The Power of the Dividend

Friday, 3rd August 2012 14:50 - by David Harbage

We are in the midst of the reporting season, with most listed companies having now provided an update of trading in the first half of 2012 and an indication of their prospects for the second half of the year. A standout feature, at least for this particular observer, has been the return of cash to investors via regular dividends and other means.

When managing monies, but away from the desk (probably on a training or golf course), one of the first places to visit within a newspaper – or, more commonly nowadays, a financial website such as LSE.co.uk – is the summary of company trading results. Rather than looking at the standard comparator of previous year’s profits or earnings, the professional’s focus is invariably upon the expectation – by particular reference to one’s own or the consensus forecast figure – of the businesses owned, or major stocks deliberately avoided, in the portfolio. Beyond a read of the outlook statement, which typically accompanies the statement detailing the company’s most recent trading, a forward-looking perspective is also aided by considering the dividend payment.

Investors appreciate a progressive dividend policy, featuring steady increases in the payout – ideally ahead of inflation (producing an income to match real liabilities) – over a number of years. Of course, businesses change (in terms of their component assets, as well as their strategy), but the market will reward businesses that provide consistent returns to shareholders. In difficult years, perhaps of apparently unprofitable trading (for instance when an asset is written down in value, with a consequent exceptional adverse impact), it may be possible to maintain a dividend. With that in mind, another key metric that fund managers regularly look at is dividend cover – the extent to which the current payout is ‘covered’ by profits (best viewed by comparing a full year’s earnings per share with the full year dividend per share).

When growth-oriented businesses struggle to expand further (by spending their profits or cash balances on new plant, factories or acquiring their competitors’ business), this might also mark a sea change in dividend policy via an increased payout. An absence of such investment opportunities might be the reality, or it could be that boardroom confidence – in their own industry’s prospects or that of the wider economy – is not sufficiently high to persuade them to write a big cheque. In a previous missive looking at the mining sector, we considered the prospect of this industry’s management adopting a more rigorous strategy of cash management – in favour of returning supra normal levels of profit back to shareholders, via steeply increased dividend payouts – rather than investing in new mines which offered dwindling rewards (below current rates of return).

Looking at the dividend announcements over the past fortnight, albeit at the interim stage of the year, there have been more than four hikes to every cut. We saw Hiscox, the insurance business, increase its dividend by 17% while household products group Reckitt Benckiser hiked by just 2% and one of the FTSE100 index’s biggest payers, HSBC, only maintained their dividend payout. On Tuesday oil giant BP and inter-dealer broker Tullet Prebon announced 14% and 6% increases in dividend respectively, despite both having experienced challenging trading periods, FTSE100 engineers GKN and Weir Group boosted their halfway payouts by 20% and 11% respectively, motor retailer Inchcape +11% while by contrast Drax, the coal-fired power generation business, cut its dividend by 10%.    

This was followed on Wednesday by increased payouts from businesses as diverse as Standard Charted Bank (+10% compared to 2011), pharmaceutical group Shire (+15%), online estate agent Rightmove (+28%), house builder Taylor Wimpey (reinstated, as no payment was made in the first half of 2011) and FTSE100 packaging business Rexam (+6%). Yesterday, medical artificial joints group Smith & Nephew featured, via a 50% jump in its interim, but provider of temporary power Aggreko also pleased with a 15% distribution increase. We also witnessed 10% dividend hikes from betting group Ladbrokes and IT equipment tester Spirent Communications, a 2% uplift at FTSE100 constituent RSA Insurance, but unchanged interim payouts from the asset manager Schroder, industrial property owner Segro and the hotel operator Millenium & Copthorne.

