3 Principles for Sustainable Dividends in Small/Microcaps

At NAOS Asset Management we invest in a concentrated exposure to quality private & public emerging companies. Whilst the concepts of smaller stocks and sustainable dividends may not typically go hand in hand, there are plenty of companies in our investment universe which have demonstrated the ability to consistently pay dividends, and we hope to see this occur sustainably into the future.

In our view, the principles which create an environment for stable to growing dividends are not necessarily dependent on company size. In this article we look at a few key principles to consider for smaller companies when investing for consistent, growing dividend returns overtime.

For any of the below, it is important to consider the medium to long term performance record as results can vary significantly from year to year.

Principle 1 – Free cash flow

One way in which the quality of a company’s operations can be measured is through the amount of free cash it generates. The ability of a company to compound capital comes down to how a company utilises/reinvests a portion of its free cash, whether that be through activities such as acquisitions, reinvestment in existing operations, incubating new initiatives, debt reduction, or building a bigger cash balance for the future.

Whilst you can pay dividends without free cash flow in the short term, over the long term this is not conducive to sustainable capital management. 

Put simply, a company that is extracting cash at the expense of reinvestment in the business is unlikely to be building upon the long-term quality of the business. We like to see capital-light businesses that allocate a portion of free cash to both strategic and balance sheet initiatives whilst allocating a portion to their shareholders.

A very basic way to look for sustainability would be to compare the total dividends paid to the total free cash flow figure. For the purpose of this exercise, we define free cash flow as operating cash flowless maintenance capital expenditure (meaning the necessary spend to continue the company operations in their current form).

A company that is generating sustainable income for investors should generally have a higher free cash flow than dividends paid.

Free Cash Flow = Operating Cash Flow – Maintenance Capital Expenditure

Free Cash Flow > Dividends Paid = Sustainable

‍Principle 2 - Payout ratio

As a dividend hungry market, payout ratios of ASX listed companies have been on the rise over the long term and are a very important factor in the context of  total shareholder returns.

A dividend payout ratio simply measures the dividend per share to the earnings per share. By inverting the payout ratio, we know how much of the earnings the company plans to retain.

Retained Earnings Per Share = Earnings Per Share – Dividend Per Share

We are mindful that there are likely to be company/industry-specific or ownership specific factors which may vary results, however, as a general principle a very high payout ratio can be a sign that dividends may not be sustainable over the longer term.

Earnings that are retained within the business can also be a risk mitigation factor in the future should a rainy day arise.  Furthermore, a very high payout ratio can prove to be unsustainable over the longer term as businesses which do not reinvest in themselves will likely face headwinds in the future as their competitive advantage dwindles.

A payout ratio can also provide investors with an insight into the intentions of the Board of directors. A very high payout ratio may highlight elements of a short-term focus and/or a volatile dividend profile may highlight elements of a lack of visibility around the long-term strategy of the business. As a general rule of thumb, the market doesn’t look favourably on cuts in dividends amounts without appropriate justification.  

One of many useful valuation metrics (which should be used in conjunction with a multitude of other factors) often used by investors is to value a company on its dividend yield.

Dividend Yield % = Dividend per share / Share Price

If a company has a very high short term payout ratio this could potentially create a short-term fluctuation in its share price. If/when this payout ratio drops it can result in a negative effect on the company’s share price.

To illustrate the above, let’s assume a company currently has a 50% payout ratio and pays a $5 dividend and current share price implies a 5% dividend yield = a $100 share price. In the below table we can seethe theoretical impact of an increase & subsequent fall in the payout ratio of this company. The drop in the share price, all things being equal can be substantial. (Please note, we are not saying a 75% or 25% payout ratio is necessarily very high/very low, rather, we are using them for illustrative purposes only)

The numerical increase in dividend per share often doesn’t tell us enough. We believe a better approach is that a company should ‘earn the right’ to increase its payout ratio. If previous investment decisions are compounding capital faster than a payout ratio increases, it demonstrates sustainability.

Therefore, if you notice a company’s retained earnings balance is consistently diminishing whilst dividends remain steady or are increasing, this could be a red flag that investors may wish to consider.

In our opinion, a capable Board is one which prudently builds the retained earnings balance at a rate greater than the dividend payments but is equally able to pay a steadily growing stream of dividends over the long term. By doing so, you are giving yourself a buffer in case of unexpected losses/impairments and are able to demonstrate good level of capital management competency upon which shareholders can depend.

Principle 3 - Financing cash flows

As the saying goes, it is best to read a company’s financials back to front; the cash flow statement first and the income statement last. The reason being, it is typically harder to ‘muddy the waters’ of a cash flow statement. Whilst all financial statements are important, the bottom section of the cash flow statement, the financing cash flow section, allows us to see how a company keeps its lights on during a reporting period.

In our view, a warning sign for any company would be continual entries in the ‘proceeds from borrowings’ line of the cash flow statement, without any entry in ‘repayment of borrowings’. There are short term reasons when this is acceptable, such as acquisitions or the need to fund a strategic working capital solution (both of which in turn should hopefully generate increasing future free cash flow) but there are other, more worrying reasons.

If a company is continually living on debt and not generating the free cash to pay it off, any dividends will most likely eventually suffer and a capital raising may be on the horizon. 

A quick way to interpret the sustainability of the funding of dividends would be to compare dividend growth to debt growth. Artificially ‘holding up’ a dividend through debt is likely not a sustainable capital management decision.

Conclusion

If tomorrow’s larger companies come from the smaller companies of today, the compounding financial growth for a successful small company can translate into substantial dividend growth over time. This may often be overlooked by investors.

The above three principles should not be solely relied upon, rather be considered as part of a wider analysis undertaken on any potential investment. These principles aim to provide an insight as to what may eventuate down the track to a dividend, which in theory should be the most predictable part of total shareholder returns.

At NAOS we believe in investing in businesses where the earnings today are not a fair reflection of what we consider the same business will earn over the longer term, and over time the business can pay dividends. Investing solely for income is not something we do, avoiding ‘yield traps’ is just as important as finding a good sustainable dividend.