Assessed Blog 5 - Dividend policy: Keep your head to keep ahead

Dividend policies are somewhat influenced by investment and financing decisions. Organisations that attain a realised profit encounter the trade-off of injecting the surplus cash they have into future investments or into the pockets of their shareholders.

Both of these outlets have very fair justifications; a company needs to continue to invest in its operations to innovate or expand in its marketplace and ultimately improve its competitiveness, whereas shareholders are an integral aspect of an organisation’s funding and essentially are ‘owners’ and therefore deserve a return for their investments. The underlying issue for most businesses, however, is to adopt a policy which strikes an optimum balance between these options – if one even exists. This issue exists because organisations fear a dividend policy which does not reflect the expectations of its shareholders can prove detrimental to the company’s share price, and consequently, value.

Modigliani and Millar (1961) first noted that share prices were determined by future earning potential and not dividends paid “now”. They proposed a rational investor, an investor who is indifferent to capital gains and dividends. However, this study was based on idealistic scenario conditions where there are no taxes, no transaction costs, all interest rates are the same and all investors have free access to all relevant information (Brennan, 1971). These are clearly scenarios which modern day managers cannot operate within and are therefore irrelevant towards their dividend policy, which leads me to agree with Watts' (1973) proposal that dividend payments are most definitely an indicator of company performance.

Furthermore, I am slightly sceptical that stock markets are entirely filled “rational” investors. Although, I do acknowledge an abundance of highly-trained and qualified fund managers make up a significant portion of stock market trade, the markets can still potentially be influenced by everyday stock traders looking for a “quick buck” and who are overly anxious to shift their investment decisions at the slightest hint of uncertainty or hunch.

It is in human nature to fear uncertainty and even businesses need to conform to the vulnerabilities of human psychology. Market uncertainty can become apparent when investors are unsure of their company’s future operations.

Consider the following discussion:

Company A discovers a novel project which could substantially improve its competitive sustainability and provide an attractive NPV. The company must utilise its cash deposit to undertake this investment before it direct competitors gain first-mover advantage. Consequently, Company A lowers its dividend pay-out to provide additional investment funding but keeps the reasoning for this manoeuvre confidential so competitors are not exposed to the exclusive information.

Perhaps this news is not revealed because companies do not want to disclose too much of their strategic intentions as competitors will become aware; therefore, the longer they can keep project information confidential, the more effective and successful their strategy will be, possibly achieving greater NPVs on projects. This is a hypothetical scenario, but a feasible one which could subsequently lead to lowering share price, thus undervaluing of a company, simply as a result of shareholders feeling uncertain.

I will try to exemplify this discussion in relation to the real world:

In February, South African petrochemicals giant, Sasol, lowered its dividend policy in response to the lowering oil price; however the day after this news release on February 17^th, share prices dropped 5.12% (Figure 1) as this evidently induced shareholder fear. Sasol themselves stated the reduction in dividend will allow the company to manage cash flexibly within its balance sheet, ultimately allowing the company to execute its growth strategy whilst continuing to return value to its shareholders to some extent.

Figure 1: Sasol Share Price February 1^st – February 27th

 

Source: Google Finance, 2015

Upon seeing this news and the market reaction, other petroleum companies have more recently either chosen to maximise their dividend policies (Exxon) or maintain them (BP, Shell, and Chevron). These companies face the exact same volatile industry as Sasol, but have perhaps gauged the market reaction towards Sasol’s dividend policy change and opted to signal greater confidence to its investors. For example, Exxon stated in early April that the company was increasing its dividend pay-out and Figure 2 provides evidence to suggest the market responded positively to the news. However, this may not be the best strategic move for Exxon’s sustainability. The company recently fell behind Shell as top revenue in the industry and has also invested less capital into its operations over the past four years. It is debatable to suggest this policy is best for Exxon’s long-term position and returns, but only time will tell.

Figure 2: Exxon Share Price March 20^th – April 20^th

 

Source: Google Finance, 2015

Here we can see an evident difference between the shareholder response towards companies utilising a high pay-out dividend policy and a fluctuating dividend policy. This example potentially provides support for the “bird in the hand” argument (Lintner, 1956), as shareholders respond more positively towards short-term dividend payments, as opposed to future gains. It also suggests that even if a company is not fully convinced internally its future performance will match up to previous standards, playing it cool and reassuring investors with steady dividend payments is the first step to take to control any sporadic market fears.

The question posed: is this method suitable for a company to take if it craves for long-term success?