I must admit…
I used to be so devoted to the popular “dividend growth investing” approach that I even wrote a book about the strategy back in 2015.
(It sold 10,000 copies in my country.)
The income-focused way felt perfect for me as I am in the wealth-building game for the long run.
Tons of evidence seemed to support the outperformance of reliable dividend payers.
But there was a problem… A BIG one…
When it comes to investing my money, I’m the type of guy who cannot trust any method that is not 100% evidence-based.
As the years went by and my experience with dividend investing grew, I became more and more troubled by some facts that dividend enthusiasts tend to ignore.
Namely, the evidence about the outperformance of “dividend growth investing” is questionable or outright incorrect.
The Myth of Dividend Superiority
Hint: The group of “non-dividend payers,” most often used as a comparison to showcase the superiority of Dividend Aristocrats, includes lots of companies that cannot pay dividends as they don’t have the profits or cash flows to do so.
Once you eliminate these lower-quality companies from the indices or the group of non-payers, and you only compare the Dividend Aristocrats to a select group of companies that consistently produce positive free cash flow, boast high returns on invested capital, and have lucrative reinvestment opportunities, that dividend advantage evaporates.
Yes, the members of this “quality growth” group (called EVA Monsters on the chart above) could afford to pay a dividend…
But most of them chose not to since they can earn a higher return on the reinvested capital than their shareholders could reasonably expect to make if they received that money in the form of dividends.
From this perspective, dividend investing is far from the “single best strategy” many want you to believe.
Don’t take my word for it! You can Google the Financial Times article “Keep your eyes on the prize: total return is what matters,” in which star fund manager Terry Smith elaborates on these exact points.
Where the TRUE profits are made
Even before the myth of “dividend superiority” had fallen, I kept devouring books to explore every possible evidence-based way of wealth building and to get better and more confident investing my money.
In 2018, I came across a life-changing book while traveling to compete at IRONMAN Barcelona.
It was Best‑Practice EVA by Bennett Stewart and was so hard to read that I literally suffered through the 300 pages.
Still, it felt obvious that Stewart’s message about EVA (Economic Value Added), which is the true profit a business makes after several adjustments to its misleading financial statements, makes a ton of sense.
When I got home from the race, the first item on my to-do list was getting in touch with the EVA guys and learning how I could use their top-quality data as an individual investor. Even their name “Institutional Shareholder Services” suggested that they mainly served institutions, but I didn’t give up.
I realized that this top-notch service is not reasonably affordable to investors like me, but I already had the FALCON Method newsletter business back then (mainly focusing on dividend stocks), and I was thinking about transitioning my stock selection process to the EVA framework if I liked what my in-depth discovery of the institutional-level service revealed.
I couldn’t afford the EVA service as an individual, but I managed to rationalize the cost as an investment to take my newsletter service to the next level.
Long story short: the transition was far from instant as I needed several months to get comfortable with the EVA framework’s most important metrics and understand their complex relationships.
As the months went by, it became more and more apparent why some of my previous stock picks turned into spectacular winners while others were laggards (despite their reliable and growing dividends).
Bennett Stewart writes that running the correlation across all stocks, it is about 82 percent, meaning that EVA and expectations about future EVA generation drive shareholder returns.
That said, I came across a white paper later, which revealed an even stronger relationship between the EVA-based shareholder return predictions and the actual shareholder returns. (TSR stands for Total Shareholder Return in the chart below.)
EVA was exactly what my long-term investing community needed to maximize the total return of our investments (and to take the FALCON Method newsletter service to the next level), but I still had decisions to make on how indispensable dividends are for my peace of mind.
So… Let’s jump in: What is EVA?
The data may look convincing, but fully understanding what the EVA guys are doing and why is absolutely necessary to take your investing strategy to the next level.
While summarizing Stewart’s book in a couple of sentences would qualify as Mission Impossible, I can still give you a feeling about the usefulness of the approach he outlined.
The main goal of EVA is to show you whether a company is creating value by earning more than its true cost of capital or not. (Surprisingly, about half of the publicly traded companies belong to the latter group.)
In the quest of discovering this, addressing the distortions of GAAP accounting one by one is absolutely inevitable.
Accounting essentially treats shareholders’ equity as a free form of capital with no required rate of return (unlike debt, on which the firm has to pay interest).
I have yet to meet a shareholder who wants no return on their investment; still, their equity contribution is treated as free money according to the Generally Accepted Accounting Principles. EVA remedies this by applying a cost of capital to the equity portion as well.
