What boards need to know about dividends

Sunday, 01 October 2023


    Numerous factors drive a board’s decision for a company to recommend a dividend to shareholders — but the big risk is how that decision will potentially affect investor expectations in the future.

    Most of us would like to forget the heady days of COVID-19, but an announcement made by the Australian Prudential Regulation Authority (APRA) in April 2020 sent a frisson through the financial sector, offering a unique insight into the way investors and boards think about dividend income. APRA told the major banks that it expected banks and insurers to “seriously consider deferring decisions on the appropriate level of dividends”.

    APRA made it clear that dividends should only be paid on the basis of stress testing (and after consultation with APRA) and that any proposal to pay dividends should be “at a materially reduced level”. Moreover, even where a dividend was to be paid, banks and insurers were expected to offset the payout of capital with “dividend reinvestment plans and other capital management initiatives”.

    It’s arguable that APRA was simply applying extraordinary measures to an extraordinary situation — or giving the banks a let-out clause.

    The pandemic had the potential to cause large- scale mortgage defaults, which would have had a deleterious effect on banks’ capital bases. There was now a perfect excuse not to have to pander to the high payout expectations of bank shareholders.

    By the end of July 2020, APRA had updated its capital management guidance for banks and insurers, in particular easing restrictions around paying dividends. It advised maintaining caution in planning capital distributions, including dividend payments. Then APRA chair Wayne Byres GAICD said the updated guidance balanced the need for banks and insurers to keep supporting households and businesses, while also maintaining a prudent approach in the face of a very sharp and severe economic contraction.

    “There was a lot of anger and frustration among shareholders. They were reliant on this money,” says Australian Shareholders’ Association CEO Rachel Waterhouse. “There were people out there who needed this money for groceries. There was the sudden shock of not having it there and possibly quite a lot of frustration within the banks, as well.”

    Byres agrees that it was contentious then and remains so now. “[APRA actions] rarely generate public attention, but this was different,” he says. “It’s fair to say very little of the correspondence was supportive of the decision and, in a few cases, the anger was very evident.”

    Always on the rise?

    The question here is whether Australian investors believe good companies must have a “progressive dividend policy”, meaning it is right and natural to continue a policy of maintaining and raising dividends over time. It also raises the question of whether constantly rising dividend payouts signal a company’s growth prospects are limited.

    Tony Catt MAICD, CEO and director of Catapult Wealth, says a progressive dividend policy has “created a rod for corporate Australia’s back”.

    “I can imagine CEOs and boards get put under share price pressure and therefore [are] worried about share prices being negatively affected by changing dividend policy,” says Catt. “They are clearly worried about the effects on their investor base.”

    Waterhouse agrees that there is a strong psychological pull not to change dividend policy — and that this runs deep in the investor psyche. Many, she says, don’t apply the age-old caveat about growth stocks to dividends and they seem to believe past history is a guide to future payouts.

    “There is an expectation that if a company pays two dividends a year, then that will always continue,” says Waterhouse. “The challenge, though, is when they base it on a history — if, say, the performance deteriorates, then the retail shareholder might still expect the same dividend, even when the money is not there.”

    Not everybody believes ASX companies are pressured to keep paying dividends, nor is a steady increase in dividends necessarily self- defeating. Simon Conn, a senior portfolio manager at Australian equities fund manager IML, notes it makes sense for a company to at least maintain and steadily grow a dividend when it can.

    “Obviously, it depends on the lifecycle of the business, the capital intensity of the business and balancing the balance sheet in terms of debt and equity,” says Conn. “It creates a more stable share price. If you can rely on a yield, it creates a floor, an underpinning of the share price.”

    He says companies will only make the payments dependent on profitability and cash requirements. “They’re not going to maintain a dividend just to maintain a certain yield level. Companies can’t control share prices, so ultimately don’t control yield.”

    Byres points to the balance that is needed here. “A track record of paying out a regular stream of dividends will tend to make it easier for companies to raise capital when needed,” he says.

    Dividend fever

    CommSec chief economist Craig James is not entirely convinced there is a psychological component involved in income strategies. “Some companies will say they have plenty of options of what to do with their cash — they’ll say, let’s give it back to loyal shareholders,” he says. “Others will say they want to see the business grow over time. They want to see it deployed for growth. Everyone’s a bit different. The older people want dividends, the younger ones to see the business grow over time.”

    James notes that these “non-” or “low-dividend paying” growth companies exist within the financial, retail, healthcare and tech sectors.

    “Dividend fever” is not ubiquitous, according to Ausbil income portfolio manager Michael Price. He says it is still possible to find companies that see the advantages of growth and believe increasingly shelling out money to investors might start something that cannot easily be curtailed.

    “When it comes to cyclical companies where the profits can go up and down, investors like us prefer to see companies with a policy to pay 40–60 per cent of their cash flow after profits and dividends, and state clearly what that policy is,” says Price. “It’s understood that when the cycle is up, that’s good and when it’s not so good, they’ll cut — and many do make that clear — to stop that negative psychology.”

