Join our community of smart investors

Dividends uncovered

The damaging impact of high dividend payouts on companies, the economy and society
March 8, 2019

One of the main features of the first-quarter (Q1) 2019 reporting season is that bank dividends are back with a bang. To shareholders, it comes as great news that Barclays (BARC), Lloyds (LLOY) and RBS (RBS) are significantly hiking their payout. Yet, there are investors who will still be put off owning bank shares, uncertain over their ability to grow profits without taking on unacceptable operational risk.

Glancing over the FTSE 100, there are reasons to doubt many of the most income-generative sectors. Are energy companies investing enough in the future? Housebuilders are heavily dependent on the government’s Help to Buy scheme. Utilities are highly geared and face political uncertainty. High-yielding telecoms companies carry burdensome debts and operate in a highly competitive marketplace. Tobacco is an industry in structural decline.

Examining the health of companies distributing most to shareholders gives cause to question the sustainability of payouts and whether they are the best use of cash. When they come at the expense of capital investment, or kicking pension deficits into the long grass, there is an existential issue: is the dividend culture bad for the economy and society?

 

Back with a bang: Barclays, Lloyds and RBS are significantly hiking their dividend payout

In defence of dividends

Reinvesting income and allowing compounding to work its magic has been a massive component of equity returns. Just looking at price returns between 1900 and the start of 2019, the inflation-adjusted compound annual growth rate (CAGR) of UK equities has been 0.8 per cent (Dimson, Marsh and Staunton, Triumph of the Optimists, Princeton University Press, 2002, and subsequent research). This means money invested at the outset of the 20th century would now be worth 156 per cent more in real terms. Add in dividends and the real CAGR leaps to 5.4 per cent or, in other words, the original investment would be worth 49,467 per cent more – quite a difference.

Buying a stock market tracker that reinvests income and watching returns compound is, it would seem, as close to a sure thing as exists in investing. Trackers reallocate cash from income stocks across all companies in the replicated index, so dividends from large ex-growth companies are also reinvested in companies that offer the best prospect of capital returns.

In a managed portfolio of shares, investors judge for themselves which companies are going to grow the most. To borrow the Boston Consulting Group matrix (see diagram, page 29), investors may choose to reinvest dividends from cash cow companies into the growth stars in their portfolio or into Question Marks that may become stars.

One could argue that, if you don’t believe a cash cow can continue to make the best return on your capital, why stop at reinvesting the dividends elsewhere? You could sell out completely and just invest in stars and “Question Marks”. Quality dividend-paying stocks have, however, often proved less volatile than growth stocks.

This leads nicely into a modern portfolio theory (MPT) argument that the most risk-efficient portfolio for an investor is not necessarily a concentration of investments capable of spectacular growth. The role of say a Unilever (ULVR) or a Diageo (DGE) in your portfolio may be for income and partly to counterbalance the downside risk of more speculative investments in smaller companies.

Overall, the best risk-return outcomes may be achieved by holding some of these less volatile income stocks alongside riskier investments. Investors can make their own capital allocation decisions, which may be more advantageous than just reinvesting in the company that generated their income. Dividends afford this choice.

Of course, people may not be looking to reinvest their dividends at all. It is quite reasonable to expect your property to pay you an income in retirement, for example. The dividend puzzle theory asks why investors shouldn’t just prefer companies to use profits to grow the business and periodically sell shares for income. There may be a tax advantage to doing this (see box) but there are other considerations.

In practice, the volatility of shares makes it difficult to sell at the best price exactly when you want to take income. While dividends may face being cut in recessions, many large companies have fiercely protected their payout in tough times, providing investors with welcome respite and allowing an income to be maintained without crystallising capital losses in a downturn.

Don’t kill the goose…

There are plenty of good reasons to demand a dividend, but problems arise when management unreasonably prioritises payouts over the long-term health of their business. Companies have a balancing act in terms of managing their capital structure, financing long-term liabilities (some of which may exist off-balance-sheet, such as pension deficits), interest payments, investment in the business, operational expenses and choosing how much cash to distribute to shareholders. At the most basic level, companies need to ensure they remain solvent and, ideally, they should be dynamic in pursuing opportunities to grow and diversify revenues.

Even for investors who are buying a stock principally for income, it is important to question whether the business is in good shape. After all, dividends can be cut and ultimately depend on the sustainability of underlying cash flows. People often focus on the basic dividend cover ratio (earnings per share divided by dividend per share), but this will not tell the whole story. Just because a dividend is covered by accounting profit doesn’t mean paying it, along with other cash outflows, can’t place the business under solvency pressure. Furthermore, a figure calculated from one income statement or trailing blended 12-month period, can’t in isolation tell you if a dividend can or should be maintained.

Companies differ across sectors, but the key tests are that they can protect or grow profits, throw off plenty of cash and shareholders don’t face too many competing interests – be they bondholders or other debtors, lessors or defined-benefit pension schemes. Even when this analysis shows that a business can afford its dividend policy, there may be opportunity costs with potentially profitable projects being shelved and underinvestment in staff and technology, which ultimately harms productivity.

