Dividend trap can leave you out of pocket

Chasing yield and ignoring growing income is a mistake — and in the long run it will prove costly for its adherents.

Chasing yield and ignoring growing income is a mistake — and in the long run it will prove costly for its adherents.

Take a business with $10 of equity a share and earning 20 per cent returns on that equity (ROE).

In the first year, the earnings will be $2. If the directors acquiesce to shareholder demands and pay all the earnings out as a dividend, the dividend will also be $2 a share.

Now, if we assume the popularity of the shares never changes and they trade at 10 times earnings, they will be priced at $20 in the first year.

You will note the dividend yield is 10 per cent.

It all seems very attractive in the context of the present miserable returns on cash and term deposits.

If we then assume in the second year the company begins with the same equity it had at the end of the first year — $20 — and it earns another 20 per cent return, then the earnings will also be $2. You will note there’s no growth, but as the popularity of Telstra shares has shown, you don’t need growth in earnings or dividends to keep a share supported.

The reason there is no growth in earnings is because we are assuming the ROE stays constant. It is also a fact the company pays its entire earnings out as a dividend, so there is no capital retained to grow the equity base. All this is rather academic until you get to the return you are going to make.

If we assume the company’s shares trade at 10 times earnings when you buy them and also at 10 times earnings when you sell, then provided the above pattern of returns and dividend payments continues year after year, your return will just be 10 per cent a year.

Now here’s where it gets really interesting.

Suppose the company paid no dividends, instead retaining all the profits so the equity grew each year, and the company continued to earn 20 per cent returns on the increasing equity.

If you bought and sold this company’s shares on a price-earnings ratio of 10 times, you would end up with an annual return of 20 per cent and double the return compared with taking the dividends.

In other words, by demanding a dividend equivalent to 100 per cent of the earnings, the opportunity cost is as much as double. The rubber really hits the road with an example.

In 2005, you could have bought $100 of Telstra shares at $4.69 on a 5.97 per cent yield — paying $5.97 on your $100. Alternatively you could have purchased shares in another, much smaller telco, M2 Telecommunications. Unfortunately the M2 dividend yield wasn’t as attractive as Telstra’s at 3.91 per cent, so your income on a $100 investment was just $3.91.

You’d be forgiven for opting for the higher-yielding Telstra shares, but as we demonstrated a moment ago, the returns are higher when a company can retain profits and continue to generate high returns.

And that’s what M2 did.

Your $100 investment in Telstra in 2005 is now worth $132. Importantly the dividends have been steady and you are now earning $6.40 a year in dividends.

Contrast this with M2. Because M2 has been able to grow its equity by retaining profits — and admittedly other techniques such as capital railings — and employ the additional capital at high rates of return, the growth in the value of the business has been much greater than Telstra’s.

A $100 investment in M2 has now grown to $3453 as the share price surged from 32c 10 years ago to more than $11 at present.

More importantly you should recall you didn’t buy M2 shares because you needed the higher income Telstra was offering in 2005. That’s a pity because the income on the shares you originally purchased for $100 is now $93.75. In other words, going for growing income rather than yield has delivered more income and more wealth — it’s the best outcome.

Roger Montgomery is founder and CIO of The Montgomery Fund.