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Low inflation is good for dividends

11 September 2014  |  Investing

GoodNewsA 1981 letter from the investment guru Warren Buffett indicates something that is of great interest to DIY super investors. In low inflation environments, it makes more sense for companies to pay out their profits as dividends. It suggests that Australia's HIROs (high income return oligopolies) should be well placed to keep giving their tax advantaged dividends, at least in theory.

Of course, theory is a poor guide to what actually happens. But it is nevertheless one way to look at investment. One of the best yardsticks in investment is the relationship between 10 year bonds, which is an interest rate, and what is called the earnings yield on shares, which is also expressed as a percentage. The earnings yield is the earnings per share divided by the price of the share. It is the upside down version of the price earnings multiple, which is used to assess how expensive shares are.

To give an example, an interest rate of 10% equates with a price earnings multiple of 10 (turn it upside down and it is 10%). At the moment, with interest rates at about 2.5%, that equates with a price earnings multiple of 40 times. The average in the All Ordinaries is about 14 times, so this suggests the stock market is "cheap". But this is really only showing how distorted the financial markets are at the moment.

This 1981 letter from Buffett suggests the ratio is useful, as this commentator observes:

"Buffett does in fact think about stocks using a similar approach. And this makes sense because there is a rational reason why earnings yield can be fairly compared to treasury bond rates. This is not to say that the stock market will always trade at parity with bond yields (history shows that it doesn't).

This may be relevant now to understand why some people like Buffett keep saying the market is trading in a "zone of reasonableness" while some charts show the market to be way out in terms of historical valuation.

And yes, we do understand that Buffett's comments make sense when you think about where interest rates are today (he does keep saying that stocks are better than bonds)."


What is really interesting about this old investment letter is that it was written at a time when inflation was soaring and interest rates were very high. One can reverse the logic of what Buffett is saying here:


"Several decades back, a return on equity of as little as 10% enabled a corporation to be classified as a "good" business - i.e., one in which a dollar reinvested in the business logically could be expected to be valued by the market at more than one hundred cents. For, with long-term taxable bonds yielding 5% and long-term tax-exempt bonds 3%, a business operation that could utilize equity capital at 10% clearly was worth some premium to investors over the equity capital employed. That was true even though a combination of taxes on dividends and on capital gains would reduce the 10% earned by the corporation to perhaps 6%-8% in the hands of the individual investor.

Investment markets recognized this truth. During that earlier period, American business earned an average of 11% or so on equity capital employed and stocks, in aggregate, sold at valuations far above that equity capital (book value), averaging over 150 cents on the dollar. Most businesses were "good" businesses because they earned far more than their keep (the return on long-term passive money). The value-added produced by equity investment, in aggregate, was substantial.

That day is gone. But the lessons learned during its existence are difficult to discard. While investors and managers must place their feet in the future, their memories and nervous systems often remain plugged into the past. It is much easier for investors to utilize historic p/e ratios or for managers to utilize historic business valuation yardsticks than it is for either group to rethink their premises daily. When change is slow, constant rethinking is actually undesirable; it achieves little and slows response time. But when change is great, yesterday's assumptions can be retained only at great cost. And the pace of economic change has become breathtaking.

During the past year, long-term taxable bond yields exceeded 16% and long-term tax-exempts 14%. The total return achieved from such tax-exempts, of course, goes directly into the pocket of the individual owner. Meanwhile, American business is producing earnings of only about 14% on equity. And this 14% will be substantially reduced by taxation before it can be banked by the individual owner. The extent of such shrinkage depends upon the dividend policy of the corporation and the tax rates applicable to the investor."



This shows several things. For one, it indicates just how different investment conditions can be. A 10% return on equity in today's environment is very healthy, whereas when Buffett was writing it was not nearly enough. The reason is that interest rates are now so low and inflation is low.

What is also interesting is that, according to Buffett's logic, even only modestly performing businesses should be able to pay out dividends in the current environment. Given the importance of dividends to most SMSF strategies, it is a positive indication. Buffett is describing the negative impact of high inflation. The same logic works in reverse. Low inflation is a positive for paying out dividends:


"Inflation takes us through the looking glass into the upside-down world of Alice in Wonderland. When prices continuously rise, the "bad" business must retain every nickel that it can. Not because it is attractive as a repository for equity capital, but precisely because it is so unattractive, the low-return business must follow a high retention policy. If it wishes to continue operating in the future as it has in the past - and most entities, including businesses, do - it simply has no choice.

For inflation acts as a gigantic corporate tapeworm. That tapeworm preemptively consumes its requisite daily diet of investment dollars regardless of the health of the host organism. Whatever the level of reported profits (even if nil), more dollars for receivables, inventory and fixed assets are continuously required by the business in order to merely match the unit volume of the previous year. The less prosperous the enterprise, the greater the proportion of available sustenance claimed by the tapeworm.

Under present conditions, a business earning 8% or 10% on equity often has no leftovers for expansion, debt reduction or "real" dividends. The tapeworm of inflation simply cleans the plate. (The low-return company's inability to pay dividends, understandably, is often disguised. Corporate America increasingly is turning to dividend reinvestment plans, sometimes even embodying a discount arrangement that all but forces shareholders to reinvest. Other companies sell newly issued shares to Peter in order to pay dividends to Paul. Beware of "dividends" that can be paid out only if someone promises to replace the capital distributed.)"




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