Dividend Policy- Don't Rock the Boat

Dividend wealth is an interesting topic for conversation when it comes to rewarding shareholder investment.  My original thoughts on dividends were that such insignificant figures would make little difference regarding fluctuations.  This was before I was made to realise the scale of investment made in companies from insurance and pension funds.  It’s a crazy concept that the future of our retirement is massively dependent on the dividend policy of these huge companies.

There are arguments, when considering NPV that would recommend company profits would be better investing in ventures with a positive rating.  Such ventures would be claimed to raise the value of a company, thus boosting shareholder wealth.  Only residual cash left from profitable ventures would be repaid as dividends using this concept.

Modigliani & Miller echo such sentiments, claiming that dividend policy has no effect on company value.

In reality however, it can rarely be seen that dividend policy has no effect on company value.  Of course, in a ideal world where humans are rational, the understanding that dividends may be low due to a high level of invest activity which would boost their wealth.

Unfortunately, humans are very irrational and such fluctuations would likely lead to a mass exodus.  If several shareholder looked to sell their shares at the same time, the share price would fall.  Although M&M’s idea is theoretically true, in the real world dividends play a huge role.

Looking at the BP Gulf of Mexico oil spill, the announcement that BP would be halving their dividend payment resulted in panic from UK pension funds, fearing such a decrease could cost the UK millions in the long run.  Although not the only factor, BP’s share price suffered badly as a result of this announcement.

It can therefore be seen that shareholders, being the irrational, over-emotional being that they are crave stability.  A constant, un-fluctuating dividend yield is met favourably, thus companies have reacted to this by attempting to maintain a steady dividend payout, regardless of good or poor performance. 

Although investors may look on such a decision favourably, I would consider it a bit of a shame that shareholders are so insistent at focussing on their short term gains, that they cannot see the bigger picture- that maybe a company’s surplus cash could be put to better use, which would eventually lead to an increase in their own wealth.  To ask shareholder to think long term is quite possibly too much of a revolutionary step I fear. 

Captial Structure: Is there an optimal level?

Optimal capital structures are an interesting (and complicated) area of research.  Personally, I’m quite a fan of the traditional view.  At the risk of sounding like a grumpy old man; back in the day, people seemed to be more sensible.  What happened to the days of companies having a concern for their levels of debt?  Of course, debt is cheap but debt is also constant.  What the good times are here, having a cheap source of capital is great... but what about the bad times?

The traditional approach considered the idea that although debt was cheap, WACC would only decrease to a certain point, where the financial risk was considered to be too high, thus seeing WACC decrease as equity was used as a source of capital.  The optimal capital structure was seen as a delicate balancing act.  ‘Was’ being the key word...

It seems in current times, or at least before 2007, shareholders were content with the risk involved in taking on massive amounts of debt because of the returns they were seeing.  Satisfied that they were maximising shareholder wealth, companies were happy to take on more and more debt.  Then came the point when the ‘credit crunch’ sunk its teeth into a bloated and unsuspecting world.  Suddenly debt finance became impossible as banks collectively panicked over their enormous shortfalls from carelessly loaning out money to any person that could ‘walk and chew gum at the same time’.  Companies like PC World that based their short term cash flow forecasts under the assumption of acquiring cheap debt struggled for survival, and shareholder wealth was obliterated.  Oh for the good old days.

A reason for this blasé attitude appears to stem from the research of Modigliani & Millar (1958), who suggested there was no optimal capital structure, and company value is based on business risk.  The assumptions made in this study were rightfully torn apart by academics, who found the idea of assuming no tax to be laughable.  With nothing being ‘certain but death and taxes’, I’m inclined to agree with the academics.  After a rethink, which included tax, it was found that debt was a significantly cheaper source of capital which would lead to company value being improved if this emphasis on debt was used.

Of course, humans seem to crave an excuse to do something if they can justify it, thus the loading on of debt became almost commonplace.  After the deregulation, which stems from the 1980’s, banks took this opportunity to greater levels which has finally resulted in the chaos we see today.  Only after such a major failure has any action been taken to rectify this, with the introduction of Basel III as an attempt to rectify this problem. 

