Complete Blog 4 - Dividends - Do they matter?

Dividends 101

Prior to this week's lecture, I assumed shareholders would prefer to have dividends than not. As the owners of the company, they would expect idle cash to be returned, in order to ensure capital is allocated efficiently. As the lecture progressed, there was a thought-provoking question posed; would shareholders prefer dividends or the company to invest in positive NPV projects. My thoughts here were different to before, such that I expected companies to invest in all positive NPV projects available in order to maximize the future earnings potential. 

My initial thoughts aligned to the 'Dividend irrelevance theory'. This theory was created by Modigliani and Miller in 1961 and it stated that share prices are determined by investment decisions. Investing in all positive NPV projects should be the only consideration when looking to maximise the company value. This indicates that dividends are the residual cash after investing in these projects. Because of the hard time I afforded them last week, I remembered MM - the assumption kings from the capital structure literature - and this made me question whether I should have a view contrary to theirs. I was then informed that the dividend irrelevance theory does indeed have many of the same assumptions. This was enough for me to think, "actually... shareholders probably prefer dividends". Indeed the evidence speaks for itself; there are very few companies which do not provide a dividend or repurchase shares, aside from those in the growth stage of the business lifecycle (a potentially disruptive company in the growth phase of its lifecycle will be expected to derive its value from the projects it undertakes and is unlikely to pay-out dividends because of this need for investment). It is therefore highly unlikely - as we shall see with Samsung - that all of these companies do not have any projects available which would create shareholder value. Thus, it implies dividends do indeed matter to most shareholders, and management must bear this in mind.

This leads me on to the second academic school of thought 'Dividend relevance'. Despite having various sub-theories within it, its foundations lay in Linter's and Gordon's work on the 'Bird in the hand' theory. The argument states that capital gains from investing in positive NPV projects are uncertain. Therefore shareholders prefer dividends because of the certainty they provide. Upon reflection, I actually agree with this theory. Taking last week's blog as an example, projects which were seen as value enhancing prior to the financial crisis by property developers and banks turned out to massively erode value. It is, at best, difficult to assess the market conditions in 5 years time when a project is expected to be delivering value. 

As a result, my thoughts on what a shareholder would prefer has been changed. My initial belief was looking from an outsider's perspective but in taking a shareholder's risk averse view, it is clear that dividends are preferable. Both schools of thought have credence depending primarily on individual firm intricacies. 

What happens in the real world?

Nestle

Earlier this year, Nestle outlined clearly that share buy-backs were not a priority in their corporate pay-out policy. By the summer months, Nestle had announced a $21b share repurchase scheme.

Initially, I thought share repurchases were only beneficial for management. In reducing the number of shares outstanding, metrics which are frequently used for executive remuneration such as EPS and ROCE would look more favourable. Therefore the only reason for shares to be repurchased would be for agency related motives.

And although this is undoubtedly still one reason for share repurchases, the lecture taught me, as with a number of areas within corporate finance, tax plays a role. With the two tier tax system in many countries, segregating income tax and capital gains tax, there are tax benefits for share buybacks over dividend payments. In repurchasing shares, it creates significant demand. This propels the share price up. However, because current investors have not sold their shares – there is not yet a tax event and thus, this capital gains tax is deferred until the shares are sold. Contrastingly, dividends received by investors are taxed immediately.

Why a sudden change in Nestle's policy?

On the face of it, applying clientele theory (part of Dividend relevance school of thought) would indicate that Nestle have taken stock of their shareholder base's tax situation and altered their pay-out policy to suit.

In digging a little deeper however, activist investor Daniel Loeb’s hedge fund, which advocates share buy-backs, has built up a 1.25% stake in Nestle. Contrary to clientele theory, this is evidence of the catering theory in action. It states that corporate pay-out policy is aligned to the preferences of a major shareholder. While only aggregating a 1.25% stake, Loeb’s activist nature gives him great power and has forced Nestle to change their pay-out priorities.

In thinking back to my previous blog about the efficient market hypothesis and index funds. I stated that shares are being purchased based on their inclusion in particular indices and not for their fundamental long term value prospects. The access to cheap funds because of quantitative easing has meant large cap companies' share prices are arguably in a bubble. Therefore, by Nestle purchasing its own shares in the current market, it could be paying over the odds. I understand that it is unlikely for management to purchase shares if they think they were overpriced. However, the pressure management feel from this hedge fund is evident by Nestle’s immediacy to alter payout policy to reflect this shareholder’s preference. As a result, this could actually be destroying shareholder value (although I don't think it is).

