Let’s Discuss Dividends

A recent Capita report on an upcoming slowdown in dividends has prompted some comments to sit through this adjustment, claiming that it is the natural end of a business cycle and therefore to keep holding.

Perhaps they are right, but I suspect that the answer is not that simple. The advice bothers me because I believe that thinking investors do not want to be patronised, let alone be confused with ostriches who bury their heads in the sand.

So, let’s discuss dividends.

Signalling

What is the motivation and consequence of companies by their act of paying dividends? One of them is signalling. Signalling gives a sense to outsiders of the strength and value of the companies. In an earlier piece on signalling here I wrote the following on dividends:

Dividend smoothing happens because companies want their dividends to appear less volatile than earnings. Dividend signalling hypothesis states that when management increases dividend, this signals their confidence in the company to be able to maintain the higher payout in the future. A dividend cut on the other hand, signals an almost desperate need for cash preservation.

Smoothing of dividend payments mean that there might be a further reduction. Therefore, companies are very reluctant to reduce their dividend payouts because of the signalling element that there could be trouble ahead.

If they do indeed have to lower the payouts, the question that begs to be asked is, does this signal a change in the future trend of payouts for this company?

Sustainability

Falling cover is an alarm but no cause for panic in itself. Therefore, question whether this is permanent or temporary. Using GSK as an example, will the new drugs in the pipeline bring cashflow back to healthy levels?

According to Peter Stephens,

Where GlaxoSmithKline has enjoyed success is as an income stock. Its dividends per share have risen in each of the last five years and the company now yields a hugely enticing 6.3%. That’s over 50% higher than the FTSE 100’s yield of 4% and means that GlaxoSmithKline is viewed as a top notch defensive stock by many investors.

Despite this, GlaxoSmithKline’s dividends could be a cause of concern for its investors. That’s because, while it is aiming to keep dividends at roughly 80p per share over the next few years (which would amount to a yield of over 6% per annum), there is a danger that they could be slashed. That’s because they account for almost all of GlaxoSmithKline’s profit, with the company due to have a payout ratio of 95% next year even though its bottom line is set to rise by 12%.

Some companies like Vodafone are capital intensive requiring them to continuously invest in new developments, often in excess of depreciation and amortisation. Since cashflow can’t be spent twice, this too needs to be taken into consideration.

In addition, think about what the growth rate of dividends would be for the particular company or sector. Weigh the possibility that the rate of increase of dividends may stagnate to zero or negative for quite some time, in which case, you should be open to rethinking your positions. Using the same example again, GSK has ruled out any dividend growth until 2017.

It is not only where the cashflow needs to go towards, but also where it’s coming from. Exposure matters. According to the Capita report, there are further downside risks to dividends in globally exposed sectors.

Source of Cover

Does the company have a reassuring and stable source of cover? BHP Billiton is considering taking on debt in the short-run to cover its policy of increasing dividend payouts each year.

Source: Bloomberg

Is taking on debt to pay dividends a good move, even if it’s just for the short run? There will be differing opinions on this, such as what the optimal capital structure for each firm commensurate with the underlying business risk should be, but this is a question that should be asked.

Safety

Be careful of assuming that a company is a tower of dividend safety – even empires can crumble overnight. Tesco today is not Tesco of the past, this year it cancelled the final dividend and I wonder its capability to pay dividends for the coming years, the supermarket scene has been brutal. If you are a turnaround specialist it’s fine to hold Tesco, but if you are an income investor, then safe to say there might be a better choice.

If you are handed a wrapped present at the airport and told to carry it throughout the flight and you will get paid when you’ve arrived, wouldn’t the first question you ask, “what is in this box?” Similarly, here is a chart prepared by Sam Stovall that says income investors should think like a landlord rather than a trader:

Source: Business Insider

There are companies that offer high dividends but come with disproportionate amount of risk. Look at the risks too and not just the yield.

It’s ok not to do anything or take any actions as long as you have considered why you are not, taking into account cognitive biases that might impair your judgement.

*Companies mentioned in this post are for example purposes only and are not recommendations.

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