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To escape the value trap, keep dividends flowing

In recent times the discount between traditional “value” stocks and growth stocks has continued to expand to historically high levels.

It is increasingly difficult to get institutional investors’ attention on undervalued small- and mid-cap stocks. There has been a flight to large-cap, well-kown, more highly rated stocks. This issues is commonly referred to as the “value trap”.

Many investors have been disappointed to find that despite substantial underlying improvements in their portfolio companies, their stock prices have continued to languish.

I am convinced that the solution to the value trap for mature companies is a 100 percent dividend payout ration by default. Companies should have to ask shareholders for growth capital. This is the same discipline that has worked well in the REIT sector, where for tax reasons 100 percent of taxable profits must be distributed.

It’s much easier to sell a stock on a price-to-earnings multiple of 6.7 than sell a stock that pays a 15 percent dividend yield. The result? Stocks trading closer to fair value and with less volatility.

This idea is not new. Over 80 years ago, it was clearly set out by Graham and Dodd in their groundbreaking book Security Analysts, where they noted that “stockholders are entitled to receive the earnings on their capital except to the extent they decided to reinvest them in the business.”

On the valuation benefit: “Given two companies in the same general position and with the same earnings power, the one paying the larger dividend will always sell as the higher price.”

Graham and Dodd’s strategy is as sound today as it was in 1934, despite the immense changes that have swept the world. It remains so because the fundamental obligations of companies to their shareholders remain unchanged – to maintain high standards of governance and to deliver fair value to their shareholders.