A further factor potentially impacting Nestle’s decision to repurchase shares is to alter its capital structure. I have previously discussed capital structure decisions, but as a reminder, by reducing the number of shares outstanding, Nestle can increase its gearing ratio. I discussed last week that companies want to gear up to a certain level to maximise the corporate valuation and minimise the WACC. I think Nestle are trying to surpass this ‘certain level’ of gearing.

Why?

With the failed hostile acquisition of Unilever by Kraft-Heinz, Nestle could become a target in the near future as an alternative fast-moving consumer goods conglomerate. While this may not necessarily be bad, executives at Nestle are evidently worried. Therefore, the share repurchase programme will increase its gearing ratio to make Nestle look more of a burdensome target.

What I would argue however, is that instead of repurchasing shares to appease Daniel Loeb’s hedge fund, Nestle, who have been signalling to focus on dividend payments, should have rewarded other shareholders with a large dividend. The clientele effect means that shareholders who have been expecting to receive dividends, will sell their shares when the pay-out policy deviates from the signals. By catering to the hedge fund, it risks alienating existing shareholders who may sell their shares and depress the share price. By providing dividends, shareholders would be receptive to executive advice should a hostile takeover attempt present itself – providing an alternative to the increase in gearing. Subsequently, I feel this pay-out alteration could be detrimental to Nestle’s corporate value.

So while there are two clear reasons for a share repurchase by Nestle, the theory it evidences is catering theory.

Samsung

Samsung reported a near 150% growth in net profit this quarter compared to last year. This growth has derived from the Semiconductor division of their operation. Many Samsung investors may not know what semicoductors are (and I certainly didn’t prior to the research conducted for this blog), but they will be thankful for the profit they have generated. This has subsequently allowed Samsung to announce they will be paying $25b in dividends over the next 3 years.

On the face of it this appears to be excellent news - a steady flow of income for 3 years. However, in applying the dividend irrelevance theory – despite its assumptions – indicates that the future prospects of Samsung look poor. It would imply that Samsung do not have any positive NPV projects available for the $25b to be used on. Therefore, Samsung have almost been forced into giving a dividend so large.

However, we know this is a floored application of the theory, because supply cannot keep up with the demand of semiconductors and therefore it appears that Samsung’s future prospects are looking extremely healthy. What is more likely is Samsung management are signalling to the market the successes of the Q3 and future prospects. Because of the information imbalance between management and shareholders, Samsung are providing a clear message that they can afford to pay out large dividends and invest in the future growth prospects of the company. It is also likely to have been influenced by the clientele effect. The decision to return cash in the form of dividends is because it suits Samsung shareholders' tax situation to receive dividends as opposed to share buybacks or further reinvestment. 

I see companies' forward-looking signals of future dividend payouts much in the same vein as Central Bankers in setting the interest rates. Central Bankers are very careful in the way their vocabulary is used to provide an indication of the future. This leads the market to have an expectation of the future and as a result, decisions are made and prices are set based upon these expectations. If subsequent actions do not correspond to the narrative outlined by companies or central bankers, there will be a shock - which is inherently bad for virtually all market participants. Although it is unlikely, should Samsung fail to generate similar levels of profit in the next 3 years, the sustainability of the dividend could be questioned. If a dividend is cut from a level which has been expected and signaled to the market, it is likely that the share price will depreciate as shareholders who rely on a steady flow of dividends may sell their shares. Therefore, signalling future expectations is preferred but a high dividend is risky because of the consequences should it be cut. Consistency is key.

Summary

Consistency is critical in sending the right message to the market and shareholders. This is why you see so many companies maintaining dividends in periods of poor financial performance. They understand their investor base’s motives for holding shares and thus any drastic deviation from this will result in many dumping their shares. Time will tell what the longer-term corporate pay-out policy turns out to be for Nestle – whether this is part of a forward-looking strategy or a short term tactic to appease a new influential shareholder. It will also be interesting to see whether Samsung can maintain their record dividends into the future because once the promise has been made, shareholders expect the dividend and should they not receive it, it could be damaging to their share price and firm valuation.