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A special case

Such times chiefly arise in the search for high-yield candidates. Obviously, there is a big difference between a stock that yields an enticing 6 per cent because the dividend includes a one-off payout that has a zero chance of being repeated and one that yields the same via an ordinary dividend that looks capable of being maintained until the crack of doom. Yet even a sophisticated database won’t readily reveal that difference. It has to be dug out.

Similarly, a stock showing a yield of, say, 10 per cent is easy to dismiss as an income candidate because, in effect, the market is saying that the dividend is about to be cut. However, if that yield is swollen by a one-off payment but underlying it is a reliable recurring payout that yields 5 per cent, then there is a plausible candidate hiding away.

Then there is the issue – arguably the most important – of the special dividends that are not that special because they have become a regular occurrence in a company’s affairs. How do you assess those? I will focus on that question.

First, let’s sketch in the background to explain why special dividends have become commonplace. Much of it has to do with fashion, for which we can blame those awfully clever people who run private equity funds.

Private equity’s business model is to treat company managers mean in order to keep ’em keen. The way to do that is to give them incentives but – more important – make them surrender (ie, pay to the private equity fund) almost all the net cash their company generates. This deprives managers of the comfort of a cash cushion and forces them to justify further cash injections with rigorous business plans.

Since this approach seems to work for private equity, there is reason to suppose it will do a job for quoted companies too. Thus paying spare cash to a company’s shareholders helps keep managers focused and honest. It is a way to solve the age-old ‘principal/agent’ dilemma in which the agents (a company’s managers) don’t act in the best interests of the principals (the owners, who hired them).

Granted, the special dividends paid by quoted companies are a diluted version of the private equity model. That’s because private equity owners are fewer in number, better motivated and more demanding than quoted company shareholders who rarely have a collective voice. So, in effect, quoted company bosses get to decide how much cash they disburse via special payments and they are unlikely to make it too difficult for themselves. Even so, it’s better than nothing; it’s progress.

And the trend has been growing for some years now. Go back to 2011 and housebuilder Berkeley Group (BKG) pledged to return £2.2bn – or £16.34 a share – to shareholders over the 10 years to 2021. At the time it seemed an astonishing promise because Berkeley’s share price was only about £12.50. How could the bosses of a company – albeit one closely controlled by its founder and chairman, Tony Pidgley – commit to return more than the company was worth without somehow consuming itself?

As it happened, quite easily. Despite being well on the way to meeting its target, Berkeley’s share price has almost tripled to £35.65. Partly that’s down to the group’s trading in a buoyant housing market; partly it is because, after a while, Berkeley’s bosses decided to fulfil most of their promise by buying in existing shares rather than disbursing cash. No matter. In 2014, another highly successful company followed suit. Fashion retailer Next (NXT) began a process of regularly paying special dividends when it dished out three within 12 months (and it has paid another nine since).

What better way for the success of these two to rub off on other companies than the others should imitate them? Thus began the fashion of special dividends. True, they have tended to be concentrated in cyclical sectors – housebuilding, non-life insurance and chemicals. Rightly so, since cyclicality means there are times when a company can flash the cash to its shareholders and times when it must hunker down.

For investors, however, the key question is how to assess special dividends? Chiefly, what needs to be judged is their sustainability. Obviously, a special dividend that’s a one-off has a much lower value than a special that looks set to be a regular occurrence. That’s the main purpose of the table, which is best studied in the spreadsheet format that’s available online, chiefly because there is useful additional data.

The table makes no attempt to be exhaustive. It does not show all the London-quoted companies that are paying special dividends. Thus, on a topical note, there is no place for West Midlands engineer Castings (CGS), which last week announced a 15p special. This has helped its share price perk up considerably and will double 2018-19’s payout compared with the previous year. Even so – and despite about £30m of net cash in the group’s balance sheet – this is likely to be a one-off.

Nor does it include Marks & Spencer (MKS), which – hard though it is to believe – paid a 4.2p special dividend in 2016. Seen in the light of the 40 per cent dividend cut announced in February, 2016’s payout now looks like another feeble attempt to disguise the group’s decline.

More contentiously, there is no room for ITV (ITV) even though the company paid a special four years running from 2013 to 2016. Certainly, with a 7.4 per cent yield based on its ordinary dividend alone, ITV’s shares would be a persuasive high-yield candidate if a special were likely. However, with debt ratios rising – net debt to equity has increased from 26 per cent to 123 per cent in the four years to 2018 – it isn’t.