As intimated within our assessment of the merit of the differing asset classes, a prime attraction of equity is the income produced. This is particularly true when investing in a business, with an expectation that over the appropriate longer term profits will increase and investors will benefit, as a portion of those earnings are distributed to shareholders. This principal and prospective benefit has been borne out in the announcement of dividend payments covering the past quarter or half year period ending 30 June 2012, when almost every constituent of the FTSE100 index has announced an increase or an unchanged interim dividend. However, with most companies having a calendar year-end, the more meaningful dividend is undoubtedly the final one (which are typically advised in February, and paid in March). Accordingly, a look at the dividend payouts for the full year of 2011 – as highlighted in a report recently produced by the company registrar Capita - merits further consideration.

In the first quarter of 2012, UK company dividends totalled £18.8 billion which represented a record Q1 payout and a 25% hike in payments made in the comparable period of last year. Essentially, dividend payouts have now recovered from the financial crisis - which brought an abrupt halt to some of the traditional prime contributors, the banks – and are expected to comfortably exceed the £67.1 billion distributed in 2008. A total £76.2 billion is now expected to be paid out by listed UK plc in 2012, which equates to underlying growth of 8.2%. When looking at the overall payout, it is important to consider the impact of companies’ share repurchases (which, being cancelled, therefore result in a reduced share base and overall payout), along with any special dividend payments.

The latter often follows the disposal of an asset and, reflecting a lack of immediate reinvestment opportunities or need to reduce debt, suggests that shareholders’ interests are best served by a repayment of capital rather than by retaining cash in the business which would dilute the return on equity. As an example of sensible management, AstraZeneca – whose business is strongly cash generative, has an undemanding balance sheet and limited growth opportunities – increased its share buyback programme to £3.9 billion last year (more than double 2010’s expense), which represents an actual 8% reduction in the number of shares in issue. Accordingly, while the pharmaceutical giant has increased its regular payout by 6%, the total cost of paying the dividend has fallen by £200 million; the company plan to spend a further £2.9 billion repurchasing stock in the current year. Vodafone, currently the biggest dividend payer in the UK market in absolute terms, has similarly made significant stock repurchases in recent years – enabling the cost of its latest dividend to fall by £240 million, despite a 7% hike in the stated dividend per share.       

Two major exceptional payouts – of £2.2 billion each by Cairn Energy (following the sale of Indian assets) and Vodafone (prompted by strong contribution from its 45% owned US business Verizon Wireless) – boosted the total but nevertheless, after excluding such special dividends, underlying growth in the first quarter of 2012 was 6.6%, comfortably ahead of domestic inflation. Leaving these unpredictable one-off distributions aside, there appears to be a concentration of income-producing equities within the overall UK market – as evidenced by the fact that the biggest 5 payers accounted for 58% of all dividends paid by companies with a full listing. Perhaps even more markedly, the top 15 dividend producers account for 87% of all the income produced by the constituents of the FTSE All Share index. For the record, in the first quarter period of 2012, these companies were: Vodafone, Cairn Energy, Royal Dutch shell, AstraZeneca, HSBC, BP, GlaxoSmithKline, BHP Billiton, Imperial Tobacco, National Grid, Barclays, Unilever, Compass Group, Scottish & Southern Energy and BT Group. Dividing dividends produced by cyclical and defensive industry sectors showed a higher level of growth in payout amongst the former – illustrating, perhaps, that economically sensitive businesses were struggling to find new growth opportunities in which to invest and, as a consequence, were returning more cash to their shareholders.

The ‘bottom line’ conclusion is one that can encourage equity investors: in times of geo-political, economic or other uncertainty – as currently pertains – owning ordinary shares in a company can be beneficial, in terms of the immediate dividend and prospect of a growing income stream, which helps to underpin the value of the asset. Rather like the goose of fiction that laid golden eggs; what price that goose if the eggs continue (or grow), what price an asset such as company shares that has the potential to grow its dividends? The long term average income yield on the FTSE All Share index is 4.25% (since it began life 50 years ago), and the current yield - based on projected dividends for the full year of 2012 - is 4.1%. This may suggest that the income appeal of UK equities is below the norm but before arriving at that conclusion, one should take into account the current low level of interest rates (short and long term) and inflation.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.