But this is just the beginning…
GAAP also fails miserably when it comes to treating different forms of investments. For example, when a company builds a new factory to scale up its production and sales, money spent on the construction is not immediately reported on the income statement; instead, the new factory appears as an asset on the balance sheet, and the money spent is deducted over several years as a depreciation expense.
You might say: Standard practice, isn’t it?
Okay, but what happens if the company spends that same amount of money on R&D to come up with a new product, which could strengthen its competitive position for years to come?
GAAP accounting treats this R&D investment as an expense, which needs to appear on the income statement in full and thus pull down the current year’s earnings. If you think like a business owner, you must admit that spending on R&D and building a factory are both investments that will serve the company in the coming years or even decades, yet GAAP accounting creates distortion by treating them differently.
Whoever still makes investment decisions based on reported earnings numbers can easily fall victim to the “garbage in, garbage out” syndrome. You can be smart, but if your input data is of poor quality, your decisions will also be far from well-founded.
The Best-Practice EVA book goes on to explain dozens of problems like these, and Stewart also details how the EVA framework addresses all the issues. I reread that book 5 or 6 times, bombarded the guys at Institutional Shareholder Services with questions…
…and came to the conclusion that there is nothing better than EVA from a business owner’s perspective.
Since I was always thinking like an owner, not a stock trader, EVA was the thing I was unconsciously looking for.
Warning: Not All Growth is Equal…
Many investors are fixated on growth (mostly EPS growth), and few take the time to contemplate that:
Not all growth creates shareholder value!
What I learned at Columbia Business School, the cradle of value investing (where Warren Buffett himself studied), was in perfect sync with what the EVA guys were saying.
Completing Columbia’s Value Investing and Advanced Value Investing courses taught me that the only type of growth that creates real value is where the incremental invested capital produces a higher return than the true cost of that capital.
Companies that can consistently outearn their cost of capital are of the highest quality and are often called franchise businesses.
Case Study: A Quick Glance at Whirlpool
As you see, earnings per share shows a nice increase almost every year between 2013 and 2019 (from $10 to $16), yet the stock price (the black line) is moving sideways. Take a look at EVA for the explanation:
Wherever EVA goes, the share price follows, as you saw from those strong correlation numbers. Still, it’s always good to see real-life examples backing up the theory!
What About Valuation? How Does the EVA Framework Measure That?
When it comes to valuation, I tend to prefer a complex approach instead of going with one single multiple or metric.
At the FALCON Method, we are using two distortion-free multiples (EV/EBITDAR and MV/NOPAT) and an EVA-based indicator (Future Growth Reliance) to assess a stock’s current valuation in historical comparison. Here’s a short sample from the newsletter’s analysis on Tencent.
No matter how you look at it, the stock seemed to be attractively valued historically (at the time of publication) since the lower these metrics, the more pessimistic the valuation.
A little explanation: EV and MV stand for enterprise value and market value, which are essentially the same, but the EVA guys are using two different labels for some reason. EV or MV equals the value of the stock’s debt and equity capital, given its share price, net of excess cash, and assuming that the book value of liabilities approximates their market value.
Simply put, EV or MV equals: market cap + total debt – surplus cash.
By using this category, differences in capital structure will not distort our assessment.
After corrective adjustments to remedy accounting distortions, NOPAT measures the free cash flow from operations that is distributable after ensuring that tangible and intangible assets needed to sustain the profit can be replenished.
EBITDAR is an improved version of the widely used EBITDA metric as it includes add-backs like rent expenses, R&D, and advertising spending. Both the NOPAT and EBITDAR multiples are useful and highly-enhanced versions of the commonly used valuation multiples, but it was the Future Growth Reliance (FGR) indicator that really caught my attention when first reading the book…
Simply put, FGR shows how much of the stock’s current market value stems from the expectations about future EVA growth.
A higher number indicates higher valuation.
A 50% FGR means that half of the company’s current market value stems from expectations about its future growth. Tons of Mr. Market’s lessons prove that faith can be fragile…
So, for example, if the FGR equals 30% and the company’s management openly admits that the firm will never be able to produce any higher EVA than the current level, the stock would most likely fall 30% to price in this information.
We mainly use the FGR for historical comparison, but this metric also comes in handy when setting the limits of the reasonable valuation range with our total return calculation. (More on this later.)
Two Eye-Opening Examples
The case of Zoom Video Communications (ZM) shows that it is easy to disappoint when essentially all the company’s value stems from future growth expectations.
On the other hand, Apple’s example shows that even wonderful companies can be bought at astonishingly attractive valuations.
The negative FGR means that the market was not only pricing in zero growth but even predicted value destruction. Investing $10K in Apple in June 2013 at the point of extreme pessimism would have netted you a ~12x result as of January 2022.
