Jack Welch took the reins of GE in 1981 and is widely seen as the father of ‘shareholder value’. While his reputation today is much diminished, there has unquestionably been a marked shift in favour of maximising shareholder return across much of the developed world in recent decades. Investments, where the likely return is less than the cost incurred, have been increasingly eschewed by corporate leaders more driven to grow their bottom rather than their top line.

Until recently, corporate Japan has generally stood aside from this change. Fundamentally, it has been over-investing. Importantly, however, the path trodden by corporate leaders elsewhere is now increasingly being followed in Japan. The era of capital destruction is increasingly ending, and the scope for enhanced shareholder return is significant. This is especially relevant in the search for sustainable dividends.

Over the long term, a share price is a function of the cash earnings distributed to shareholders. Simply put, as equity investors we should always remember that we are owners of a share in a business and that the value of the business to us is ultimately determined by the cash that we take out of it.

Assuming a business is broadly happy with its capital structure and liquidity, when it makes a profit it has two options for deploying it:

1) Re-invest it – in either the existing business, or by acquiring all or part of a new one.

2) Distribute it to shareholders – in either a dividend, or by buying back and cancelling some outstanding shares.

Ideally, as shareholders we want the management of the business to take the first option up to the point where it generates a positive net present value to us, and to take the second option with the residual.

But in the real world even the most appropriately motivated and incentivised management team will find it impossible to live up to this ideal. There are just too many variables outside their control. The best that we can reasonably hope for is a sensible combination of the two.

From the businesses in which we own shares therefore, we should demand capable management to generally generate profit, re-invest or acquire profitably for the future, and/or remunerate us via a dividend and/or share count reduction.

Fortunately, a large diversity of businesses pay dividends and many of these are enjoying profit growth in excess of the opportunities to re-invest profitably. More generally, companies that can sustain higher and growing dividends tend to be more profitable, and those that can’t tend to be under pressure. Faltering dividends are often an expression of faltering business health.

Crucially therefore, the search is not for dividends per se, but for sustainable dividends.

A credible investment goal is to own a portfolio of sustainable dividend-paying stocks, which have also demonstrated a capacity and a commitment to growing their dividend over time.

To build such a portfolio, it’s helpful to set absolute hurdles – such as the four below – which must be overcome for any stock to qualify:

  • Payout Ratio: The payout ratio is the proportion of earnings accounted for by the dividend payment. This shouldn’t be too high. To both minimize the risk of a dividend cut in the case of earnings disappointment, and in the more positive case, to ensure that there is a reasonable level of earnings being re-invested for the future.
  • Free Cashflow Cover: FCF is the Funds-from-Operations minus Total CapEx. This should be comfortable. To heighten the likelihood of dividend sustainability, the dividend payment should be covered by this conservative definition of FCF.
  • Dividend Growth: Compare the current dividend payment to the dividend payment 5 years ago. For evidence of a capacity, and commitment to dividend growth, the current dividend payment should be the higher.
  • Total Payout: Total payout is the sum of the dividend payment and the issuance or destruction of shares. This should be positive.The dividend payment should not be negated by new share issuance, and in the more positive case, it’s important to recognize the benefit of share destruction to shareholder return.

In building portfolios, the significant changes to dividend sustainability at a regional level i.e., the percentage of companies successfully passing the four absolute hurdles described above – the screen dynamics in each region – can provide helpful insight:

2020 To Date: Regional Sustainability Analysis

Recently, the standout change is clearly in Japan with a marked increase in dividend sustainability over the past 3 years.  Many Japanese companies that historically never paid a dividend are now paying dividends, many that never grew their dividends are now growing their dividends, and many that never bought back their shares are now remunerating shareholders by buying back and cancelling them.

Today, at a time when opinion on the macro picture in Japan remains contested, via the above analysis of dividend sustainability, there is clearly a significant change in behaviour at the micro/corporate level.

While the focus on ‘shareholder value’ has been clear across much of the developed world for decades, corporate Japan has only recently joined the trend. Companies that can sustain higher and growing dividends tend to be more profitable, and those that can’t tend to be under pressure. Crucially, therefore, the search is not for dividends per se, but for sustainable dividends. The strikingly positive evolution of dividend sustainability in Japan over the past three-plus years argues strongly for paying increased attention to this oft-neglected market.