Interactive Investor

The hidden downside of dividend payments

19th November 2013 14:09

Esther Armstrong from interactive investor

Some investors see dividends as their bread and butter, while others view them as the icing on the cake.

The camp an investor falls into will depend largely on their stage of life and risk appetite, but either way dividend payouts are usually deemed to be positive for shareholders.

But what if these payouts were detrimental to the long-term growth prospects of their holdings?

Companies can use excess cash in a number of ways, including: paying down debt, for research and development, buying new machinery or rewarding shareholders for their investment and patience.

When it comes to the latter, the most common method is to give money back in the form of a cash dividend.

Share buybacks are another way of keeping investors sweet because, as companies cancel the shares they buy, the relative value of the remaining listed shares increases.

Stack of cash

Largely as a consequence of the financial crisis - which many feared could escalate into financial Armageddon - the corporate sector has stronger balance sheets than ever.

For the first couple of years after the worst of the crisis was over, companies stashed away large sums of cash, mainly because they didn't yet know the worst had passed.

This led to legions of frustrated investors, who felt they were entitled to some of the money, particularly since many companies had bunkered down to such an extent their capital growth suffered.

Gradually, as the mists lifted and systemic catastrophe was averted, companies began to contemplate sharing their wealth.

Subsequently, since 2010 there have been three bumper years for dividend payments, much to the delight of yield-hungry investors, and 2014 is predicted to trump them all, according to Capita Asset Services.

Looking at the behaviour of the equity market, it is not difficult to see why the return of cash is prioritised. Keith Wade

At the other end of the spectrum, capital expenditure (capex) has disappointed earlier expectations.

Keith Wade, chief economist at Schroders, says: "Last year there was a strong consensus that capital expenditure would contribute to global growth in 2013.

"However, as the year evolved it became clear that investment would disappoint such that it is now expected to drag on growth in the eurozone, UK and Japan.

"In the US, business investment is still expected to be positive but is only expected to increase by 2.7% this year. In 2011 and 2012 it grew at a 7% annual pace," he continues.

These downgrades in capex have been seen across all regions, Wade says, and are partly behind the cut in general growth expectations for 2013.

One potential reason for companies' capex-adverse attitudes is the behaviour of shareholders. Investors are rewarding companies who pay out, not those who invest in the business.

Shareholders take charge

Recent figures from the US show there is now a reduction in the rate of cash flow growth on corporate balance sheets, but this has been driven by an increase in dividend payments, not a revival in capex.

"Looking at the behaviour of the equity market, it is not difficult to see why the return of cash is prioritised as quoted companies with low capital expenditure relative to depreciation have significantly outperformed those with higher rates of capex to depreciation," explains Wade.

"This trend has been in place for some time but accelerated during and after the financial crisis. Part of this can be attributed to pressure from shareholders who have pushed companies to release cash - a trend which could well continue.

"Underlying the preference for cash-returning firms has been the very low level of interest rates and bond yields available to investors," he adds.

This has been likened by some commentators to Pavlov's dogs: each time shareholders are happy with the dividend payout the share price increases, thereby conditioning the company to do more of the same.

If companies are giving cash back to shareholders rather than investing, it is stating the obvious that it can hurt the underlying business."Jamie Forbes Wilson

An example of this was seen with BP's "surprise" third-quarter dividend hike this year, which prompted an almost 5% rise in the share price. 

So, even in historically capex intensive sectors, the trend is towards capex reduction and dividend payouts.

Neill Morton, analyst at Investec, says: "The stockmarket doesn't want the oil majors to spend money. Instead investors want their cash back. BP obliged with an increase in the dividend, a new $10 billion (£6.2 billion) disposal programme (with proceeds going to share buy backs) and indicated flat capex in 2014."

Another commodities giant, Rio Tinto, cut its expenditure on exploration and evaluation by 48.5% in the first nine months of 2013 and said it would continue to target lower capex going forward. 

Such is the change in the management mentality of some of these companies that they have started to change from traditional value/growth stocks to be considered by income investors.

Lower for longer

But is there a danger that firms are increasingly being run for cash to meet investors' near term income needs, rather than as vehicles looking to invest and grow their businesses?

If so, the knock on effect could be weaker economic growth for longer.

Naturally, some companies are more capital intensive than others. Many manufacturers, for example will be constantly designing and building new products or looking for ways to innovate their old products.

Others, especially internet-based firms, do not require huge swathes of cash once the original set-up costs are taken care of - Rightmove is such a company.

