Dividend Growth and Share Price Appreciation

Earlier this month, McDonald’s (MCD) raised its quarterly dividend by a robust 15% to $1.16 per share.  McDonald’s is not currently owned in any of the portfolios that I manage on behalf of clients, but as a dividend-oriented equity investor, I am always pleased to see companies providing a tangible manifestation of their business success by increasing cash distributions to company owners.

My next thought was about the share price. In my business-based view of the equity markets, an increase in the dividend—assuming it is sustainable and based on long-term profit growth of the underlying business, not just borrowing money—should be reflected in a gain in the asset price of roughly the same amount over time. I have made this “share prices-follow-the-dividends” argument in The Strategic Dividend Investor (for individual investors), The Dividend Imperative (for corporations), and most recently in Getting Back to Business (in regard to portfolio construction).

In any private business setting and in almost every mature stock market outside the United States, this is not a controversial statement. The greater the distributable cashflows of an asset, the greater the value that most reasonable investors would put on said asset.  Businesses with declining distributable cashflows face the same math, in reverse. It’s not that big of a deal.  But the issue can be confusing in the public equity markets where assets reprice on a daily basis, versus dividends which are set once a year and paid quarterly for most companies. And there are lots of other factors beyond cash distributions that can affect near-term share prices. In this environment, investors can lose sight of the correlation and, even more importantly, the causal relationship between long-term distributable cashflow generation and long-term asset prices.

The exception is the US stock market over the past three decades, where, through an unusual confluence of modern investment theory, technology, taxation, and popular sentiment, distributable cashflows as a tangible manifestation of business success are viewed dimly. In some corners of the market, the idea is downright heretical, bordering on the absurd. Why would anyone ever pay a dividend with their free cashflow? Better to buy back stock and push up the share price.  Or perhaps buy another company with the cash and wring out the synergies. Or buy that start up with what sounds like a great new mousetrap. For investors who may have come of age since the 1990s, the notion of a dividend as a measure of a company’s success may come as a shock. When the FANGS and so-many New Economy companies do not now or do not foresee ever paying material dividends, having a dividend just doesn’t seem relevant anymore.

That sentiment is reflected in the broader market’s dividend yield. Using the S&P 500 Index companies as a proxy for the market, the trailing twelve-month dividend is 50.99 (thru 6/30/18).  As I write today (9/26/18), the market is at 2920 so the trailing yield comes to an awfully low 1.75%. Annualize the current quarter’s dividend and one gets 52.41 and a yield of 1.79%. Not much better. Given reasonable expectations of dividend growth over the next few quarters, one can easily forecast a prospective dividend of 55, for a yield of 1.88%.  That’s pathetic, but it is what it is, and the market’s yield has been at or near that 2% mark for several decades. (Prior to the 1980s, the market yielded between 4-6% as far back as the 19th century.) It is very hard to say what the current payout ratio of the market is given the indeterminacy of earnings. “Profit is an opinion, cash is a fact”, as the old investment adage goes.  Using the trailing reported numbers for the S&P 500 Index (thru 3/31/18), however, we can derive a payout ratio of 43%.  (Data from S&P https://tinyurl.com/ydbsao2v )

Rather than pay dividends with their free cashflow, US corporations like to buy back their own stock. (It is a topic that I took up at length in The Dividend Imperative). In 2017, the S&P 500 Index companies bought back $538 billion in stock. That’s about twenty percent higher than the $451 billion that was distributed as dividends. (Data from FactSet Research Systems, Inc.) Do a back of the envelope calculation and one can see that large, US, publicly traded corporations are spending more than 50% of their profits on share repurchases. In 2018, the amount spent on buybacks will increase sharply again. In the rising market which we’ve enjoyed since the Great Financial Crisis—almost an entire decade—this capital allocation decision has looked pretty smart. Companies have bought back shares at prices lower prices than the current quote. Should the market’s trajectory change, as it has in the past, that interpretation can be reversed.

Despite the business “outlier” nature of the US stock market over the past several decades, many of our mature publicly traded companies still do pay material dividends.  And over long measurement periods, the correlation between share price and dividend growth for publicly traded companies must necessarily be close. The causation is not in doubt, only the precise amount of the correlation. In The Dividend Imperative (p. 35-36), the correlation for the 123 companies that had dividends in 1962 (as far back as I had data) and the end of 2010 was 0.87. (The calculation used the CAGR of the dividend versus the share price CAGR. That is, it was based on the starting and ending points, rather than individual dividend and share price movement in any given year.)

I recently had that analysis updated through the end of 2017, and the correlation had moved up, 0.90, albeit on a smaller n-count, 104, as companies have disappeared from the data set over the past seven years. Apparently a number of them were outliers. Now keep in mind that these are Old Economy companies that were mature enough to pay dividends in 1962 and are still around today to tell the tale. Their share prices and dividends move pretty much in lock-step when looked at over long periods.

