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All change, please

In the current climate, I first came across this ruse in June when the bosses of Randall & Quilter (RQIH), whose shares are in the Bearbull Income Fund, used it. Without more explanation, they said they were giving each shareholder one new share for every 22 held, which enabled them to claim a total distribution for 2019 of 9.9p a share, 8 per cent higher than 2018’s when, in fact, the cash distributed was 3.8p.

And this week, in search of new holdings for the income fund, I see that Bloomsbury Publishing (BMY) is playing the same trick. Instead of a final dividend for 1919-20, its bosses plan to distribute new shares roughly on the basis of one for every 27 held. Value of new ones can be contrived at 6.9p a share, the cash payout the bosses would have proposed had normality prevailed.

Granted weird times are likely to induce weird reactions, but it’s important for shareholders to understand why, in effect, they get nothing when they receive a bonus dividend. The first step to understanding is to stop calling them ‘bonus’ dividends and use the old term, ‘scrip’ dividends. In other words, instead of cash, shareholders are getting a bit of paper or – more precisely – an electronic adjustment to their holding on the company’s share register.

Nothing else alters. There is no transaction between payer and payee. No value changes hands. There is just a bookkeeping adjustment that shuffles an amount from one part of shareholders’ funds (distributable reserves) to another part (paid-up share capital). Shareholders get what they already own.

To spell it out, let’s revert to the old days when scrip issues were common because company bosses wanted to keep the share price low since that helped the notion that somehow the shares must be cheap. In those times, a one-for-one scrip was quite common. So if I owned 5,000 shares in Motheaten Textiles, or whatever was around in the 1980s, then the one-for-one scrip meant my holding doubled to 10,000. But I was no better off because everyone else’s holding had also doubled and there hadn’t been a single solitary change to Motheaten’s assets and liabilities except for this bookkeeping item within shareholders’ funds. As a result, its share price halved. Where I owned 5,000 shares whose value was, say, £10,000 at 200p a share, now I own 10,000 shares whose value must still be £10,000, therefore the share price halves to 100p.

Just the same is happening in 2020 when Randall & Quilter, Bloomsbury or whoever else has a bonus issue. The only difference is the number of new shares in relation to the number already issued is small enough to have little effect on the share price. Specifically, the effect should be to reduce the share price by the amount that an equivalent cash dividend would have reduced shareholders’ funds. So when Bloomsbury issues its new shares, in theory the effect should be to reduce the share price by about 3.5 per cent and that is the same as the amount that the price should drop if the company was actually distributing cash.

Why, then, all the fuss? For the simple fact that Bloomsbury, or whoever, is not distributing cash. When companies do make cash distributions, shareholders receive a little of what they already own, but in a special form (ie, cash), enabling them to do with it what they will; in effect, it’s a mini-disposal of their investment. They have actually got some money out, and that’s important. When companies hang onto cash, that might work out well for shareholders or it might not. But the risk is that the bosses are keeping cash to make their job easier rather than to help make shareholders wealthier. Meanwhile, it is indisputable that scrip issues – let’s not use this ridiculous ‘bonus’ euphemism – make no difference at all.

Which is why I won’t be adding a holding in Bloomsbury to my income fund. Sure, I could manufacture my own income by selling the new shares I receive. But, costs aside, that’s not a long-term solution, chiefly because selling shares to generate income is a bad habit to get into; it risks over-exploiting capital.

Pity, because the Harry Potter publisher was one of 10 stocks, two of which are already in the Bearbull fund, that I had provisionally identified as producing a ‘Goldilocks’ dividend yield – not too high, not too low (see Bearbull, 7 August 2020). In a way, this illustrates the limitations of winnowing investment possibilities from a database. The devil is always in the detail that the data does not pick up. Just as the yield on Bloomsbury’s shares won’t be as good as the database indicates because not enough dividend is in cash, so another possibility fails – automotive consultancy Ricardo (RCDO) – because it generates less free cash than the database indicates.

That is not as bad as it sounds. Free cash generation falls short because Ricardo does much capital spending hidden to the database in the form of capitalised development costs. Yet that spending should generate value in the future. Short term, however, it undermines Ricardo’s ability to pay dividends.