Jamie Forbes Wilson, manager of the AXA Framlington Blue Chip Equity Income Fund, says the focus should be on total shareholder returns, not just income for income's sake.

It is possible that 2014 will see a capex revival which will support the upswing in global growth."Keith Wade

"If companies are giving cash back to shareholders rather than investing, it is stating the obvious that it can hurt the underlying business, but it needs to be looked at in the context of the economic environment.

"During the crisis a lot of companies undertook emergency measures and for the first time in history, probably, workers were aware the economic environment was under extreme stress and pressure, so companies could justify pay cuts or freezes and shorter hours.

"Now the corporate sector is awash with cash and balance sheets are repaired, but management have been reticent about doing anything with that cash," Forbes Wilson adds.

More recently boards of directors have started to modestly and steadily increase their underlying dividend payments because management have become more confident they do not need to shore up the company to such an extent.

There has also been a degree of mergers and aquisitions, but more dramatically a surge in special dividends.

Managing expectations

The beauty of special dividends, Forbes Wilson explains, is they are by nature "one offs" and so companies are not tied into paying the same amount out the follow year.

ITV and Vodafone are just two of the most high-profile companies to have recently announced significant special dividends.

In fact, so large was Vodafone's commitment to paying a special dividend (£16.6 billion gross) after its disposal of its stake in Verizon, that it masks a slowdown in the underlying growth in income being paid by UK firms.

UK dividends are set to burst through the £100 billion mark in 2014, far outstripping the record payout of £80.6 billion in 2012, Capita Asset Services says.

Yet the third quarter of 2013, the quarter which is usually the biggest paying quarter of the year, failed to top the second quarter for the first time since 2008.

We have been warning for some time that dividend growth would slow down. That slowdown has been greater than expected."Justin Cooper

Excluding special payouts, dividend growth slowed to 6.2% in the third quarter, down from 7.7% in the first half of the year. This slowdown means the headline total for 2013 is now likely to fall below the 2012 level, the first decline in headline dividends since 2010.

So perhaps companies have stopped paying out to shareholders at the expense of capex.

The investment intentions of manufacturing firms continue to present a mixed picture, however.

According to the Confederation of British Industry, plans for spending on plant and machinery declined in the three months to October, although spend intentions for "intangibles", such as product innovation, were the strongest they had been for six quarters.

Meanwhile, plans for spending on training and retraining were the strongest since October 1997.

Interestingly firms did not cite shareholder pressure as an influence on their capex constraint. Instead they said uncertainty about demand was the number one constraint.

Double blow?

So, in 2014, shareholders could conceivably be faced with a year of both reduced capex and lower dividend payments.

Justin Cooper, chief executive officer of shareholder solutions at Capita, doesn't think so: "We have been warning for some time that dividend growth would slow down. That slowdown has been greater than expected on an underlying basis and reflects a very soft patch in company profitability over the past year.

"With the economy on the mend, profits should begin to recover over the next twelve months. And companies are rich with cash - the FTSE 100 (UKX) has £166 billion on its collective balance sheet. This should all mean a pick-up in dividend growth next year on an underlying basis."

Wade is also hopeful for capex spend in 2014: "It is possible that 2014 will see a capex revival which will support the upswing in global growth, and the recent strengthening in orders for capital goods suggests that there are grounds for optimism.

"However, a similar picture emerged last year as orders revived before fading away," he says.

The standoff in Washington over the fiscal cliff was one of the major factors weighing on capex spend at the end of last year and start of this year. This means the recent shutdown and the potential for another in the New Year could encourage further delay.

Dividend cuts are rarely, if ever, popular and the market has travelled a long way throughout 2013 and most of 2012."Jamie Forbes Wilson

"We are actually optimistic that another damanging crisis can be avoided in January, not least because politicians will wish to avoid conflict in an election year. Whether businesses are prepared to bet on this remains to be seen."

Can both capex and dividends increase at the same time?

Forbes Wilson says this is essentially a question of whether the market can keep rising: "Dividend cuts are rarely, if ever, popular and the market has travelled a long way throughout 2013 and most of 2012.

"During this time we have been seeing, on aggregate, corporate earnings results cut by analysts, but we hope the downgrades are coming to an end and the next six to 12 months need to see earnings upgrades.

"I think we will see those. The underlying trajectory of the economy in the UK and US means there is a very good chance the market will continue to move higher, and could move substantially higher."

Maybe investors can have it both ways after all.