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Bad proxy – Investors should avoid a growing trend for using dividends as a valuation metric

05/08/2013

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

“Hey – you have the opportunity to invest outside the UK so why don’t you own Starwood Property Trust?” a client asked the other day. “It’s a great US investment paying an annualised dividend yield of some 8.7%.” This is one brief example of a growing trend among some investors for using a business’s current dividend as a proxy for valuation. Here is why The Value Perspective will not be joining them.

Since it was the name thrown at US, let’s use the example of Starwood, a US property trust that invests in a mixture of performing and non-performing mortgage bonds. While some investors may find the headline yield attractive, some extra digging shows that, since 2010, the business has raised four times as much money through issuing extra equity as it has paid out through dividends.

Furthermore, investors are presently paying a premium for the shares – of 1.2x price-to-book – that the business’s 8.8% return on equity would not appear to justify. After all, without the equity issuance of the last few years, Starwood has not really grown its book value.

In the case of Starwood Property Trust, the current dividend yield includes a return of investors’ capital, as well as a return on capital. This is an important distinction. any valuation ratio that compares price and profit-proxies such as price-to-earnings, or price-to-dividends, should always use a sustainable denominator. Sadly, returning investors’ own money cannot be continued in perpetuity.

Starwood is by no means alone in being, to our eyes, curiously priced – and prized – by US investors. While the top quintile of highest-yielding US stocks used to trade at a discount to the broader market, that discount has collapsed to the extent that, even though such companies tend to offer lower growth, they are nevertheless trading on the same price/earnings valuation as the broader market.

In other words, some investors are apparently happy to pay a premium for some US businesses just because they happen to return their cash to them through dividends – and even if that cash has actually come via the injections of money from existing shareholders through rights issues that have necessarily involved paying significant fees to the investment banks working on them.

Nor should UK investors be feeling too complacent about all this – in The wrong track, for example, we highlighted how the £585m, after fees, that first group was looking to raise via its rights issue was not too far away from the £570m the travel operator had paid out in dividends over the previous five years.

Meanwhile, in Skewed priorities, we suggested the managements of a number of businesses, most notably among the utilities and insurance sectors, had refused to cancel their dividends despite weakened capital positions and were instead shaping up to ask investors for extra funding through rights issues – once again to the delight of the investment banks.

Using current dividends as a valuation metric can be very risky. as income investors, we must look beyond a business’s present yield and consider its sustainability and the prospect of it growing over time – and that can lead us to avoid some of the very highest dividend-paying companies in the market. When we do so, it is because ultimately we believe those dividends should not be being paid and the fact they are suggests some skewed priorities and unhealthy decision-making within those businesses.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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