That said, lousy trading is currently undermining the company’s ability to pay dividends anyway. Even though Ricardo’s order book is holding up decently – at the end of June it was £310m compared with £314m a year before – delayed orders and a drop in productivity caused by Covid-19’s effects mean the group has made zero profit in the second half of 2019-20, so full-year profits will be much the same as the first half’s £16m underlying and pre-tax. That’s also a pity because, as the small table shows, a guesstimate of Ricardo’s per-share value – whether driven by average accounting profits or cash-flow generated – dwarfs its share price.

Cheap or dear?
 Share price (p)Accounting (p)Cash flow (p)
Anglo American1,9222,3472,636
Ricardo363660521
Bloomsbury Pub'g209174207
Berkeley Group4,7236,2054,886
Vesuvius430590433
Stock Spirits228186213
Carr's Group135137103
GlaxoSmithKline1,5411,9901,539
Moneysupermarket.com299195532
Wm Morrison19668248
Source: FactSet   

Despite these shortcomings, I have chosen five stocks from the list to replace five holdings sold from the Bearbull fund in its biggest shake-up in 20 years. First, those that have gone – Elementis (ELM), Zytronic (ZYT), Topps Tiles (TPT), Empiric Student Property (ESP) and Hollywood Bowl (BOWL).

Of those, the holdings in tiles retailer Topps Tiles and bowling-alley operator Hollywood Bowl are sold with regret. Both are sound companies with – so far as one can tell from the outside – plausible business models and markets that won’t go away. However, neither will be paying dividends in the foreseeable future, so their shares have no place in an income fund. Period. That observation applies to the other three sold, but there is the added factor that each company – in its own way – looks weak.

Student accommodation provider Empiric faces short-term disruption to university life dealt by the response to Covid-19. However, longer term – and perhaps more damaging – will be the declining number of overseas students in the UK, to whom Empiric is disproportionately exposed. True, there will almost certainly be a long-term use for Empiric’s halls of residence. But making the transition to a different – and possibly less lucrative – clientele may be painful.

Touchscreens maker Zytronic is also in pain. So much so that one wonders whether there will be a business left much longer. For a quoted company, Zytronic is already very small. At 102p, its equity is valued at just £16.5m. That’s only a third more than the £12.4m of net cash in its end-March balance sheet. Put another way, Zytronic’s equity minus cash is valued at less than the pre-tax profit the group generates in a decent year. Yet there is no sign this has sparked the interest of predators, especially private equity. Odd and even ominous.

Of the disposals, that leaves speciality chemicals supplier Elementis. Selling this holding makes me feel much like, I imagine, the powers-that-be at Manchester United football club must feel now that they have at last got rid of their very expensive mistake, Alexis Sanchez.

Details of prices paid for the five brought in are shown in the table for the full income fund (click on the link below). They are mining group Anglo American (AAL), housebuilder Berkeley Group (BKG), drinks distributor Stock Spirits (STCK), foods processor Carr’s Group (CARR) and price-comparison web site Moneysupermarket.com (MONY).

The key point is that all five remain on probation pending more analysis of their prospects and ability to pay dividends. Sure, for all five, prices paid stack up fairly well in relation to my guesstimates of value (see small table). It looks particularly good at Anglo American and Berkeley, but that is predictable to the extent that both groups are heavy in tangible assets and have shares that sell at lowish multiples of profits.

The opposite applies to Stock Spirits and Moneysupermarket.com. These are asset-lite operations that are closer to growth stocks than conventional income plays. That truth is highlighted at Moneysupermarket.com by the big gap between the estimates of value based on its accounting profits (195p per share) and its cash flow (532p). The cash-flow figure is largely a function of Moneysupermarket.com’s heavy capital spending in excess of depreciation and the high return on equity (RoE) the group has generated. The ensuing value estimate in the table is tempered with caution – I could easily get clear of £16 per share using the RoE from Moneysupermarket.com’s latest accounts – even so, it still needs to be treated with great caution. Even looking from the inside of a company it is difficult to estimate how much excess capital spending will be done in the coming years let alone the returns that such spending will actually generate. Think how much tougher it is to make such estimates from the outside and how much more tentative the conclusions must be.

Still, such exercises provide food for thought and this is the game we play. For now, the Bearbull fund is once more loaded with holdings that should – repeat ‘should’ – pay dividends in the coming months. But instinct also tells me there will further chopping and changing before I get a portfolio that I really like.