Putting a figure on special dividends      
   Div yield (%)   
 CodeShare price (p)Weighted yieldInc-specialEx-specialChance of future specials*Payout policyNet debt/ebitda
AdmiralADM2,0835.96.04.39ord div 65% post-tax profit; special div earnings not needed for solvency & capital buffers0.1
BarrattBDEV5606.78.04.96Ord div to be 2.5 times covered; special paid "when conditions allow"na
Berkeley GroupBKG3,5651.6see text1.11Return £2.2bn (£16.34p/share) between 2011 & 2021, mostly buybacksna
BHPBHP1,8985.69.04.82At least 50% underlying profit as div's;  one-off special div0.6
BodycoteBOY7933.44.92.44Cover 2.0 times on ord div plus special div depending on cash & funding needsna
CrodaCRDA5,2702.53.81.74Special divs when leverage close to 1.0 times net debt/ebitda1.1
Direct LineDLG32210.111.06.38Grow ord div in line with business; distribute surplus capitalna
ElementisELM1364.84.84.84Ord div not over 50 per cent adjusted eps; special div when net debt below ebitda2.8
FergusonFERG5,5763.68.02.62ord divs to grow in line with long-term eps; return excess cash0.7
Int'l Consol AirlinesIAG4516.813.16.11See co's div policy, 2018 annual report, page 460.3
NextNXT5,5723.43.72.97To return surplus cash by way of share buybacks or special dividends1.2
PersimmonPSN1,93612.112.112.18To pay £4bn (£13/share) between 2103 & 2021; 845p/share paid so farna
Rio TintoRIO4,8685.58.64.82Ord divs 40-60% underlying earnings; special divs after strong cash generationna
Royal Bank of ScotlandRBS2132.96.12.61Ord div 40% attributable profitna
Taylor WimpeyTW.1569.711.74.97To pay ord div of 7.5% of net assets; special div of surplus free cashna
VictrexVCT2,0965.66.82.87Grow ord div in line with eps; special divs when possible (min 50p/share)na
Wm MorrisonMRW1974.36.43.43Ord div 50% basic eps; return surplus cap after cap-ex & maintenance debt ratios1.2
Source: Company accounts, S&P Capital IQ; *Scale of 1 (least likely) to 10 (most likely), see text; †Latest 12 months; na = little or no net debt, or not relevant

What the table does include is entries for 17 companies from the FTSE 350 index that pay a special dividend, or have been doing so until recently, and seem capable of continuing or resuming such payments. Okay, two of the entries are exceptions to that. Royal Bank of Scotland (RBS) is included almost as a novelty. After an absence of 10 years, it returned to the dividend-paying lists in 2018 and threw in a special payment for good measure, even though its annual report does not explain why. Similarly, the bosses of International Consolidated Airlines (IAG), the owner of British Airways, decided to pay a special for 2018 for reasons not entirely clear.

That leaves 15 where there are varying chances of future special payments and where most shares could be candidates for a high-yield portfolio. The attraction of those payments depends on the likelihood that they will materialise combined with their impact on the dividend yield.

The table has columns for three sorts of dividend yield. Most important is the ‘weighted yield’, which I will explain in a moment. Then there is the ‘full-fat’ yield, which includes all of the most recent special payment in the dividend. Last is the basic dividend yield, calculated using just the ordinary dividend as the numerator.

The chance of future special dividends is shown in the column of the same name. This puts a figure, on a scale of one to 10, on the probability that such payments will continue into the foreseeable future, at least at the rate they have been paid in recent years. The score is my subjective estimate and it is influenced by how often in the past five years a company has paid a special and by its stated dividend policy.

Take the score of nine for insurer Admiral (ADM), which is as near to certain as it is sensible to get. So, in assessing the impact of the special on the dividend yield, nine-tenths of the most recent payout is factored in. Thus the column for Admiral’s weighted yield shows 5.9 per cent, which is derived from the effect of all of its 90p ordinary dividend plus nine-tenths (ie, 32p) of its 35.6p special.

This exercise is most dramatic where the gap is widest between the weighted yield and the ‘full-fat’ yield. So, for International Consolidated Airlines, a 13.1 per cent all-in yield plummets to 6.8 per cent after factoring in the slim chance of further specials.

But perhaps it is most instructive where a realistic high-yield candidate becomes borderline. Take metals technologist Bodycote (BOY), whose shares offer a 4.9 per cent yield including all of 2018’s special – an attractive figure for a successful company. Bodycote has paid a special in the past two years, but that’s only two out of the past five, making the chance of future near-term payments not that likely. Hence the weighted yield of just 3.4 per cent – not enough for an income portfolio.

The other useful effect of using weighted yields is that they give a guide to how much income an investor might spend from a full-fat payout. Sure, it might be fun to spend every penny that, say, International Consolidated Airlines will pay early next month. A similar temptation might befall shareholders in housebuilder Persimmon (PSN) where the special is wrapped into the ordinary dividends until 2021. To do so might be a mistake. In effect, investors would be turning some of their capital into income and, by spending it, making themselves poorer. Restricting what’s cashed out to the amount dictated by the weighted yield would be a good restraint.

That’s another thing about special dividends. Not only can they mess up investment calculations, they can be too much of a good thing.