Testing the sustainability of big dividend payers

Over the past 12 months, investors have pocketed £67,814m from the top 20 FTSE 100 dividend payers (first quintile by total cash distributed, data from Morning Star via SharePad). More than one-quarter of this amount came from oil giants BP (BP.) and Royal Dutch Shell (RDSB), with mining and banks the next two biggest sectors, followed by the contributions of big pharma companies Astrazeneca (AZN) and GlaxoSmithkline (GSK).

 

FTSE 100 top 20 dividend payers

Company nameLast 12-month cash dividends paid (£m)Dividend yield (%)Dividend cover (Basic EPS)Dividend cover ex specials (Basic EPS)
Royal Dutch Shell (RDSB)122995.91.51.5
HSBC (HSBA)78876.21.21.2
BP (BP.)52565.71.21.2
BHP Group (BHP)49865.10.51.0
Rio Tinto (RIO)42025.21.52.7
Unilever (ULVR) 36533.22.32.3
Vodafone (VOD)35799.6-1.6-1.6
GlaxoSmithKline (GSK) 39275.30.90.9
Astrazeneca (AZN)27343.40.60.6
British American Tobacco (BATS)43476.81.41.4
Glencore (GLEN)22254.91.21.2
Lloyds (LLOY)26735.11.71.7
Imperial Brands (IMB)16767.50.80.8
Barclays (BARC)165841.41.4
Diageo (DGE) 16062.21.81.8
British Telecom (BT.A)15257.20.00.0
Ferguson (FERG)10452.70.92.9
Carnival (CCL)10623.42.32.3
Anglo American (AAL)10133.72.82.8
Prudential (PRU)121331.81.8

Source: Morningstar via Sharepad, S&P Capital IQ

 

The snapshot provided by trailing 12-month blended earnings figures suggests that, while on the whole companies can afford these huge sums, they are stretching what is prudent. There are differences between sectors but, as a rule of thumb, dividends should be covered by between one-and-a-half and two times earnings. Cover below one is a warning sign.

Excluding special dividends, there are several large companies with cover at the lower end of the prudent range and some with scores in the red zone. AstraZeneca and GlaxoSmithKline have dividend cover below one, as does tobacco company Imperial Brands (IMB). Vodafone (VOD) pays its chunky dividend on the back of no profits at all.

Ultimately dividends are supported by free cash flow (cash from operations minus tax, interest expense, capex and adjusted for working capital requirements) so it’s not just the level of cover from accounting profit that we should consider. The exception to this is the banks, as due to lending activities it makes more sense to look at profits rather than cash; there are other ways to evaluate banks’ solvency alongside the cover analysis.

Companies’ strategies cannot be assessed looking at only one trailing 12-month period, however. Cash fluctuates depending on business cycles, corporate fundraising, divestitures, acquisitions, investments and exceptional costs. As Rio Tinto's (RIO) announced special dividend (to be paid in April 2019) demonstrates, cash from non-growth activities such as asset sales can be earmarked for shareholders in the future. Just looking at the past 12 months, Rio’s ordinary dividend was covered a healthy 2.7 times by basic earnings. Add in special payments and that figure falls to 1.5 times, not reckless but a clear indication of priorities.

Alex Newman pointed out in his write-up of Rio’s latest results (Rio Tinto’s $4bn special delivery, 27 February 2019), that the enormous special due in April will take returns to shareholders, in dividends and buybacks, to $29bn since 2016: “more than the total capital allocated to reducing net debt ($14bn), sustaining operations ($6bn) and growth projects ($7bn).” Clearly, the ordinary dividend cover in just one 12-month period can belie the extent of the distribution policy over time.

Short-changing future generations (and business cycles)

Investors may ask themselves why they shouldn’t demand a progressive dividend policy supplemented by special payments when the opportunity arises. Companies such as Rio Tinto that are at the mercy of commodity prices when estimating the required internal rate of return for capital investment projects, cannot guarantee they will make that money work harder than shareholders. Should the companies only focus on the most profitable projects and return excess cash to the capital owners? After all, dividends are an important part of maintaining the incentive for investors, which supports the share price. Happy shareholders make it easier to raise money from equity markets in the future (and hence the cost of capital will be lower) when there are attractive projects requiring additional capital.

This is all well in theory, but mining and oil & gas are capital-intensive industries that require a high level of replacement capex. Furthermore, it is important to speculate on new reserves. With cyclical industries subject to price fluctuations, it is hard to forecast future revenues and break-even points, but investments must be made nonetheless. Making hay while the sun shines should not just apply to harvesting cash when commodity prices are high.

More critically, companies have a responsibility to use some of their profits to solve the planet’s future energy and resource needs. Research at Stanford University (Jacobson, Delucchi, Cameron and Mathiesen, 2018) suggest that the world will need to invest $100 trillion by 2050 to transition to renewable energy. This astronomical figure could not be met just by not paying dividend, but large companies undoubtedly have a role to play in investing in new technology, to help bring about advances to revise down such huge cost estimates.