Against this backdrop, I thought the McDonald’s announcement was a good opportunity to revisit the core argument in the form of a case study.  Incorporated in 1955 by Ray Kroc (and succeeding a small restaurant chain founded by the McDonald brothers in the 1940s), McDonald’s had its Initial Public Offering of shares in 1965 and started paying quarterly dividends midway through 1976. To keep the math simple and on an annual basis, we’re going to start with 1977, when the company made four quarterly payments. They amounted to $0.175 cents per share. The shares have split seven times since (four times 3 for 2 and three times 2 for 1—the divisor is 40.5), and so the base figure on today’s share price is actually $0.00432 cents. (I’ve dropped a few decimal points to spare you death by insignificant numbers.) The shares ended that year with a price of $1.2716, also on a split adjusted basis and shortened for simplicity.

At the time McDonald’s started paying a dividend, it was very much a growth company, and the dividend was utterly insignificant from both a profits perspective and a share price perspective. The trailing dividend yield at the end of 1977 was just 0.34% and the company was paying out a mere 5.2% of its profits that year.  At those low levels, it is hard to make an any argument linking the dividend payment and the share price.

The company increased the payout ratio to 15% in 1982 and it remained in that range (13-17%) until 2001. This becomes the first material analytical period of our study. These two decades were still a period of very strong growth—usually measured in new store openings, as well as the same-store metrics. Sales and profits were booming. Median annual sales growth was 9.5%; median EPS growth was 13.2% and the EPS CAGR was 10.7%.  During this period, the dividend kept pace, with a median annual increase of 10.4% and a CAGR of 11.4%, but it would strain the argument to suggest that with a low payout (and an average yield 0.86%–yes, less than 1%) investors were paying attention to the dividend when determining what they might pay for the shares. This is an instance of a broad correlation, but no causation. As an aside, it is worth noting that while the share price moved around a great deal, with a standard deviation of 24%, the dividend grew steadily, with a much more modest standard deviation of 5%.  That is one of the other virtues of viewing one’s portfolio through the prism of cashflows, a core argument in Getting Back to Business.

In sum, McDonald’s up to 2001 looked a lot like many of the growth companies that investors have supported over the past two decades. It’s all about the share price and the opinion of future profits. In MCD’s case, fortunately, they were not just an opinion, but real and sustained profits, even if company owners never really saw much of them in cash form.

That model was fine until it wasn’t.  Sales growth slowed in 2001, and profits fell sharply.  (This was at the same time as the tech bubble burst and an economic recession, but McDonald’s had its own business issues not directly related to those macro factors.) In response, the Board did a reset, putting in a new CEO and a new dividend policy. Call this stage two. Rather than have a payout ratio in the teens, the dividend payout was moved up in two years to the mid 30s level as the company shifted away from rapid expansion mode into a more moderate growth strategy. The reduced capex for new store openings freed up a lot more cash for the dividend.  From 2002 through the present time, the payout ratio has doubled to the current 60% level. So in effect, dividend growth has had a two tailwinds, earnings growth and a payout boost. Using 2003 as the new base year, profits have gained 13%, while the dividend has grown at a 17.5% clip. The share price rose at still very robust 14.8% CAGR. As a result of the dividend expanding faster than the share price, the yield has gone from 1.6% to 2.25% (at the end of 2017).  More generally, during the past few years the yield has been in the 3% range and, at time of writing, it is 2.8%.

During this stage of the company’s trajectory, the dividend has been and continues to be far more visible and of greater concern to many investors. That is reflected in correlation figures between the annual share price movement and the annual dividend growth rate. For the 14 year period from 2003 through 2017, the correlation is 0.57 using those yearly numbers (as opposed to just the starting and ending figures used in the 1962-2017, broader market analysis).   Given that MCD share price changes on a daily basis whereas the MCD dividend is adjusted just once a year, the 50%-ish correlation of price and dividend is a notable figure. This is not to say that other factors don’t affect MCD shares, particularly over short measurement periods, but just to highlight that perhaps the greatest single factor in determining an on-going enterprise’s worth, as in any business, is the distributable and distributed cashflows to company owners. At this point in time, McDonald’s is a more mature corporation and has a shareholder base that is generally very sensitive to the dividend. The exact correlation of its share price and its dividend announcements may vary, but the causation cannot be in question.

McDonald’s history offers something to both anti- and pro-dividend camps. At inception and during its growth phase, it was successful “stock” with little consideration of the cashflows actually distributed to company owners.  Since the turn of the century, however, it has been a cashflow-correlated business in which company owners have directly and tangibly benefited from its on-going success.   It’s time for lunch. I know where I’m going.

September 28, 2018

Note: The views expressed here are those of the author alone, and do not necessarily reflect the views of his employer. Nothing written here should be construed as investment advice. Consult your investment advisor for specific recommendations.