Surprise! Higher dividends = higher earnings growth

‘Surprise! Higher dividends = higher earnings growth‘.

That is the fascinating title of a 2003 study by Robert Arnott and Clifford Asness which found that companies paying out a higher percentage of their profits are aligned with higher earnings growth! (The full study, in all its glory, can be read here.)

It sounds counter-intuitive, as the authors themselves note. Shouldn’t companies with lower payout ratios have more money to reinvest back into their business and grow at a faster rate?

The reinvestment riddle

That may be true of many young ‘growth’ companies which need the cash early on to fund the opportunity at hand. But Arnott and Asness looked at decades of data and found a strong relationship between the payout ratio of U.S. equities and future earnings growth.

The cause, they believe, is that managers use dividend payout rates to signal their optimism that the future dividend will not need to be cut due to future earnings growth.

Arnott and Asness also proposed that companies with low payout ratios, and thus more cash to invest, may not be using the money (your money!) effectively for growth. Instead they waste it on “inefficient empire building and the funding of less-than-ideal projects and investments” which result in poor subsequent growth.

Case study: QBE Insurance

Shareholders of QBE Insurance Group Ltd (ASX: QBE) may certainly agree. After dozens of acquisitions under departed CEO Frank O’Halloran, QBE suffered years of earnings retrenchment, when value failed to materialise and acquisitions began dragging the ’empire’ down like dead-weights.

Only in the last 12 months have earnings started to show signs of promise, allowing directors to raise the maximum dividend pay-out ratio from 50% to 65% of cash profits (effective October 2016), which per Arnott and Asness could be a positive sign for earnings.

It could be a similarly rosy picture for Insurance Australia Group Ltd (ASX: IAG), which has also increased its dividend payout ratio for 2016. The company expects to pay out between 60% and 80% of full year cash earnings in 2016, up from between 50% and 70% in 2015.

Of the two companies, QBE looks to me a more appealing opportunity. However if you're serious about big dividends AND earnings growth, then you can't miss this top dividend share. A strong yield and potential share price gains make this a great investment idea in my opinion.

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Motley Fool contributor Regan Pearson owns shares of QBE Insurance Group Ltd.. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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