    Of course, there are structural reasons for the higher dividends paid by Australian listed companies. There is the beneficial tax treatment known as dividend imputation, which allows companies to pay out their dividends from after- tax profits. The imputation of these tax credits avoids taxing the same profits twice — once at the company level and again in the hands of shareholders.

    Shareholder bases are only reacting to the beneficial treatment of income. The fervid desire for income among retirees in a low tax bracket is the fuel behind such expectations.

    According to Byres, it’s also worth noting that for companies there is no value in hanging onto a large pile of them. “Dividends are the most common means by which they can be transferred into the hands of those who value them,” he says. “So it makes sense for corporates with franking credits to pay dividends of a sufficient size that the credits can be distributed over time.”

    The numbers don’t lie

    Research shows an inexorable rise in corporate payouts that, at times, seems to defy the surrounding economic conditions. As of December 2022, the trailing 12-month dividend yield of the S&P/ASX 300 was 4.5 per cent (by comparison, the US is 1.7 per cent). It is the highest among all major developed markets.

    Research by S&P DOW Jones Indices reveals that ETF assets-tracking dividend strategies in Australia have grown from $571m in 2012 to $3.8b by 2022 — a compound annual growth rate of 21 per cent.

    During the 10-year period between 2010–19, close to 180 companies, on average, either maintained or increased dividends compared with the previous year. While the pandemic crisis triggered dividend cuts in 2020, the market soon recovered in 2021, with 164 increases and only 53 cuts.

    In 2022, despite the S&P/ASX 300 being down by 6.05 per cent, 148 companies still increased their dividends. This number is close to the historical average number of companies doing so.

    James says the Australian market is clearly taxed favourably on income, while the US is taxed more generously on capital gains. The result is two countries with vastly different investor “psyches”. That said, the dominating ASX-listed companies — mining and banking stocks — have collectively experienced strong profit growth and cash generation over time. James believes dividend policy should be a question of looking backwards at earnings achieved, and looking forward to the economic road ahead.

    There are alternatives

    With interest rates and inflation rising, James says it might prompt some investors to opt for bank deposits as those returns start to approximate and possibly even overhaul dividend yields. Expenses and costs have been rising, outpacing revenue.

    “If you’re not in a position to pass expenses on to customers and clients, you may well see revenue and profitability affected,” says James, who believes only those with the pricing power will be able to maintain their dividends.

    However, until a regulator calls a crisis “official” — as APRA did in 2020 — it’s anybody’s guess how companies will react to more difficult economic conditions. “There’s greater value in holding on to extra money than paying it out at the moment,” says James. “They may go down the route of takeovers or buybacks. There are other options than simply paying out.”

    Byres mentions dividend reinvestment plans that provide a means to effectively lower a company’s dividend payout ratio by allowing shareholders to use their dividend to buy additional shares (often this can be done without brokerage costs and at a small discount to the market price of the share).

    James says investors want to know the thinking behind the numbers. “They want to see companies have been thoughtful in allocating capital.”

    Catt hopes companies will “do the right thing” and adapt to reality. Why, for instance, would companies try to compete with bank deposits as interest rates spiral upwards? “The psychology has already started to turn,” he says. “Investors haven’t lost sight of the fact that they can get 4.2 per cent in a long-term bank deposit without any share price risk, so might be wondering why they should bother with a 4.5 per cent yield in Wesfarmers shares. I hope companies do what’s right for the business and don’t react to outside noise.”

    Show us the money

    There are alternatives to paying dividends to shareholders as companies seek to manage their capital and investor expectations.

    In the past two to three years, Qantas, National Australia Bank, Santos and Whitehaven Coal have all opted for share repurchase arrangements, which they have effected in one of two ways. They either go straight to the market to buy back the shares, or they approach their shareholders directly.

    The theoretical advantage of a buyback is that a company with fewer shares on issue will automatically increase its earnings per share ratio, which — in technical terms — lowers the price-to-earnings ratio. The result should be, and often is, a rallying share price. The company buys back the shares and then extinguishes them.

    Qantas, in particular, has been using this capital management tool over the past three to four years in lieu of paying out dividends during the loss-making COVID-19 years. The airline undertook a $400m buyback in 2022, announced another “on-market” $500m buyback in February this year and then in June added a $100m extension.

    NAB completed a successful $2.5b on-market buyback in March 2022, then announced another for the same amount once the first was completed. Again, it was all done to improve the bank’s capital ratio and — “to reduce share count and increase sustainable returns on equity benefits for our shareholders”.

    A board may believe that its shares have been unfairly or wrongly valued by the market and that a buyback will return some strength to a flagging share price. Investors, too, see it as a sign that a company has growth ambitions. It’s an expression of future self- confidence.

    A less sanguine view is that a buyback is little more than a short-term panacea to improve the share price. Shareholders can and do rebel, believing that the cash available to the company could be better used for stock investment or research. Others wonder where the money to buy back shares is coming from. Is the company buying the shares with its own equity or simply adding to its own debt?

    This article first appeared under the headline 'The Psychology of the Dividend’ in the October 2023 issue of Company Director magazine.

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