Coronavirus: Market perspectives
By: Mark Nelson
Divided on dividends
The topic of dividends has long been the subject of significant debate amongst the finance community. Hours of academic research have been dedicated to attempting to judge the importance of dividends in the valuation of a company. Some have suggested those that pay dividends are more valuable than those that do not, all else being equal. Others have suggested the opposite. Nobel prize winners Franco Modigliani and Merton Miller, who are responsible for perhaps the most well-known piece of academic work on the subject, opine that whether a company pays a dividend or not is irrelevant to its valuation, ignoring the impact of taxes.
Dividends are also an important factor in the differentiation between investment styles, specifically growth investing and value investing, with the latter far more likely to invest in companies with high dividend yields, while the former is likely to have a preference for those companies that reinvest earnings back into their businesses
Against the backdrop of the ongoing coronavirus outbreak, and its impact on the global economy and the value of financial assets, dividends are back in the spotlight once again. More than 150 companies in the UK have cut, cancelled or suspended their dividends since the start of the Covid-19 crisis, with companies abroad also putting dividends on hold. For some of these companies, this course of action has been necessary in order to safeguard the future of their businesses. For others, the dividend cancellations have followed government or regulatory pressure, with the UK banking sector being a notable example.
This has led many to ask how one should invest for income in the current environment. Our response to this question is twofold. First, we would caution against investing purely on the basis of yield. Our view on dividends, and their importance in the valuation of a company varies very much on a case by case basis. The appropriateness of a dividend is related to a variety of factors, but principally it should be a function of a company’s stage in the corporate life cycle. For mature businesses, with lower reinvestment opportunities, a high dividend payout ratio – that is the percentage of net income a company pays out as dividends – may well be appropriate.
However, only investing in companies that pay high dividends means that you are likely to be overexposed to certain types of businesses at the expense of large parts of the investment universe, including geographies in which dividend payments have traditionally been lower such as the US. For example, an investor interested only in income would likely never have owned shares in companies such as Amazon, Nike, and Google – just three of many more companies that pay no or relatively low dividends but have produced strong total shareholder returns over extended periods of time.
That said, dividends can help to support shareholder returns and also act as a useful check and balance for management, helping to avoid mistakes in capital allocation such as ill-judged mergers and acquisitions or expansions into new areas in which the company has little expertise or competitive advantage. One should consider the track record of a company’s capital allocation decisions when considering the appropriateness of its dividend.
Secondly, in an environment where many companies are reducing cash returns to shareholders, it has rarely been more important to carefully consider the dividend sustainability of businesses. There are a number of ways in which to do this, including well known techniques such as the Piotrowski F-score which considers the profitability, leverage, liquidity and operating efficiency of companies, or the Merton Model, which calculates a distance to default and can be used to assist in measuring a company’s ability to maintain its dividend.
These are quantitative approaches and, while valuable, in this most unique of times we believe that it is important also to qualitatively consider the impact that the current coronavirus outbreak and indeed the current weakness in the oil price will have on companies’ financial strength, with certain consumer sectors and energy stocks expected to be particularly impacted. Conversely, parts of the utility, healthcare, telecoms and consumer staples sectors are likely to be relatively less impacted, in our opinion.
As referenced earlier, it is also important to consider the influence of governments and regulators in judging whether a company will maintain its dividend, with those making use of support packages in order to navigate this crisis likely to find it difficult to justify continuing to return cash to shareholders whilst receiving financial assistance.
Overall, our opinion on dividends is that they are neither uniformly good nor bad and that the appropriateness of a company’s dividend policy should be considered very much on a case by case basis, with reference to where that company is in its business life-cycle, its reinvestment opportunities and its track record in capital allocation. We would also stress that it is total shareholder returns that is the most important performance metric for investors, not the amount of income received and that focusing purely on yield precludes investment in certain high quality businesses which we would argue have more value accretive opportunities in which to put their cash to work than simply returning it to shareholders.
Also, in these unprecedented times, investors must look beyond a headline yield and consider the financial strength of the business, the likely impact on its profitability and cash flows from the ongoing coronavirus outbreak, and the potential influence of government and / or regulators in assessing the safety of a company’s dividend.
Should you have any questions about anything raised in this article, please don’t hesitate to contact us via email, or on 0207 337 0777.
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