Dividends: a trap to avoid

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03/10/2019 | 12:27 am
Certain companies get listed on the exchange in order to meet a structural and permanent need to raise capital. These companies are, to speak with the words of Warren Buffett, Ďdepending on the generosity of strangersí to prosper.
We find this kind of company, for example, in hyper capital-intensive industries such as the mining of raw materials or, in a less exotic register, such as the real estate sector.

Letís take a closer look at the latter: since property companies have a privileged tax status - providing they distribute all of their profits in dividends - they are unable to auto-finance their investments which are considerable; outside assistance, therefore, becomes necessary to maintain and develop the property park.  

This is why these companies need to have a high valuation on the market so that they can do their future capital increases against preferential conditions - otherwise, new shares will be issued at levels that are dilutive for the existing shareholders, which may, of course, upset them.

In other words, since property companies are in the vast majority of cases valued according to their dividend yield, the safest way for the management to propel said valuation to those much-desired peaks is naturally to Ö. constantly increase the dividend.

This is where, sometimes, the problem lies: itís not uncommon that the profits of these companies no longer cover the dividends they distribute, for example when their rental income decreases under the influence of unfavorable market conditions, or because they invest considerable amounts in the expansion of their property park. 

The companies then transform - despite themselves - into Ponzi schemes: they are forced to pay a dividend that they canít afford in order to support a favorable valuation at all cost. Therefore they use a part of the newly raised capital from new shareholders so that they can continue to pay the dividend to their historical shareholders.

When such a dynamic has started, the management can only hope for a sudden improvement of market conditions to save them from this situation, or for a miraculous takeover offer to be proposed by a competitor that either doesnít really pay attention or is too optimistic.  

If none of these exits materialize, the temptation to manipulate the dividend to lure new investors will be even stronger. After all, fresh capital will now be necessary not to grow but to survive.  

We know, companies that are subject to major stress - like car manufacturers during the last financial crisis or, more recently, energy companies like EDF or Engie - are always reluctant to reduce their dividend because they are aware of the devastating impact that such an announcement would have on their market capitalization.

And this even when common sense has long ordered to accumulate reserves rather than squander them on fat distributions!  

This is why itís wise to always be extremely prudent when it comes to welcoming the different shareholder communications - naturally, these are more optimistic than they should be. Instead, itís better to focus on the fundamentals of the company, in particular, the free-cash-flow per share; this is how we can verify cheaply whether the dividend is sustainable and whether the value creation is tangible.

On this topic, you can also read our article Accounting profit vs. free cash-flow, published in parallel with this article.  

Such an approach, however, requires method and craft; it involves knowing how to restate accounts carefully and understanding the various accounting subtleties. The net result of a property company, for example, has nothing to do with its actual profit since itís burdened with substantial non-cash accounting adjustments like depreciation and amortizations.

Due to a lack of time or interest, this analytical effort tends to find itself outside the reach of the majority of individual investors. Once they have been burned, the latter are tempted to blame the lightness - or even the blatant dishonesty - of the management concerned. 

However, and apart from some cases of gross fraud, the reality is often more nuanced: even professionals who are initially well-intentioned can, because they believe it will be good for the company, start telling a white lie here and thereÖ only to find themselves trapped in a big web of lies a couple of years later.  

To speak with the words of the former boss of Citigroup the day after its crash: ďAs long as the music keeps playing, you have to keep dancing.Ē

Neelie Verlinden
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