Research – that the oil and gas industry may contest – calculates that fossil fuels received subsidies totalling $5.3 trillion in 2015, which was 6.5 per cent of world GDP (Source: Coady, Parry and Shang of the International Monetary Fund and Sears of the University of California, 2017). The report has a “broad notion of subsidies arising when consumer prices are below supply costs plus environmental costs and general consumption taxes”. In other words, fossil fuels are subsidised because they are not being forced to pick up the tab for the damage they cause.

This is controversial and it would be a fantastical leap to assume pushing these supposed costs on oil companies and end users would free up the world’s resources to plough into a sustainable renewable future. Any such attempt would surely lead to economic depression and render green investment on the scale mooted wholly unlikely.

What discussions on the externalities of energy supply do highlight, however, are the political risks facing energy companies. Fossil fuel subsidies, whether real tax breaks or contested estimates, are a public relations challenge. The emphasis on companies’ environmental, social and governance (ESG) scorecards is growing. Paying large dividends and neglecting investment in a sustainable future may come back to haunt the energy giants. In fairness, Shell did invest $922m on research and development in 2017, but that figure pales in comparison to its dividend payments ($10,977m in its 2017 financial year).

More parochially, the issue of subsidising company profits is heating up for the UK housebuilders, thanks to the super-normal earnings they have made since the government’s Help to Buy scheme was launched in 2013. Unlike externality costs, Help to Buy is a very tangible subsidy – as the government underwrites up to 20 per cent (40 per cent in London) of the purchase price of new-build properties up to £600,000 in value. Arguably, as Phil Oakley has often written, this has enabled companies to inflate the price of qualifying newbuilds, helping them make fat profit margins. In terms of yield, housebuilders are some of the UK’s best dividend payers, but as building costs rise, their margins will come under pressure when Help to Buy finishes in 2023, which will probably spell the end of the cash bonanza shareholders have enjoyed.

Does the dividend spell danger?

Strong and growing margins and good conversion of operating profits to cash should be at the forefront of income investors’ minds. This is underpinned by companies maintaining capex and at times being prepared to prioritise investment. Professional investors agree. Fund manager Laura Foll of the Janus Henderson Lowland Investment Company (LWI), says the “dividend shouldn’t be the tail that wags the dog”, and businesses cutting capex or selling assets to maintain a dividend is a warning bell.

In the short term, confident management may not see the need to suspend payouts that aren’t covered by free cash flow, if they are investing in projects to fund future growth. It may be that some additional capex lowers FCF cover but a positive trend in cash generation means the board is happy this will be temporary.  

Working capital management (the difference between short-term and liquid assets such as cash and short-term liabilities) needs to be looked at distinctly. This too can come under pressure for good reasons – for example an exceptional spike in orders may require an increase in short-term borrowing or payables to fulfil the volumes – but a negative trend in working capital is a red flag.

Some companies that pay large dividends would rather maintain their payout at all costs and plug gaps by borrowing. As more debt is taken on, the growing interest expense eats into cash flows, which places the dividend under pressure if there is no increase in organic cash generation. If the dividend is still the priority, then capex may be cut and investors are left with a business with poor productivity that is overreliant on debt.

This can end up in a vicious circle as the only reason to hold the shares becomes the dividend, which is maintained to give investors a risk premium for holding the stock. Take Vodafone, for example. The shares yield 9.6 per cent, but the company is heavily indebted (37 per cent of capital, says Sharepad data) with net debt 2.6 times the Ebitda (earnings before interest, tax, depreciation and amortisation) measure of cash profits. Mobile telecoms is a highly competitive industry; with margin progression uncertain and Vodafone’s return on capital employed (ROCE) weak, the yield is the only thing about the shares that looks attractive. How long it can be maintained is questionable and the high yield is possibly a warning sign of a value trap.

 

Why management loves dividends

Chief executives (CEOs) are incentivised to grow earnings per share (EPS), and the temptation exists to overlook longer-term growth opportunities to boost short-term profitability. The best way to align shareholders’ interests with CEOs’ bonus cycles, is to share the wealth with a dividend payout. Special dividends help quell discontent among investors at the scale of executive rewards. Furthermore, remuneration committees often give hefty weightings to measures such as total shareholder return, of which dividends are a major component. Some executives will be paid bonuses in share options, so they are also enriched directly by rising dividends.  

It is much easier for management to endear themselves to investors by handing them cash than it is to extol the virtues of an investment programme, the fruits of which may not be enjoyed for years. Sadly, this contributed to chronic under-investment in the developed world economy since the early 1960s. Of course, there have been significant technological advances, but as Gerard Minack (founder of consultancy firm Minack Associates) points out, savings have been passed to capital owners not reinvested to boost productivity.

Greater reinvestment would have seen more benefit accrued by workers in the form of training and wage growth. The obvious retort to this is that wage growth is inflationary. However, increased capital investment would have increased the supply of goods in the economy, thus maintaining the equilibrium of aggregate supply and demand. When companies make capital investments, this feeds back into the economy. Sustainable growth that boosts supply and demand has the multiplier effect on wealth. Increasing gross domestic product (GDP) is good for company profits and cash flows – especially dynamic and capital-efficient companies. So, while investors shouldn’t feel under duress to be social justice warriors, it is in everyone’s interest to question whether the current level of dividends and buybacks is sustainable.