In search of 'progressive' dividend policies

Institutional investors find a company attractive when its dividends gradually increase as a proportion of profit

27 Oct 2012 08:57 by BY GENEVIEVE CUA PERSONAL FINANCE EDITOR

DIVIDENDS have emerged as a major investment theme since the financial crisis. But how committed are companies to paying and growing them, even when times are tough?

Simon Bailey, equity portfolio manager at UK-based M&G Investment Management, is on the lookout for Asian companies with a "progressive" dividend policy. This means an explicit commitment to pay out a portion of earnings - and to grow that payout even when profits drop.
There are only a handful of Asian companies, he says, with a track record comparable to the US, where an estimated 94 companies have grown their dividends in each of the past 25 years.
"What we think is very important is dividend growth, rather than just chasing dividends . . .

Dividends are important because paying them disciplines the company. Pretty much every company wants to grow as fast as possible, but often a lot of growth isn't value creative. They invest in projects that are unnecessary and generate no returns, because often they have too much money.
'What we think is very important is dividend growth, rather than just chasing dividends...

Dividends are important because paying them disciplines the company. Pretty much every company wants to grow as fast as possible, but often a lot of growth isn't value creative.'
- Simon Bailey

"We think that committing to pay a portion of income back to shareholders forces (companies) to prioritise which of the projects they should be doing and to choose better projects. So the business generates better returns on capital."

M&G is part of the Prudential plc group. It manages about US$317 billion in assets.
The common thinking is that companies will pay dividends out of residual earnings, or what is left over after all suitable investment projects have been financed. In theory, if companies have good investment opportunities, they will retain more of their earnings for these investments. A "progressive" dividend policy, however, is one where dividends gradually increase as a proportion of profit. This is something that institutional investors find attractive.

Global dividend fund
Persistently low interest rates and market volatility have whetted investor appetite for income as a means to enhance returns and cushion volatility. Historically, dividends have proved to be the main driver of returns over long periods.

A DWS study has found, for instance, that over five years, dividends account for 80 per cent of returns, and this share rises to 90 per cent over longer periods.

M&G runs a global dividend fund which is available to sophisticated investors. The fund aims to deliver a total return while generating a dividend yield in excess of the world average and a rising income stream over time. The fund has US$5.9 billion in assets.

Mr Bailey is spending 4-5 weeks in Asia, visiting companies in Singapore, Hong Kong and Taiwan among various countries, to suss out companies' dividend policies. "We look for companies with reasonable track records. Trying to get them to where they can continue to grow their dividends going forward is the challenge.

"Often companies have a great dividend history in Asia because they are growing earnings consistently. But we're trying to work out what would happen if there was another crisis and they saw earnings decline. Would that involve a cut in dividends? . . . What is encouraging is that companies are moving towards a more progressive dividend policy, but there is a long way to go."
Asian companies in the group's portfolio include Hong Kong's Link Reit and DBS.

Companies with progressive dividend policies include cyclical mining companies such as BHP Billiton and consumer giant Johnson & Johnson. A progressive stance forces companies to take a long- term view of business cycles, and to evaluate projects with a view to the most attractive risk-adjusted return.
Mr Bailey says: "Asian businesses have been growing rapidly and they have good potential to reinvest in the business. Therefore, by returning money to shareholders, you give up some of the potential to grow the business. But if you look at Asian businesses as a whole, return on capital tends to be inferior to the West. I think it's because they chase growth too much.

"We're not saying to return everything to shareholders. We're just saying to find the right balance . . . And the amount or split will depend on the opportunities."

He reckons the payout ratio could sit somewhere between 25 and 75 per cent of earnings.
"For businesses that have really good projects and can generate good returns on capital, then 25 per cent can be paid out and the bulk reinvested in the business. If they pay more than 75 per cent to shareholders, we think they'll struggle to grow the business. We want them to grow the business to pay a growing dividend stream."

Growing income stream
Mr Bailey warns that chasing yields could be dangerous. Investing in companies with progressive dividend policies often means eschewing those with the highest yields, where dividends are also more volatile. "We think you get superior performance by sacrificing a bit of initial yield by not chasing 6 per cent-yielding stocks. But if you can find stocks that yield 4 per cent, but grow their dividends 10 per cent a year, within 4-5 years you'll get a better yield."

There is also potential for capital appreciation as the market warms to a stock where the income stream is growing. "This investment style should hopefully give you a growing income and capital return, whereas a lot of income funds give you income but not growth in the value of investments," says Mr Bailey. He seeks to ascertain that dividends are paid out of underlying earnings and cash flow rather than debt or a share issue.

Asian companies are predictably under-represented in the portfolio because very few have a progressive dividend policy.

Mr Bailey sums up: "I'm just looking to see the options in Asia. How flexible do we need to be to find enough options for a global fund? Maybe in Asia we just have to be more flexible to say - we can't get the same types of dividend track records. But if a business has shown over time good dividend growth with only minor cuts in dividend, maybe that would be good enough for us."