Yield of dreams

PUBLISHED : Monday, 26 March, 2012, 12:00am
UPDATED : Monday, 26 March, 2012, 12:00am


It is axiomatic that a company's current share price simply reflects the present value of all dividends paid out over the lifetime of a firm. In other words, it's all about the dividends. Investors some day need to be repaid for their capital, through dividends or a share buyback.

But it is not as simple as looking for the highest dividend payers when selecting stocks. There are several intriguing dimensions to this discussion.

For example, the Nobel Prize winners Franco Modigliani and Merton Miller argued that if a company has investments with returns greater than its cost of capital, it should cut dividends to finance such investments, which would then be reflected in higher share prices.

When Central Huijin, the holding company of many state-owned financial institutions on the mainland, announced in February that the dividend payout ratio would be cut by 5 per cent to 35 per cent of profit in 2011 at Industrial and Commercial Bank of China (ICBC), China Construction Bank and Bank of China to strengthen their capital bases, the banks' share prices rose on the view that they could now make more loans to increase profits.

If a company in need of equity continues to pay the same level of dividends, it will need to raise equity, which is a costly form of capital.

For example, ICBC conducted a rights issue in November 2010 that raised about 45 billion yuan (HK$55.1 billion), or about 2.5 per cent of its market capitalisation. The proceeds were less than the 57 billion yuan of dividends it distributed the year before.

The bank said it incurred HK$280 million in expenses on the rights issue.

Foreign shareholders and mainland residents must also pay 10 per cent withholding tax and 20 per cent income tax on the dividends. It would have been cheaper and simpler if ICBC had just cancelled or cut its dividends in 2010.

But usually dividends are positive for investors.

Mature companies with a stable cash flow should - and usually do - distribute a decent level of dividends. Stocks in the telecom, power generation and distribution and public transportation sectors typically fall into this category.

Dividend plays tend to perform well in bear markets: investors prefer solid dividends rather than uncertain capital gains during bad times.

While the Hang Seng Index fell by about 60 per cent between the beginning of 2008 and 23 October 2008 (the trough of the global credit crisis), the share prices of CLP fell around 1.3 per cent and Power Assets - two perennial dividend stocks - fell by 2.7 per cent. The total returns would have been positive if dividends had been included.

However, as the Hang Seng Index rebounded by some 89 per cent between October 23, 2008, and this Wednesday, CLP's and Power Assets' share price appreciated by only about 44 per cent and 52 per cent, respectively, over that time.

In the current low-interest rate environment, most long-term blue-chip Hong Kong dollar bonds are yielding about 2 per cent. Although interest rates are expected to remain low for some time, some bonds face major downside risks when rates increase with economic recovery.

Investing in dividend-play stocks could be a more attractive choice. For example, CLP pays a dividend yield (dividends per share divided by the share price) of more than 3.8 per cent and HKT pays 6.6 per cent. There could be an upside as their share prices rise in line with economic recovery, albeit probably less than the overall market.

Then there are people who rely on dividends to cover expenses. A regular dividend-paying stock could be held long term as there will still be cash inflows even when there is a capital loss.

So, those who buy a non-dividend-paying stock might have to judge when to sell it (even potentially at a loss) to meet their cash-flow needs. This could also involve some reinvestment risks. Therefore, there are bound to be investors interested only in dividend-paying stocks.

That's why some recent initial public offerings such as HPH Trust, Huixian Real Estate Investment Trust and HKT have touted their high dividends. The idea is to attract investors hungry for yield.

Even Apple, which has close to US$100 billion in cash (almost one-fifth of its market capitalisation) and has consistently delivered stunning growth, announced last Monday that it will start paying a quarterly dividend of US$2.65 (around US$10 billion annually) and buy back some US$10 billion in shares. Apple's share price breached US$600 for the first time after the announcement.

Higher dividends can raise the share price, but not always.

Telstra, an Australian telecoms company, had a net debt of 1.3 times its earnings at the end of its 2011 financial year, before interest, tax, depreciation and amortisation (ebitda, a proxy for operating cash flows).

This level of leverage is low for a company such as Telstra.

On the back of improved operating performance and the idea that it could and would borrow to buy back shares, its share price has out-performed the overall Australian market over the past 12 months. Investors responded positively to the idea of buyback even though it would take money from dividends.

Microsoft started paying regular quarterly dividends in 2004 when it realised its stagnating growth meant it was no longer attractive as a growth stock. It has since raised its dividends six times. But investors were not impressed. Its share price is up only some 15 per cent from five years ago, against more than a fivefold rise for Apple and a 40 per cent jump for Google.

Companies hoarding cash in excess of their investment needs destroy value as low yields on the excess cash drag down returns.

They could also squander their cash on dubious acquisitions. Microsoft, with a cash pile of about US$50 billion, has spent billions on what many regard as overpriced acquisitions of dubious value to pump up growth, which have not helped its share price performance.

Companies with too much cash may prove tempting targets for controlling shareholders to divert the cash to other group companies by way of loans and acquisitions (Money Post October 24, page 7).

Khor Un Hun is a former investment banker with extensive experience in advising on mergers and acquisitions and fund-raising in Asia