Personally, although you cannot deny the benefits of debt, the level we have allowed our businesses, governments and ourselves to become reliant on debt is ridiculous.  It is a damning assessment to look at our inability to be sensible and level headed.  As soon as the banks were deregulated, greed seemed to override common sense.  Is there an optimal capital structure?  Most definitely.  Are we anywhere near it?  Looking at the mess we’re in after our love affair with debt, probably not.  Oh for the good old days...

The Global Financial Crisis- A warning of things to come?

The start of my university life back in September 2007 coincided almost perfectly with the emergence of the dreaded credit crunch.  Walking down Northumberland Street to see countless people queuing outside of Northern Rock provided me with a great source of entertainment.  I saw it as a massive overreaction made by people that consider the scaremongering of the media to be gospel truth.  To an extent, I was correct; government policy protected the first £75,000 in a person’s bank account.  To actually learn the extent of the problems the economy faced on a global scale is quite terrifying, and utterly infuriating.

The level of confidence in the marketplace before the financial crisis was incredible.  The house market was booming, credit was cheap, and everything was rosy.  Collateralised debt obligations were a big source of this increased liquidity in the market, which promised a source of cash depending on the rating assigned by the credit rating agencies.  The rate of return in the AAA rated assets were so high, even banks were utilising these options.

Incredibly, these banks that were supplying long term mortgages were investing in assets that depended on the success of the mortgages they were issuing.  Confidence was so high in these assets, banks built up assets around these CDOs.  The problem arose when the house market began to decline, which saw the increase on defaults on mortgage payments.  All of a sudden, these ‘safe’ assets became far less secure. 

The cash shortages created a chain reaction that went on to cripple the banking sector, leading to panic amongst the public that their hard earned saving were at serious risk.  Suddenly cash became a rare commodity and successful businesses were finding it increasingly difficult to fund their operations as a result of this shortage.  The decision made by the UK government to offer a bailout option to the banks illustrates how severe the situation became, with the bailout dwarfing the annual cost of running the NHS.

The use of the word ‘confidence’ in this blog to describe the mood towards the marketplace is perhaps a poor choice.  Confidence implies a belief in the ability to succeed, yet the banks ability to succeed was so heavily hinged on the housing market and CDO’s, that the word ‘arrogance’ seems more appropriate.  The importance of planning, spreading risk and assuring cash is always available has been emphasised at every aspect of my business education.  How is it that bankers were so blind to this? 

The arrogance in assuming the bubble could never burst, that market value will continue to increase is beyond belief.  To not consider the possibility of a problem emerging in the future as a result of ‘putting all your eggs in one basket’ is madness.  To find a source of this particular financial crisis and focus on avoiding that particular mistake again is to miss to the point in my opinion however.

Maybe there will be greater regulation in future regarding the assumed security of investment assets, but in 10 years time, house prices will still demand staggering mortgages, banks will still take out loans to fund these mortgages and the world will run on the assumption that credit will be available to them to get by.

It is frustrating to think that we, the taxpayer are the victims in this financial crisis and I sincerely doubt we will ever get so much as a ‘thank you’ from Northern Rock or RBS.  It is scary to think that we appear to have applied a band aid to a broken leg in making no drastic changes to the regulations surrounding business.  Maybe we will learn from our mistakes and prosper from a more restrained credit system.  I worry however that we will continue to make the same fundamental mistakes in future.  Maybe the next time we see a credit crunch, the ramifications could be far more serious than public spending cuts and increases in tax.

Multinational Tax Management- The Illegitimate Way to Boost Profits

Amazingly, I briefly covered the issue of corporation tax a few weeks ago.  Although this highlights the fact that I hadn’t read the TLP, I’m quite proud of my brilliant proactive background research.  All jokes aside though, this link does highlight a great worry for the average, honest, hard working British taxpayer.

In the case of Barclays, although they saved the taxpayer money by refusing the government bailout, that does not excuse the corporation tax, or lack of that they were reported to have paid earlier this month .  Does this mean that in the future if I choose not to apply for benefits when I am in trouble, I will only have to pay a 3% tax rate?  If only...

It’s easy to see why people are so angry about this issue.  As individuals, we are all victims of a financial structure that has failed, yet we are the ones that have been lumped with increased VAT rates, rising levels of unemployment, freezing of public sector pay; the list goes on and on...  Barclays of course will argue that they are abiding by the laws set in place, and they are right.  With businesses looking to maximise their profits, why would you not capitalise on the opportunity to look abroad, where tax rates can be far more attractive? 

