Figure 4. Company 1 Company 2 Company 3 Company 4 Figure 5. Factors other than dividend yield also can attract significant dividend-focused fund ownership 5% 14% 81% 49% 32% 19% Yield 1.0% 1.2% 1.3% 2.1% Ownership 14% 19% 17% 33% Industry Media & Telecom Financial Healthcare Retail 27% 17% 56% 33% 7% 60% Source: Bank of America Merrill Lynch analysis based on FactSet ownership data and fund filings These companies highlight that having a well-articulated capital allocation policy regarding dividends, a path to sustainable future dividend increases, and positive business fundamentals can be equally important in attracting dividend-focused funds. -focused funds are willing and able to invest in stocks when other attractive qualities supplement a currently below-average dividend yield. 6

9 5 How much bang you get for your dividend buck depends on what your competitors are offering Each company has an inflection point at which an incremental dollar spent on dividends will still attract incremental dividend-focused investors, but at a decreasing marginal rate. Capital markets views and shareholder analysis can provide a general guide for identifying this inflection point. This knowledge can be valuable to management teams and boards during their internal capital allocation discussions. A stock s dividend yield is a key quantitative factor contributing to the inflection point. Other quantitative and qualitative factors including payout ratios, growth expectations and corporate strategy influence this point as well. This discussion focuses solely on dividend yield to illustrate one aspect of capital markets analysis. The dividend yield of a stock relative to competing equity investments can be just as important to attracting incremental investors as the absolute level of the stock s dividend yield. Attractiveness is relative because most mutual funds benchmark their performance versus an index. For most large dividend-focused funds in the United States, this is the S&P 500 Index. At a very high level, a fund may seek to track its benchmark by maintaining sector weightings loosely in line with those of the index, while overweighting or underweighting specific stocks within each sector to achieve the fund s yield and total return objectives. For a company in the S&P 500 Index, two key competing investments are the S&P 500 Index itself and comparable companies in the same sector. Figure 6 shows the distribution of dividend yields among S&P 500 constituents, while Figure 7 shows the contribution of various sectors toward the total dividends paid by S&P 500 companies. S&P 500 Only Div. Payers Average 1.9% 2.3% Median 1.9% 2.1% Top Quartile 2.7% 2.9% Figure 6. Distribution of dividend yields among % 0.0% 0.5% % 1.0% % 1.5% % 2.0% % 2.5% % 3.0% % 3.5% Bottom Quartile 0.9% 1.4% % 4.0% % 4.5% % 5.0% 5.5% 6.0%+ 5.0% 5.5% 6.0% S&P 500 stocks Source: FactSet 7

10 A common inflection point for dividend-focused fund ownership is the 1.9% yield currently offered by the S&P 500 Index. Generally, our experience is that for companies in most sectors, there are step-like increases in ownership levels for each 1% increase in dividend yield. To maintain an overall yield above that of the S&P 500 Index, funds must subsidize each stock yielding below 1.9% with a stock carrying a correspondingly above-benchmark yield. This means a fund must be selective about owning stocks with relatively low yields. In contrast, a 3% yield places a company in the top quintile of S&P 500 constituents. Marginal benefits generally decline above 3% because ownership levels by dividend-focused funds already are quite significant, as shown in Figure 4. Incremental yield beyond this may not be viewed as valuable if it comes at the expense of growth, sustainability or other factors. 18% Figure 7.* contribution to S&P 500 by sector Sector s as % of S&P 500 s 15% 12% 9% 6% 3% 0% 0% Real Estate 2.9% Transportation 1.6% Gaming & Leisure 1.6% 3% Consumer 2.9% Utilities 3.6% Basic Materials 2.1% 6% Media & Telecom 2.8% Retail 1.6% 9% Energy 2.9% Sector Weighting in S&P 500 Industrials 2.3% Technology 1.4% Healthcare 1.6% Financials 1.6% Legend: S&P-Weighted Avg Yield in Sector 3% 2% 1% 12% 15% 18% *The size of the marker for each sector reflects the average dividend yield offered by stocks in the sector, defined as aggregate dividends paid by the sector divided by the aggregate equity value of the public float of companies in the sector. The graph should be further segmented on a subsector basis when doing company-specific analysis. Source: FactSet 8

11 The inflection point also depends on the dividend yields of other companies in the sector. s have comparative scarcity value in sectors that fall materially below the line in Figure 7. In these sectors, offering a dividend that is below average for the S&P 500 overall but above that of comparable companies can still be viewed as attractive as funds allocate on a sector-by-sector basis. On the other hand, trying to offer outsized dividend yields in a sector like utilities may not result in a significant increase in ownership because dividend yields already are attractive. In dividendheavy sectors, a strategy of paying a dividend that is sufficient so as not to be materially underweighted versus other companies may actually be appropriate. Figure 8 is a final example illustrating the importance of markets-based analysis. It pairs two close competitors, one of which offers a 2.1% yield and one that currently does not pay a dividend. Large-Cap Company Direct Comparable Figure 8. -focused funds overweight the dividend paying comparable 73% 23% 4% 47% Yield 0.0% 2.1% Ownership 4% 33% 20% 33% Source: FactSet and fund filings Ownership by dividend-focused funds is negligible in the non-dividend paying company, as expected. However, the dividend-paying company has a materially greater degree of dividend-focused fund ownership than is typical in our experience for a company offering a yield in line with the overall S&P 500 Index. focused funds appear to have kept their subsector weighting in line with the benchmark index, but have overweighted the dividend paying stock at the expense of its direct competitor. Many factors may support the decision to not pay a dividend. Still, considering a meaningful yield, even if below that of its competitor, could allow the non-dividend paying company to reclaim a significant set of shareholders that are currently providing capital to its competitor almost by default. 9

12 Conclusion The desire for return of capital has been a consistent theme among equity investors over the last five years. As a whole, companies have increased their dividends and share repurchases in a consistent manner that has kept pace with the significant price appreciation of the stock market. -focused mutual funds comprise a significant amount of the mutual fund market and should continue to attract additional assets, relative to other strategies, under current market conditions. Public companies can consider using markets-based analysis to identify if their current dividend is optimized to attract dividend-focused funds, and to predict how changes in dividend policy will impact ownership levels. In the long-term, a company s willingness to fine-tune its dividend policy to attract dividend-focused funds can have a material impact on the breadth and depth of its shareholder base and lower its overall cost of capital. 10

13 For more information, please contact: Souren Ouzounian Head of Americas Corporate Finance Jay Bliley Amir Mirza Philip Turbin Gus Garcia David Sullivan bofaml.com/corporatefinance

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