Amwal Investment Outlook
April 2014

How important are dividends?

As we come to the end of dividends season, it is worth asking the question: How important are dividends? It is widely known that local investors in the Gulf region prefer high dividend paying stocks, and also that when a company announces an increase in dividends, the market generally responds positively. But is this sustainable performance or just a short term jump, and are high dividends an indication of future positive performance of stocks? In this report we share our analysis comparing the performance of high dividend paying stocks versus low dividend paying stocks, both relative to the index.

As can be seen on the chart above, which shows performance relative to the Qatar Exchange Index, high dividend paying stocks have performed significantly worse relative to the market over the past 5 years. This is probably a surprise to many readers since stocks usually react well to dividends. It is true that stocks usually see more investor demand in advance of dividend announcements, but quite often they decline afterwards more than the dividend per share payout. From a differentiation point, low dividend paying stocks have performed better than high dividend paying stocks. But even low dividend paying stocks have not consistently outperformed the market. Or put differently, dividends on their own have not proven to be a good predictor of future stock performance.

So, do dividends have any relevance? Yes, but only if they reflect strong profitability and earnings quality of the underlying company. If a company generates more earnings than it needs to retain for future expansion, distributing this excess reflects prudent financial management and good corporate governance. In rapidly growing economies however, growth prospects are generally greater than the internal cash flows generated by companies. Hence retaining capital is usually required, to take advantage of growth opportunities. For example, non-oil GDP growth in Qatar in the last 5 years has been around 18% per year which compares to an average return on capital of around 16% for listed companies.

To illustrate with a simple example: let us say a bank earned 15% return on equity, and decided to distribute 2/3rd of its profits to investors. Assuming its capital adequacy was just optimal, it will then be able to increase its risk weighted assets by only 5%. In a country where non-oil GDP growth has been around 18%, this would be a limiting factor. The bank would then either need to raise capital or lose the growth opportunities to its competitors.

Dividends are good, but only if growth and investment opportunities are lacking

Businesses are going concerns, and the only way shareholders receive value directly from the Amwal Investment Outlook April 2014 company is through dividends. So from this point of view dividends are key, but not just current dividends but future dividends too. Fundamentally speaking, a company’s worth lies in its ability to generate healthy cash flows, however, for minority investors in the stock market who don’t have control over the use of these cash flows, dividend policy as well as a clear understanding of how the cash flows will be deployed are important considerations.

If a company needs to retain profits to grow future profits (and pay out higher dividends in the future) it should do so, rather than pay out high dividends today and be capital deprived. This is particularly true in our view for a country like Qatar. We see significant growth opportunities in the economy, across sectors. Looking at just infrastructure spending, the government is expected to spend close to QAR 250 billion (Source: Qatar National Development. Strategy) over 5 years; there is good population growth; and in addition there are significant expansion and acquisition opportunities.

They key here is whether the company has good investment opportunities to utilize the internally generated extra funds. If not, it is better to pay it out to shareholders, so shareholders can invest in other companies with better growth prospects. In closing, we would like to emphasize that in managing portfolios, we focus on total return paying particular attention to value creation including the productive use of retained earnings.