Tap “dividend investing” into your search engine and you will be bombarded with articles on the merits of investing in those companies that pay out a healthy and growing distribution to shareholders. Sure, I can understand the benefits of receiving a regular flow of income, particularly for retired investors, but I can’t help thinking there are some great companies that fall below the radar simply because they don’t pay out enough of their earnings.
Maybe it’s my private equity background, but when I consider buying a stock, I hardly look at the dividend history. The most important metric for me is return on capital (ROC). A company that consistently generates a robust ROC will always grab my attention. There is no better measure to demonstrate the effectiveness of its leadership team in exploiting the business’s competitive position in the market.
Take one of my favourite stocks, Stryker Corporation. Headquartered in Kalamazoo, Michigan, the company is a leading manufacturer of medical devices. Over the last 12 months, Stryker enjoyed an operating profit margin of 23%, producing a stellar return on equity of 33%. Its unswerving superior financial performance has led to the share price rising two and a half times over the past five years. Yet many dividend investors wouldn’t have considered this stock because of its low (circa 1%) dividend yield. Rather than fill the pockets of shareholders, the company has kept to a payout ratio of 36% and chosen to plough most of its earnings back into the business.
That is my point. Provided a company can find high-returning projects in which to invest its capital, I don’t mind if dividends are low or non-existent. In those circumstances, I’d much rather see profits reinvested. The resulting additional earnings will eventually feed through to the stock price, and I’ll receive my reward that way. I don’t mind whether my return comes through capital appreciation or dividends. What matters to me as an investor is total shareholder return. And if I need more cash than the current dividend provides, all I have to do is sell a portion of my holding.
By looking at total return rather than income only, I believe I have a greater universe of investments from which to choose. Some fund managers have picked up on this. For instance, my preferred fund manager is Terry Smith who runs Fundsmith Equity, a London-based open ended investment company (OEIC). Ranked number one amongst his peers, Terry and his team have achieved a 160% growth in unit value over the last five years, almost double that if you take their record back to inception in 2011. He’s my kind of manager, making long-term conviction buys in a portfolio of low-debt, market leading, international large caps. If an investor ever needs more cash flow from his holding in the Fundsmith OEIC, Terry offers a regular withdrawal facility whereby he will automatically sell part of it at regular intervals in order to supplement the paid-out return.
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Martin holds positions in both Stryker and Fundsmith. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.