Whilst on my work placement, I had a discussion with a colleague about my plans to move abroad and work somewhere with a lower income tax rate than in the UK; he raised the issue that it was unfair to want to do that.  After everything this country has given me in having an excellent healthcare system and free education etc, what right do I have to not repay that debt through paying taxes to the country that has given me the opportunity I have? 

It goes to show the huge gulf there is between what is ‘right’, and what is good business. 

For all the talk of legitimacy and corporate social responsibility, the more I look into it; the more I question its relevance.  If a business were to genuinely claim that they were legitimate, would they utilise the tax havens of this world through outsourcing operations?  There has to be a point where you draw the line between making money to improve shareholder wealth, and just being plain greedy.  This isn’t a business being innovative by developing new ways to improve efficiency; it is cheating countries out of money through loopholes.  With academics like Suchman suggesting that businesses needing to conform to the sets of rules and values held by a society to have a right to exist, there is very little evidence of some of these companies adhering to any of the rules and values I hold.

Yet the power that they hold puts governments in the situation where  they can not afford to lose these companies by closing up these loopholes.  It’s not right.  It’s not fair.  It’s also not going to change any time soon, and until the day it does, it’s people like us that are going to feel the effects whilst companies like Barclays get to report £4.6 billion profits that we will never see.

It’s a shame, but it’s something I suppose we have to live with.  In this case, maybe ignorance is bliss..

Shareholder Wealth: As Value Adding as it Seems?

Creating shareholder wealth is seen almost as a holy grail for business to achieve.  If you can maximise the wealth of your shareholders, you are attaining one of, if not THE most important strategies of the business.  It can be difficult to argue against.  Albeit over two centuries ago, Smith’s idea of the ‘invisible hand’ guiding the marketplace in such a way that efficiencies are rewarded with investment can still be seen as relevant in modern times.  This success can then be seen to benefit the society as a whole.

Just look at BP- before the Gulf of Mexico oil spill, it was estimated that for every £8 paid into UK pension funds, £1 can be attributed to BP.  A perfect example of looking after the shareholders and also creating a positive outlook for millions in the UK, surely?

Looking at the picture after the oil spill however and we see a potential problem with focussing too much on shareholders.  BP halved their dividend paid from the figure before the disaster.  This will have a significant impact on both shareholders, and in extension, almost every member of the UK public that holds a pension.   In non-monetary terms, the environmental impact of the coastline has devastated livelihoods and sea life, and killed 11 people.

Is it too harsh to hold BP so culpable for this?  It could be chalked down to misfortune, maybe it was completely unavoidable.  Looking at BP’s track record; namely the Texas City disaster, the history of budget cuts forcing cutbacks on safety and training cannot, and should not be ignored.  These budget cuts will have undoubtedly resulted in improved profit margins and will most likely have had a positive impact on the shareholder, and yet now BP are in a situation where a relentless pursuance of maximising shareholder wealth has come back to bite shareholders where it hurts the most- their wallets.  With an estimated £40bn loss for shareholders in dividends over the next 10 years, every shareholder and almost every UK citizen with a pension will see a huge loss. Maximising shareholder wealth?  Perhaps not...

The use of performance indicators as tools to measure shareholder wealth can also be brought into question.  Domino’s Pizza are considered to be one of the best performers on the stock exchange since the economic downturn.  This can be seen by an ever improving EPS figure.  Are these the be all and end all indicators to highlight good business performance though?

Writer and producer of The Wire, David Simon has an interesting take the use of statistics when reporting, “as soon as you invent that statistical category, 50 people in that institution will be at work trying to figure out a way to make it look as if progress is actually occurring when actually no progress is”.  A perfect example of this in the real world is the use of a share buyback shame- something Domino’s and several other FTSE companies frequently take part in.  By spending surplus cash to buy shares and take them out of circulation, businesses are able to artificially increase the earnings of each individual share without actually improving the share price.

The emphasis of improving shareholder wealth is stressed to managers so much that they are put under immense pressure to meet these figures.  When it comes to self preservation, why wouldn’t management do anything they could to make the figures appear more attractive than they actually are?

Should shareholder wealth be held in such high regard even with the clear and obvious flaws?  Maybe not, but with the power shareholders wield, nothing is going to change any time soon.