Using top-quality data pays off big time! Now let me show you something really interesting…
My Evolution: From Income to Total Return Focus
Discovering all the above, I still wanted those reliable dividends to give me peace of mind, but I started to pay more attention to the other components of total return: valuation and EVA growth.
The deeper our team dived into the EVA data of reliable dividend-payers, the more obvious it became that most of them are mediocre companies when it comes to creating shareholder value (by consistently outearning their true cost of capital).
This doesn’t mean that you cannot make money with dividend stocks. But the data clearly shows that in the lack of exceptional fundamental performance, the valuation must be very attractive to propel the total return potential to acceptable levels.
In other words, investing in reliable but mediocre dividend payers only makes sense when their shares are significantly undervalued.
When compiling the FALCON Method newsletter’s list of Top 10 stocks, we are building EVA-based financial models to calculate a reasonable range for every stock’s annualized total return potential.
After reading the annual reports, earnings call transcripts, and watching management’s presentations, we feed our models with input data like analysts’ expectations on sales and margins, dividends, share buybacks, and historical valuation multiples. We build both a conservative and an enterprising scenario to arrive at a range of results, as shown on the chart below.
Nobody knows the future, so thinking in ranges is the only sensible way to go. When you see numbers in the neighborhood of 20% while having a total return requirement of 12-15%, you know you have a significant cushion (a margin of safety) built in.
That said, we tend to be cautious when putting together the underlying models, so when the potential total return figures are this high after applying the margin of safety principle at every preceding step of the process, we know we are on to something promising.
The most typical mistake “dividend growth investors” tend to make is the fixation on the entry dividend yield component and ignoring the other drivers of total return.
As a result, it is easy to fill up one’s portfolio with high-yielding crap, only to realize later that it wasn’t the wisest decision.
The problem is that this realization can be so painful that many give up investing altogether, which is the worst that can happen considering the formidable wealth-building power of the stock market.
Stock investing is the way to go; you just need to do it a bit more thoughtfully than buying the widely promoted dividend stuff out there.
EVA for Everyone? Really?
Regardless of your investment style, I firmly believe that the EVA framework has something to offer you. For dividend investors, it may be worth taking notice that wherever EVA goes, the stock price follows; and it is also nice to earn great total returns while harvesting those reliable dividends. See for yourself on the chart below.
Where EVA growth was lackluster, the share price went nowhere in the examined 5-year period, and dividend growth rates were also unimpressive. On the other hand, dynamic EVA expansion entailed exceptional share price performance and dividend growth in the case of Domino’s and BlackRock. My preference is with EVA growers…
For hardcore value investors, EVA can help avoid value trap situations. Investing in melting ice cubes that always look cheap all the way down to zero is the most costly mistake a value investor can make, and here comes EVA to the rescue, as shown in GameStop’s case study.
You can see that traditional, widely-used metrics like P/E showed that GME stock was cheap all the way down from $32 to $3. Earnings per share was not there to guide your decision-making, while EVA acted as the canary in the coalmine and would have convinced you to steer clear of this value trap situation.
Last but not least, for growth investors, it comes in handy that EVA lets you separate the wheat from the chaff; thus, you can focus on the time-tested category of quality-growth stocks instead of buying all the speculative, cyclical “pure growth” names out there.
I am ready to admit that after rereading the EVA book 5 or 6 times and diving deep into ISS’ institutional-level data, I wouldn’t make an investment decision without looking at the EVA metrics of the company I’m analyzing.
(Of course, there is a do-it-yourself way to calculate EVA, but as soon as you gain an in-depth understanding of all the accounting distortions and the accompanying remedies, you will most likely feel that it would take an unreasonable amount of your time.)
I am grateful that the FALCON Method newsletter business made it possible for me to access the EVA database, evolve further, and take a giant step as an investor.
Moreover, I could also repay my subscribers’ trust by taking the newsletter service to the next level, making 1000+ of them even more satisfied. (We have a ~95% subscriber retention rate as I write this, which is considered exceptional in an industry with a standard rate between 70-80%.)
At the FALCON Method, we are using the EVA framework to identify the couple dozens of truly exceptional quality-growth companies worldwide (we call this category EVA Monsters, as shown on the first chart), and we are also continuously monitoring the market for reliable dividend payers with attractive total return potential (we call them Fallen Angels).
Our subscribers get the best of both worlds within the same service, so they can have their dividend income without compromising on total returns.
Makes sense? You can learn more about the FALCON Method here and see how you can make institutional-level decisions for a price that is affordable to individual investors.