Synthetic dividends

Dividends may be great for income seeking investors, but should never be the sole reason to make an investment.

Companies that produce high returns on equity, have manageable debt levels, and the potential to advance the business and its value through promising growth opportunities will best serve shareholders by reinvesting earnings back into the business.

But what about shareholders who want and need income? A strong case can be made for companies that possess these attributes to reinvest all of their earnings, and for investors to create their own dividend-type capital by selling a portion of their shares.

Here’s an example inspired by Warren Buffett’s annual letter to shareholders.

First, let’s make the following assumptions:

• You are the sole owner of a company that has a net business worth of $1 million;
• The business earns 12% annually on its total net worth, and you can earn the same rate of return on reinvested earnings;
• The business can be sold to an outsider at 125% of net worth at any time;
• To satisfy your current investment income needs, one-third of annual earnings will be paid out as a dividend, and the remainder will be reinvested in the business.

Scenario 1 Pay yourself a dividend

Your $1 million business generates a $120,000 return in your first year of ownership. As a result, you pay yourself a dividend of $40,000 (one-third of earnings) and reinvest the remaining $80,000 into the business.

This reinvestment will ultimately grow at 8% (equivalent to the 12% the business earns, minus the 4% that’s paid out as a dividend).

After ten years, the business has a total net worth of $2,158,925, which can be sold for $2,698,656 (125% of net business value), and the dividend in the upcoming year will have reached $86,357.

This is a great investment proposition that will produce lucrative returns.

However, there is an alternative approach that’s even better.

Scenario 2 Reinvest all earnings in the business

To create income from your investment, you will need to sell a portion of your shares every year to raise cash. Let’s call this the synthetic approach to creating a dividend.

To generate the same $40,000 dividend received during the first year in the prior scenario, sell the equivalent of 3.2% of your outstanding shares (at 125% of net worth).

After 10 years, the total net worth of the business grows to $3,105,848.

However, because you have been selling 3.2% of your shares each year to simulate a dividend, your ownership of the company decreased from 100% to 72.2%. This portion is worth $2,243,540, and can be sold to another investor for $2,804,425.

Despite the reduced stake in the business, your 72.2% remaining ownership is worth 4% more than 100% ownership in the previous dividend-paying scenario. And you’ve generated a great deal more income, with the sell-off dividend reaching $124,234 in the 11th year of ownership.

Allowing the company to reinvest all its earnings and create its own dividends leaves investors with more cash in their pockets and greater net worth.

Reality check

The average profit margin for companies that make up the S&P 500 in 2012 was 13.4%, while the 7-year average is 12.9%. And although we stipulated shares could be sold for 125% of net worth, the 500 companies that make up the index sold at an average price of 230% of book value over the last seven years.

If you still think the scenarios are far-fetched and a synthetic method won’t create returns, let’s look at a real example involving Buffett’s stock ownership of Berkshire Hathaway, which does not pay a dividend.

Seven years ago, Buffett pledged to donate 4.25% of his shares each year to charity, reducing his share count to 528.5 million from the 712.5 million (split-adjusted) he had in 2005.

His ownership percentage has decreased, but the $40.2 billion value of his remaining shares is more than the $28.2-billion book value of the shares he had seven years ago.

Dividends paid out by a company impose a specific cash-out policy on all shareholders, but each shareholder has differing needs for income.

A company can try to keep shareholders happy, but it can’t satisfy everyone.

Meanwhile, the synthetic dividend approach allows shareholders to make their own decisions when it comes to receiving or building up capital, and it also puts them in control of their taxes.

Dividends are taxed in the year received, whereas the sell-off approach gives the added control of deferring taxes to the new year, if a shareholder sells shares in January 2013, as opposed to December 2012, for instance.

Also, all cash received in the form of a dividend is taxed, while the synthetic approach is only taxed on one half of the capital gains portion of the cash raised.

Many income seeking investors shy away from companies that do not pay dividends.

However, when armed with the synthetic approach to income generation, investors can make superior yielding investments based on strong business fundamentals and the enhanced returns they bring.

Susy Abbondi is a portfolio manager at Duncan Ross Associates.