Investment Matters

Chasing rainbows?

Chasing Rainbows

As at the middle of April, roughly 14% of companies listed on the ASX200 had deferred or cut their dividends.

This has been a result of the global economy coming to a sudden stop, the resulting impact on cash flows and uncertainty that still remains.  The share price of several companies have fallen dramatically, and their dividend yields have risen accordingly.

The question is: do the dividend yields currently on offer present an opportunity?  Better still, are high dividend yields the hallmark of an attractive investment?

To answer this, we must explore what a dividend yield tells us about a company.

Dividend determinants

Dividends are an output of a number of factors.

These are generally company specific but can also relate to regulation (for instance, tax treatment), market and economic conditions.

Being an output of several factors – dividends should not be viewed in isolation.

To understand more, let’s take a moment to sit at the desk of your favourite company’s Chief Financial Officer (CFO).

Sitting here as CFO, we mull over three basic decisions: 

  1. Capital structure – How should we finance our company? What proportion should be financed by debt?
  2. Invest – What projects or investments should we commit our capital to?
  3. Distribute – What proportion of the capital that is left should we payout?

The dividend or “distribute” decision, in theory, should, therefore, come after the first two decisions.

So, what do the level of dividends tell us about a company?

Generally, we could say a company that pays dividends is more likely to:

  • Have low to moderate opportunities for growth – that is, more likely to be in the mature phase of its life cycle – it is producing more cash than it is able to re-invest.
  • Have relatively stable earnings or cash flows – less of a need to keep less money aside for a rainy day and is better forecast its financials.
  • Have a strong balance sheet – it does not need to retain cash to pay down debt (i.e. it is at or close to its optimal capital structure).
  • Be large – mature companies or those with fewer options for growth tend to be those that have already grown significantly and by virtue are now larger in size.

This is not necessarily the case for all companies.  Some companies are able to grow strongly and still pay a dividend.  Furthermore, some smaller companies are also able to pay a dividend.

CML Group has been a good example of both.

However, the insight from sitting at your favourite CFO’s desk is that dividends are a function of a number of factors, including a company’s balance sheet and opportunities for growth and reinvestment (capital growth).

This trade-off and complexity must be considered when investing.

The COVID-19 CFO

It is now May 2020. You are now sitting on the CFO’s couch. Sitting here on a Zoom call you mull over what is a difficult predicament. Revenue has fallen off a cliff. You have cut what expenses you can, government policies have assisted to some degree but there are some fixed costs that you can’t get away from paying.

The economy looks like it will re-open, however you remain uncertain.

So, what do you do?

  • Capital structure: You need more money, fast, out of necessity or just in case. You will look to conserve cash and will also look raise more capital from shareholders or existing/new lenders debt holders. 
  • Invest: One lever to conserve cash is to cut back of investment. You decide to cut back investment significantly. Only projects/investments in progress or those that have the highest returns are to continue. But you are less likely to grow as quickly as you planned on before.
  • Distribute: It is much less likely that there will be the same level of funds left to distribute after the first two decisions.

In this context, we can see why companies have chosen to either cut or defer their dividends, particularly while uncertainty around COVID-19 and the impact on the economy remains.

We can also see why there may be further cuts to come.

The insight from sitting on your favourite CFO’s couch: dividends over the coming period will be lower, and rightly so.

Investing in this context

Investing in the current environment has therefore added another consideration to investing in a company based on a high dividend yield.

The first was the trade-off between dividends and growth.

The added consideration is: will the company be able to pay these dividends and are they sustainable? Several companies have been sold off heavily during the recent period – which has made their dividend yield look attractive on a historical basis.

However, we have already seen large cuts to dividends, particularly in sectors such as Real Estate, Discretionary Retail, Infrastructure and Energy.

230519 divs

Given the uncertainty around the virus and the impact on the economy – particularly on a microeconomic level, some of the dividend yields currently on offer may prove to be a mirage.

These companies may have their earning power or dividend paying ability impacted by the virus longer term.  In this case these companies may not rebound – and have their capital value permanently impaired.

By the same token companies that may pay a limited dividend in 2020, may prioritise investment to offer high dividends in the longer term, or offer higher capital growth. 

So how do we interpret dividend yields in the current environment?  Simply, we do not.

We have looked to assess companies not based on what they can pay in dividends next year but based on the cash flows we think they are able to produce over the long term.

A longer-term cash flow-based analysis provides much more flexibility to take into account the complexity present at this point in time.

This complexity includes all the aspects that go into the dividend decision (including capital structure and investment decisions), the trade-off between dividends and growth, sustainability of dividends longer term as well as how a company is likely to perform and change in the future (particularly post COVID-19).

Conclusion

Dividends are an output of the overall capital allocation decision by a company.  They are a function of a number of variables and should not be viewed in isolation.

There will always be a trade-off between dividends and future growth which must be taken into account.

Furthermore, post COVID-19, dividends are likely to be lower and rightly so. Many of the dividend yields currently on offer may fail to materialise and there may be impacts on dividends and earnings growth longer term.

Dividends yield therefore serve as a poor indicator of how an attractive an investment is in the current environment.

Our approach has been to focus on capital value and the cash flows we think a company can sustainably generate longer term.