Why invest in dividend-yielding stocks? This has been one of the most asked questions in 2022, even as markets throughout the West sold off in dramatic fashion.
There seems to be a continuing sense of belief in the resilience of Western equity markets (and even crypto) rather than what has been transpiring in the domestic and regional markets by many skeptics. The Efficient Market Hypothesis (EMH) asserts that markets are ‘efficient’, in that the only way an investor can achieve higher returns is to take on more risk. But this is not necessarily true in practice, as 2022 has shown.
More importantly, research by Guggenheim Partners shows the least volatile decile of stocks generated annualized total returns of 8.7 per cent over the last 40 years, while the most volatile decile lost 8.8 per cent. This seems to flatly contradict the hypothesis; if we needed any reminder we have seen it with the performance of former ‘stars’ like Meta, Tesla, DropBox and Snapchat.
Of course, in the background, the cost of capital has risen with interest rates continuing to rise. This brings into focus yet another study, conducted by Goldman Sachs which looked at the CROCI (cash return on cash invested). Better companies made better decisions.
Think CROCI
For a retail investor to understand and navigate this smorgasbord of data is a battlefield laced with mines. However, it can be boiled down to first principles, which is to invest in companies that are easy to understand in terms of the business model. If you cannot understand what a company is doing or how it is earning money, chances are it is because you are not meant to understand it.
A useful takeaway from this is to avoid these investments altogether and focus on ones that are generating (and distributing cash). Dubai and the UAE have led the way in the recent wave of IPOs that offer such returns. Yet, the narrative has been to focus on the ones that have been sluggish in their initial secondary performance. Even a cursory analysis reveals that this conclusion is false. Companies like DEWA, Taaleem and Tecom (whilst considered ‘staid’) have consistently generated superior CROCI, and any relative underperformance (whenever that happens) presents itself as an opportunity to capitalize on their stream of predictable returns and superior fundamental performance.
Can’t seem to convince pundits
Others such as Salik, Empower, Bayanat (which was the best-performing IPO last year) and IHC (the highest-performing stock among companies with a valuation of $1 billion or more) have already had market recognition. Time is on the side of companies that have higher returns on capital invested, and yet this simple truth has been largely ignored by the asset management industry. The focus has been on being bought out or having management changes that continuously modify the business model.
We have companies (including the new IPOs) that have consistently stuck to the basics of generating high rates of return on their capital, and yet we have bizarre scenarios where moneY-losing companies like Snapchat are valued higher than companies like Emaar. The critic in the room may point to the difference in growth potential between the two companies and even protest at the ‘apples and oranges’ comparison, but on a fundamental level, growth is part and parcel of the valuation process. Rising interest rates have hit technology companies the hardest, but that has only been because the return on capital for these companies has been low (Amazon’s retail margins remain negative).
Rather than chasing superior portfolio performance by chasing high risk stocks - euphemistically and yet startlingly coined by many as ‘return-free risk’ - investors should be looking at ‘boring’ quality companies that generate higher returns of cash and hold on to them, comfortable in the knowledge that the ‘new new thing’ will eventually give way to those that are consistent and stable. Dubai and the UAE have shown that repeatedly in other areas, and with its emphasis on capital markets, the outcome will be no different.
