“The evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low.”
– Robert Arnott and Cliff Asness
Last week, I had a special guest at my financial economics class at Chapman University: Rob Arnott, CEO of Research Affiliates Ltd. Based in Newport Beach, California, the company manages more than $200 billion in assets.
Arnott has won more awards for writing breakthrough financial articles than any person I know, including seven Graham and Dodd Awards from the CFA Institute, a global association of investment professionals.
The Wall Street Journal calls him the “godfather of smart beta” and the creator of fundamental stock indexes. He’s a value investor, recommending stock indexes based on sales, earnings, cash flow and dividends rather than highest market capitalization (such as the S&P 500 Index).
Beware of Money Losers
In my class, he compared the value stock Exxon Mobil (NYSE: XOM) with the growth stock Tesla (Nasdaq: TSLA). He said Exxon is a much safer bet. Exxon has $42 billion in debt but made nearly $20 billion in profits last year.
On the other hand, Tesla is losing money every year and is likely to run out of money soon. Arnott predicted that Tesla could self-destruct within a year or two, given its huge $12 billion debt load, high burn rate and growing competition in the electric vehicle market.
“Tesla is no Amazon,” he warned.
Arnott is skeptical that the tech sector can continue to grow as fast as it has. He expressed alarm that the seven biggest companies on Wall Street based on market cap are all tech companies: Alibaba, Amazon, Apple, Facebook, Google, Microsoft and Tencent. It’s unprecedented to have one industry dominating the market.
Best Buy: High-Dividend-Paying Value Stocks
Arnott thinks value stocks will have their day in the sun soon. He is especially bullish on high-dividend-paying stocks with high payout ratios.
His 2003 study, “Surprise! Higher Dividends = Higher Earnings Growth,” co-authored with Cliff Asness, is still valid.
They found companies that have a high dividend payout ratio tend to be more profitable over the long run, while companies that have low payout ratios grow slower. They conclude that companies with “low payout ratios lead to, or come with, inefficient empire building and the funding of less-than-ideal projects and investments, leading to poor subsequent growth, whereas high payout ratios lead to more carefully chosen projects.”
The only caveat is to avoid companies that pay out a higher dividend than current earnings. That could spell danger as they could cut or even suspend their dividends in the future.
Here are a few examples of quality companies with sustainable high dividend yields and high dividend payout ratios…
- Verizon (NYSE: VZ): 4.9% yield, 32% payout ratio
- McDonald’s (NYSE: MCD): 2.5% yield, 60% payout ratio
- Enterprise Products Partners (NYSE: EPD): 6.5% yield, 90% payout ratio (based on cash flow).