Amid the ongoing uncertainty of the Covid-19 pandemic, corporations are prioritising cash on their balance sheets.
But even with a vaccine in sight, investors will need to be cautious - against a backdrop of an uneven recovery in demand, companies are unlikely to resume at pre-Covid levels. Excess capacity will allow for postponements in capital expenditure (CAPEX) spending in order to preserve more cash.
As companies display greater frugality towards investing, incentives exist to remain generous with dividends.
This issue is politically contentious - it is not lost on taxpayers that in some sectors, public bailouts were equal to buybacks and dividends paid in previous years. Buybacks divest investments away from the underlying company and instead are seen as inflating earnings per share growth.
But from a shareholder’s perspective, the dividends reflect operational sustainability with operating cash flows meeting fixed costs.
Growth in dividend payments bodes positively for the share price under the dividend discount model, valuing a company based on the sum of its future dividend payouts to shareholders. With bond yields and interest rates depressed, asset values are pushed up higher, as more money chases fewer investments.
“The long-term problem creates a liquidity trap, where excess capital flows into unproductive assets and leads to a moral hazard,” says Eric Ritter, former Asian hedge fund manager and current adjunct professor of economics at Lakeland University in Tokyo, speaking to FinanceAsia.
The appeal of a stable dividend for shareholders is best demonstrated when payments are suddenly taken away. Back in March, HSBC and Standard Chartered lost nearly a tenth of its market value after announcing plans to follow the UK financial regulator’s request to suspend dividends in order to preserve capital.
The opposite also holds true. Saudi Aramco’s share price has outperformed other major oil and gas companies, as the state-oil company remains committed towards paying dividends despite the collapse in profits and challenging operating environment.
DIVIDEND SOURCE
More than half of the globally dividend paying companies are cyclically exposed, according to estimates by Janus Henderson, suggesting that with payouts under pressure, investors will be chasing returns. The combination of low borrowing costs amid an aging population creates a perpetual challenge for investors searching for yielding assets.
When investors purchase government paper, bond prices increase which lowers their yield profile (bond prices and yields move in opposite directions). To achieve the previous level of absolute returns, investors are forced to buy larger quantities of debt, extending the downward cycle on yields.
Abundant liquidity is best exemplified by the more than $14 trillion in government paper trading with negative interest rates, meaning investors will lose money should they hold these purchases to maturity.
The hunt for yield forces investors to offer cheaper, longer tenure bonds. Given market premiums for dividend stocks, the temptation to maintain payouts via financial engineering exists. One possible option includes taking new leverage to lower the overall cost of capital, i.e. using cheaper new debt to pay off older, more expensive debt.
The consequence of this exercise is immediately noticeable on the corporate balance sheet. Debt levels rise, expanding the book which then lowers other valuation metrics such as return on equities (ROE) and return of assets (ROA), all else being equal.
The lingering impact also spills over from the financials, as rated companies could see their credit rating scores fall, thus increasing the cost of raising debt later. When debt covenants are broken, reestablishing trust between management and investors tends to be a lengthy process. “The market multiple discount to peers is then justified,” says Ritter.
DEBT V. EQUITY
Outside of cash, businesses rely on debt and equity to expand their businesses, normally reaching a manageable combination of the two. While costs vary due to interest rates and risk-free assumptions, holders of either are not treated the same.
Debt is prioritised over equity, meaning companies are obligated to pay interest expense before paying dividends. Despite the lower ranking, shareholders are compensated by having company ownership, being a beneficiary of any asset appreciation.
This makes sense. If a stock price offers a 5% dividend, the yield falls to 4% after a 20% rally because the base share price is higher (dividend yield is calculated as dividend paid divided by the share price). Few shareholders would bark at the trade-off with the dividend a likely afterthought.
The practical difference is accessibility. Debt raised via bank loans and bonds are more generally available while few can access equity, which is normally burdened with regulatory paperwork and additional costs. In China, banks account for two-thirds of all new credit, reflecting Beijing’s recent push to liberalise its equity markets.
TURNING JAPANESE
Prior to the Covid-19 outbreak, the focus on balance sheet management was becoming incrementally more mainstream. This is most evident in Japan where the rise of shareholder activism is lobbying cash-rich companies to return excess capital to investors.
In February, 45% of the Tokyo Stock Exchange was trading below book value, higher than the 6% on the S&P500 and 16% in Europe’s Stoxx 600 benchmark. The argument goes that once dividends are paid, balance sheets shrink which improves ROE and ROA, all else being equal, unlocking value for shareholders to trade closer to, or above, book value.
But the coronavirus pandemic has pushed companies to follow Japan’s historical conservatism, demonstrated in the trend towards companies prioritising the longevity of their businesses, rather than simply maximising profits and efficiency.
Janus Henderson notes that total shareholder holder payouts fell by a fifth in the second quarter of the year. This complicates how dividend payments are viewed, provoking questions whether short-term returns are worth the expense of future vulnerabilities, justifying a dividend cut.
