While preparing this post, I stumbled upon something interesting that I'd like to share.
In the U.S., the average P/E ratio for the S&P 500 over the past decade has typically ranged from 18 to 25, with some years even exceeding that range. In stark contrast, the FTSE 100, which represents the top 100 stocks in the U.K., has seen a lower average P/E ratio of around 13 to 16 during the same period.
These differentials have increased over the decades and there is a clear trend of U.S. stocks trading at increasingly higher multiples compared to their U.K. counterparts.
But why?
Consider the example of Company A and Company B mentioned in this post. It provides a clue.
In the U.S., the average dividend yield for the S&P 500 over the past decade has typically ranged between 1.5% and 2.5%, with a payout ratio of about 30% to 40%. Meanwhile, the FTSE 100 in the U.K. has offered a higher average dividend yield of 3.5% to 4.5%, with payout ratios ranging from 50% to 70%.
U.K. companies seem to prioritize dividends, often treating them as a matter of tradition based on conventional wisdom.
I would argue this approach is long on convention, short on wisdom!
In contrast, U.S. corporate management tends to be of a higher caliber, possibly due to stronger business education in North America. Instead of following entrenched policies, U.S. companies prioritize retention of earnings and determine capital allocation based on opportunity cost, reinvesting more earnings into growth.
Given this difference in approach, it's no surprise that U.S. companies tend to grow faster than their U.K. counterparts, which justifies their higher valuation multiples.
It shows how $100 invested in the S&P500 would have grown between 1973 and 2020, but it breaks the index into segments based on their dividend policy. On the face of it, the suggestion seems to be that investing in companies that pay dividends, or which have a progressive dividend policy, produce the best shareholder returns.
However, it reminds me of the Mark Twain quote, "There are three kinds of lies: lies, damned lies, and statistics".
The reason why the dividend payers outperform in this chart is that most S&P500 companies that don't pay dividends, are unprofitable companies, that can't afford to pay a dividend. So the statistics used to formulate the chart is skewed to suit the investment firm producing the chart in order to sell the virtues of income generating investments. It is all a matter of incentives!
A proper analysis, as set out in the post above, is to look at all the companies which have consistently compounded at the highest rates of growth for an extended period and discover that the key ingredient that they all have in common is the retention and reinvestment of earnings instead of slowing growth by parting with valuable corporate capital in the form of dividends.
For the avoidance of doubt, I believe it's a mistake to completely avoid investing in companies that pay dividends, and I do invest in them myself.
However, an even bigger mistake is to stand by and watch the CEO of a company you're invested in deplete balance sheet assets and allocate capital in ways that hinder the business from reaching its long-term potential, without questioning or challenging the strategy.
It is also worth pointing out that there are companies which throw off so much free cash flow that they have enough for reinvestment, and buybacks and still have some left to pay dividends. Apple is one such example. However, these are exceedingly rare.
While preparing this post, I stumbled upon something interesting that I'd like to share.
In the U.S., the average P/E ratio for the S&P 500 over the past decade has typically ranged from 18 to 25, with some years even exceeding that range. In stark contrast, the FTSE 100, which represents the top 100 stocks in the U.K., has seen a lower average P/E ratio of around 13 to 16 during the same period.
These differentials have increased over the decades and there is a clear trend of U.S. stocks trading at increasingly higher multiples compared to their U.K. counterparts.
But why?
Consider the example of Company A and Company B mentioned in this post. It provides a clue.
In the U.S., the average dividend yield for the S&P 500 over the past decade has typically ranged between 1.5% and 2.5%, with a payout ratio of about 30% to 40%. Meanwhile, the FTSE 100 in the U.K. has offered a higher average dividend yield of 3.5% to 4.5%, with payout ratios ranging from 50% to 70%.
U.K. companies seem to prioritize dividends, often treating them as a matter of tradition based on conventional wisdom.
I would argue this approach is long on convention, short on wisdom!
In contrast, U.S. corporate management tends to be of a higher caliber, possibly due to stronger business education in North America. Instead of following entrenched policies, U.S. companies prioritize retention of earnings and determine capital allocation based on opportunity cost, reinvesting more earnings into growth.
Given this difference in approach, it's no surprise that U.S. companies tend to grow faster than their U.K. counterparts, which justifies their higher valuation multiples.
For more on this topic, see: https://rockandturner.substack.com/p/why-is-uks-arm-holdings-listing-in
Someone raised a challenge based on this chart: https://newacademyoffinance.com/wp-content/uploads/2021/07/image-62.png
It shows how $100 invested in the S&P500 would have grown between 1973 and 2020, but it breaks the index into segments based on their dividend policy. On the face of it, the suggestion seems to be that investing in companies that pay dividends, or which have a progressive dividend policy, produce the best shareholder returns.
However, it reminds me of the Mark Twain quote, "There are three kinds of lies: lies, damned lies, and statistics".
The reason why the dividend payers outperform in this chart is that most S&P500 companies that don't pay dividends, are unprofitable companies, that can't afford to pay a dividend. So the statistics used to formulate the chart is skewed to suit the investment firm producing the chart in order to sell the virtues of income generating investments. It is all a matter of incentives!
A proper analysis, as set out in the post above, is to look at all the companies which have consistently compounded at the highest rates of growth for an extended period and discover that the key ingredient that they all have in common is the retention and reinvestment of earnings instead of slowing growth by parting with valuable corporate capital in the form of dividends.
For the avoidance of doubt, I believe it's a mistake to completely avoid investing in companies that pay dividends, and I do invest in them myself.
However, an even bigger mistake is to stand by and watch the CEO of a company you're invested in deplete balance sheet assets and allocate capital in ways that hinder the business from reaching its long-term potential, without questioning or challenging the strategy.
It is also worth pointing out that there are companies which throw off so much free cash flow that they have enough for reinvestment, and buybacks and still have some left to pay dividends. Apple is one such example. However, these are exceedingly rare.