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April 16, 2020


Pandemic infects dividends & buyback policies

Part I: should we fear dividend cuts ?

In an attempt at balance sheet preservation while navigating
the pandemic crisis, corporates are slashing dividend payments and suspending
buyback programs. Where firms don’t take this initiative on their own accord,
they may be obliged to do so if in receipt of assistance under a government
stimulus program, most of which come with preconditions that limit buybacks and
dividends, as well as prohibiting  “unethical”
remuneration practices. Moreover, amidst the market turmoil, companies are
seeing that share prices are getting little or no support from any commitments
to defend a dividend. Finally, some companies may be deprived of the luxury of
choice because both their top line and bottom line is washed out, given the
magnitude of the economic shock.

Dividends, and buybacks even more so, are traditionally
polarizing topics. Without trying to address 
socio-economic considerations or more broadly what is good and what is
bad, having a view on dividend and buybacks is crucial in navigating equity perspectives
over the mid to long-term.

There are two primary factors that can be considered as
determinants of long-term equity returns – value creation (i.e. growth) and the
valuation. As a prudent disclaimer, it should be clear to any investor short
term equity returns are a shot in the dark - daily prices having the ability to
go anywhere.  Investors are encouraged to
adopt a longer-term investment horizon and, as the old adage goes, consider the
stock market as “a warehouse of cash-flows, not a casino”.

The first rule of thumb is that the faster a business grows
its earnings and cash flows, the greater the long-term returns it will generate
for its stakeholders. In analyst jargon, this is referred to (quite
unsurprisingly) as the “bottom-line” and is the first element of return for
investors. The second determinant of returns, is the stock’s valuation. This is
not simply the price paid for the stock, but the price in relation to the
intrinsic value of the company,  measured
using different accounting metrics and then compared against cyclically-adjusted
peers. In a ‘Goldilocks’ scenario, investors should not pay too much, nor too
little relative to the intrinsic value of the stock. Considering that under
normal circumstances, dividends are paid out of company earnings (or
cash-flows), dividends should not be understood as a source of return, but
rather as a contributor to long-term returns. Indeed, for some companies, activities,
sectors and cyclical perspectives, dividends hold a great deal of importance,
while for others, they may be totally irrelevant. The same is true when looking
through the lens of an investor. Income thirsty investors will chase dividends,
 while return maximizers will probably
give preference to  growth stocks that
offer little to nothing in the way of an income stream.

Although dividends are traditionally much less volatile than
earnings during recessions, investors should nevertheless prepare for some
sizeable cuts in payouts going forward. According to a recent research paper by
Morgan Stanley, company announcements  so
far suggest that more than 30% of EU dividends already appear at risk of cuts
or suspension (albeit, these figures understate the risk to dividends as they
largely exclude Energy stocks, given that there has been little in the way of
company comments at this stage.)  In the
US, dividends look likely to fall for the first time since 2009, when they
dropped 21%. Retailers, Autos, Banks, Transport and Luxury companies have the
highest proportion of vulnerable dividends on both sides of the Atlantic.

Should investors be scared of massive dividend cuts and a
potential dividend drought? Basically, the answer mostly depends on the specific
objectives of the investor. For those looking at the income component,
perspectives will probably be depressing. However, for investors with a longer
investment horizon, if a dividend cut is part of the near-term price that must
be paid to ensure a firm’s long-term survival, it looks more reasonable; a case
of short term pain for longer term gain. Capital appreciation is still a decent
assumption, as long as the valuation paid at the point of purchase is

This is one of the key reasons for our current preference
towards quality stocks (well-poised, high-cash, low-debt companies), despite the fact that the unprecedented
context we operate in makes it a demanding task to forecast future cash-flows. Selling a
quality stock that has slashed its dividend because of tough — but
temporary — economic times may, in retrospect, be a classic case of
selling low and buying high.

In essence, the ex-post diagnosis of return contributors
should be split into three elements: earnings contribution, dividend
contribution and price movement contribution. This is the traditional backward
analysis to gauge what supported past price changes. Ex-ante analysis, or any
attempt at forecasting or scenario building should primarily focus, in a
simplified world,  on only 2 factors:
earnings growth and relative value. 

Don’t be confused by looking in the rearview mirror. Studies
showing that X% of past returns were driven by dividends are valid. X will
always depend on the specific market and time frame used in the analysis. But one
shouldn’t try to drive their car by only looking backwards, as long the
objective is to progress forwards.

Ultimately lower equity dividends could see outflows as investors
hunting yield depart. Prior to the sell-off, with the yields of so many assets
close to or even below zero, equity dividends were being used as a way to
satisfy the appetite for income.


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