Monday, August 13, 2007

The Importance of Dividends

Several events over the last few months have led to me to question the importance of declaring a dividend for any invested company. After all, as shareholders, what better reward should we expect than an immediate cash “return” on our investment in the form of a dividend ? As I was attending AGMs and EGMs, shareholders of all shapes and sizes and ages would almost invariably come up with this million-dollar-question: will the dividend increase next financial year ?

To begin to analyze this seemingly innocuous question, let’s first take a look at what a dividend represents. A dividend is simply an appropriation of a company’s retained profits and earnings from the previous financial year, which they are paying out a portion (say 30-50%) in cash to shareholders. This payout is entirely optional as Management is not contractually bound to pay out any part of the company’s earnings as dividends, unlike in the case of bonds (or debentures) where interest payment obligations have to be met. Thus, most of the time, a dividend payout is a signal that Management either wishes to reward shareholders for their loyalty (and themselves too, as most of the time Management and Directors do hold shares of their own in the company) or has too much cash on hand which they don’t know how to make good use of. Let’s take it part by part.

Management says in the first example that dividends are a way of rewarding shareholder. This is well-supported because as the business takes off, the earnings, revenues and margins of the company also increase, thus increasing the total shareholders’ “value” in the company. The value is then crystallized in the form of dividends, which represent a return on what the shareholders had originally invested in the company. Looking at it from this angle, it seems perfectly justified. However, an informed shareholder should also note the company’s cash flow requirements (such as for capex and future capital commitments) and ensure that Management is not paying out more than it should. This is a difficult aspect to determine as usually only the insiders know how much funds the company needs and how much it can disburse as dividends, but a good estimate would come from the nature of the industry, the company’s strategies and the capital commitments note (from the Annual Report).

In the second example, Management gives out cash as a special or one-time dividend because they have too much cash sloshing around and they have no better use for it. All I can say is Management is probably not confident of putting the money to better use, which is why they would rather give it back to shareholders. This is not necessarily a good thing as it may indicate that the company has entered the mature or even decline phase of the business such that its products have a stable (rather than growing) demand and sales may even start to stagnate or taper off. Most companies that I have noticed which pay out a special dividend may do so due to the aforementioned reason, or due to the sale of a property or shares in an investment. Shareholders should not invest in a company hoping for such “one-time” payouts, as this may imply the company’s business may be on the decline and that they are considering divesting and moving into another. Carefully scrutinize the business of each company you intend to invest in so as to avoid this costly mistake. Otherwise, the dividend gain may very well be offset by the capital loss !

Another form of dividend which may be declared is a dividend-in-specie. This in essence is a share dividend, meaning a dividend in the form of shares in another company rather than in cash. One recent example is Boustead’s dividend-in-specie in the shares of Easycall International Limited (now renamed as China Education Limited) of about 3.14 cents/share. Ezra had also initially intended to dividend out its shares in EOC Limited to shareholders in the form of a dividend-in-specie, but later decided to sell the shares away as vendor shares in order to raise more funds for expansion. The advantages of this exercise are that shareholders get to hold shares in another company which may have its own growth prospects as well. The downside is that such companies may also have dormant or stagnant business models with little growth, thus “trapping” your investment for many years. In Easycall’s case, it was bought over by Raffles Education Corp and the shares soared from a low of about 8 cents to a high of over 90 cents, returning about a 1000% gain to those who faithfully held on to them. But this is more of an anomaly than the norm, and shareholders should remain cautious about dividend-in-specie announcements.

To summarize, dividends are a double-edged sword as it can be either a good or bad thing for a company depending on the context and the company’s business cum industry. There is no right or wrong and each case should be evaluated on its own merits. For high-growth companies such as Swiber, for example, it will be much better for them to retain earnings rather than pay out dividends as they can use the cash more efficiently to grow the business. Reinvested dividends can help to grow a company’s intrinsic value and if this is the case, then the argument should be made for no dividends until the company has reached a stable rate of growth (becoming a cash cow). For the record, Berkshire Hathaway (Warren Buffett’s holding company) has NEVER paid a dividend (except only once which Buffett admitted was a mistake), but has seen the value of its shares soar to as high as US$100,000 per share. Thus, there is really no limit to share price appreciation as long as the business is growing and earnings are increasing.

Next post: Analysis of Swiber's 2Q 2007 Financial Results + Updates for Boustead and Global Voice....stay tuned !


Anonymous said...

good morning mw,

your dividend blog allow me to reflect, and somehow felt that investment objectives are closely related to the desire for dividend payout.

for example, a conservative or defensive investor, the constant stream of dividends provide extra income.

for a agressive investor, capital gain from growth stocks provide the satisfaction esp when the intend was met with outcome.

the guru for stock investments advice the conservative investors to select companies that have not stop paying dividend for the last 20 years! he stressed on margin-of-safety instead of growth stocks.

so, a balance can be achieved upfront if the objective for the investment is clear.

closer to home at sgx counters, there are cash cows (yes!) and dividends play... sph, st engg, etc. st engg has been paying dividends to my joy over the past years ever since i invested in it.

for growth, pac andes paid about a third of their earnings in recent years. this to me is a good balance as they are reinvesting the other two-third to grow their biz.

like the part, and i think investors should pay heel, on investing in company anticipating a special dividends. the financial community are the ones to benefits as they are fast to act, leaving retail investors smelling the dust!


kolslorr said...


Just like to mention that Babcock&Brown is another strong dividend play, around 10% yield...

Looking to load up on the next red wave..

sj reader said...

I wouldn't have minded at all at zeor dividend if I'm one of BH's investor who bought a share at say $1000 or $3000 and now worth $100000...

One thing to point out abt the non contractual nature of dividend as mentioned by Musicwhiz. For years, Robinson has been rewarding their investors richly but big fat dividend... It came to an abrupt end this year since Lippo took over last year.. they declared a 10cents divvy this year, to loyal and surprised investors. Lippo now decides to keep the $$ for expansion. Although the result is impressive, investors see no appreciation in share price..(in fact, it had tumbled before the subprime woes) and now measly dividend. This might turn investors away...

Just like what the funds always qualify in their sales prospectus: "past performance is not a guidance for future performance".

musicwhiz said...

Hi Anonymous,

Yes, you are right in that people with different investment horizons and objectives will view dividends differently. An older person, for example, may want more steady dividends as cash flows for retirement rather than an aggressive growth company which gives capital gains but no immediate cash rewards.

Many of the blue chips including SPH are giving good and steady dividends at yields which are higher than bank deposit rates. REITS are also currently giving decent yields. For PAH, yes they should be re-investing the dividends in order to grow their business.

musicwhiz said...

Hi kolslorr,

10% yield for Babcock and Brown ? That's very impressive. However, take note of their revenues and cash flows to see if this yield is sustainable in the long-term. Good luck !

musicwhiz said...

Hey sj reader,

Yep, definitely BH has been increasing the book value and earnings of the Group steadily over 20+ years; thus in effect your dividend has been reinvested 100% back into growing the company's business. Warren Buffett is the ultimate creator of value for his shareholders and too bad I wasn't even born at the time, otherwise would have snapped up some of BH's shares ! :P

Good example of Robinsons. Some companies achieve stable growth and become cash cow companies, effectively giving away large amounts of cash to shareholders. It really depends on what an investor is looking for.