John Reese is founder and CEO of Validea.com and its Canadian site Validea.ca, as well as Validea Capital Management, and is a portfolio manager for the Omega American & International Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
As U.S. companies have built up huge cash stockpiles over the past few years, many investors have urged them to put those funds to work. Hedge fund guru David Einhorn recently sued Apple Inc., calling for the company to issue preferred shares in order to return a portion of the billions of dollars of cash on its balance sheet to shareholders. Many other investors have urged companies to use their cash to increase dividend payments or buy back more of their shares.
Buybacks and dividend increases are two ways to increase shareholder value – raising dividends puts more money directly into shareholders’ pockets, while buying back shares instantly increases the value of the company’s remaining shares. But they’re not always the best use of corporate cash.
In fact, in his recent letter to Berkshire Hathaway shareholders, Warren Buffett said that to do the best for shareholders, “a company’s management should first examine reinvestment possibilities offered by its current business – projects to become more efficient, expand territorially, extend and improve product lines or to otherwise widen the economic moat separating the company from its competitors.”
Mr. Buffett even laid out a scenario in which an investor would earn more money – and pay less in taxes – if he or she earned income not by receiving a dividend, but by selling off a portion of his or her shares each year, with the company keeping its cash and reinvesting it in its business.
The idea of profitably reinvesting profits isn’t anything new for Mr. Buffett. In fact, one of the criteria my Buffett-inspired Guru Strategy (which is based on Mary Buffett’s book Buffettology) looks at is return on retained earnings. This figure is determined by taking the amount that a company’s earnings per share have risen over the past 10 years and dividing it by the total amount of earnings that the company has retained (i.e. not paid out as dividends) over that time.
Essentially, this shows you how good a job the company is doing at putting its cash to work to grow its business. My Buffett-inspired model looks for this figure to be at least 12 per cent, and prefers it to be over 15 per cent. If a company is earning those kind of returns on its retained earnings, you’re probably better off with it putting its cash to work that way, as opposed to buybacks or dividend increases.
I recently checked to see which companies in North America have been hitting that 15 per cent target, and then cross-referenced them to make sure they also get approval from one or more of my strategies. (As important as a high return on retained earnings rate is, it’s not a silver bullet). Here are a handful that made the grade.
If you are investing in companies like these, remember: As nice as it would be for them to write you a big dividend check, in the long run you may well be better off with them keeping their cash.
Syntel, Inc. (SYNT)
Michigan-based Syntel, which provides business analytics, cloud computing, IT infrastructure management and other services, has retained $13.85 (U.S.) in earnings per share over the past decade, while its earnings per share (EPS) have risen by $3.45. That makes for a stellar 24.9 per cent return on retained earnings, part of why it gets strong interest from my Buffett-inspired model. The strategy also likes that Syntel has upped EPS in all but two years of the past decade, has no long-term debt, and has a 10-year average return on equity (ROE) of 28.6 per cent.
Syntel also gets high marks from my Peter Lynch-based model. The mutual fund legend famously used the P/E-to-Growth ratio to find bargain-priced stocks, and when we divide Syntel’s 14.4 price/earnings ratio by its 20.0 per cent long-term growth rate, we get a PEG of 0.72, which comes in under the model’s 1.0 upper limit.
Stepan Company (SCL)
This Illinois-based chemical maker has retained $12.57 of per-share earnings over the past decade, while its EPS have risen by $3.26. That’s a 25.9 per cent return. The firm gets strong interest from my Lynch-based model, thanks to its 20.2 per cent long-term growth rate, 0.89 PEG ratio, and reasonable 38 per cent debt/equity ratio.
Alimentation Couche-Tard Inc. (ATD-B.TO)
This Quebec-based convenience store stalwart has held onto $10.97 (Canadian) in earnings over the past decade, while its EPS have risen by $2.15, making for a 19.6 per cent return. That’s one reason it gets strong interest from my Buffett model. A couple more: Its EPS declined in only one year of the past decade, and it has averaged an ROE of 19.2 per cent over that period.
Rolls-Royce Holding PLC (RYCEY)
This British firm hasn’t produced its famed luxury cars for four decades (BMW now does). It makes power systems for land, sea, and air uses, and over the past year has taken in more than $18-billion in sales.
Rolls has retained just $3.89 in per-share earnings over the past decade, but it’s made great use of that, increasing EPS by $1.74 for a 44.8 per cent return. My John Neff-based model likes the stock’s moderate 9.2 P/E.
The model also likes the firm’s 1.92 total return/PE ratio. This metric adds a firm’s EPS growth and dividend yield and divides the result by the stock’s P/E. The result should be at least twice the market (0.61) or industry (0.77) average, and Rolls makes the grade.
Disclosure: The author owns shares in Syntel and Stepan