Danger money: why a big dividend is not always a good dividend

Dangerous Dividends

Anthony Aboud

Portfolio Manager

Are ASX blue chip companies with dividend yields over 5% really an attractive option?

On face value, it may seem like a sensible way to secure a future income stream – especially when bank deposits pay interest of around 2.8%*. But should investment decisions be based on the dividend that a particular stock is likely to pay?

It may be a simplistic and flawed approach.


Dividend payments are subjective

Put simply, the dividend paid to the owners of a business (shareholders) is a decision made by the company board. When a company generates its audited earnings for a year, the board of directors can either reinvest the earnings back into the business for growth or return the earnings to shareholders. The proportion of earnings which is paid out in dividends is called the pay-out ratio. When determining the pay-out ratio, the board will consider a wide range of factors including:

  1. Current capital structure. Does the company have a sustainable capital structure? Might it need to preserve capital and reduce the pay-out ratio to pay down debt?
     
  2. Future capital commitments. Is there a potential future contingent liability for which the company needs to preserve capital? This could be a regulatory requirement to hold more capital or the costs associated with, say, remediating a shut down mine.
     
  3. Requirement to re-invest in business to maintain earnings. The company may have a depleting asset or operate in an industry in structural decline. If the board wants to maintain the current level of earnings, the company may reduce the pay-out ratio and use the spare cash to invest in growth (either organically or inorganically) to fill a potential future hole in earnings.
     
  1. Quality of earnings. The board will consider if reported earnings paint a true picture of business performance. Reported earnings can be volatile because they include non-recurring items like litigation fees or write-offs. That’s why boards often look at cash earnings - they are often a more accurate reflection of business performance.
     
  2. Growth opportunities. If the company has identified good investment options then the board may reduce the pay-out ratio and use the cash to pursue growth.

These considerations are subjective, led by human decision-making on the board which can be influenced by short-term trends.  


Equities are for growth not income

Investors have traditionally bought equities for growth and bonds for income.

One benefit of a bond is that - in the absence of a default - the investor knows what income they will receive over a set period of time and when the original capital will be repaid. While it’s essential to analyse the chance of default before buying a bond, changes in sentiment about a company will not affect the coupon paid and the return of capital at the redemption date.

Equities are different. First, the dividend over the medium term is dependent on the company’s ability to generate earnings after paying interest and tax and allocating capital for investment in the business. These are all subjective decisions made by the board. The return of your capital is not guaranteed and is dependent not only on the performance of the business but also on the vagaries of market sentiment – especially in the short-term.


Short-termism can erode company value

When talking to some Australian companies about the rationale of their current dividend policy, a recurring theme keeps emerging. “We cannot cut our dividend because our long-term retail investors rely on them for income.”

The potential conflict of objectives between the average age of an ASX company (essentially infinite in the absence of being acquired or going bankrupt) and the tenure of a board member – which is on average 5-6 years – can motivate behaviour that maximises the company’s short-term value to the potential detriment of longer term value creation.

The big four Australian banks may be one example. Over the last eighteen months, the four banks combined raised $24bn of equity through capital raisings and dividend re-investment plans^. At the same time payouts increased significantly after taking into account the new shares on issue. All things being equal, this dividend payout will only get larger once the full effect of the higher share count takes effect. Interestingly, for the period of 2011 to 2015, three of the four major banks gradually increased their payout ratios.


Implications for investors

Raising equity from shareholders to pay dividends to these same shareholders may be ‘robbing Peter to pay Paul’. This failure to make unpopular dividend decisions in the short-term can destroy significant shareholder value in the medium to long-term.

Dividends from Australian shares can be attractive# – especially when they are tax-effective franked dividends. However, it could be dangerous to base investment decisions on short-term dividend expectations. Investors should assess the long-term value of a business without considering the next dividend and if they are really seeking immediate income, consider different asset classes more suited to generating short-term income.

*1 year term and a deposit amount of AUD$10,000, as per www.infochoice.com.au, 24 November 2015

^Source: Company annual reports and Perpetual Investment analysis.

#Depending on your individual objectives, financial situation or needs.

The views in this article express the opinion of the author and may contain general advice. It has been prepared without taking into account your objectives, financial situation or needs and because of that, you should consider the appropriateness of the advice before acting, having regard to your objectives, financial situation or needs. Any information referenced in the article is believed to be accurate at the time of compilation and is provided in good faith. The author is an employee representative of Perpetual Investment Management Limited (PIML) ABN 18 000 866 535 AFSL 234426.

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