31 Jul Paying dividends
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One of the outcomes on investors (apart from the precipitous and, so far, largely temporary) plunge in capital values in March) of the current global pandemic is that a decent proportion of companies have suspended their dividend payments. This is usually a step that boards are extremely reluctant to take as investors tend to punish reductions in dividends with disposals of their holdings and thus falls in the share price. Even disregarding their duty to shareholders, If the remuneration of the directors is linked to the share price performance, anything that jeopardises that is not going to be something done lightly.
Yet these are not usual times.
The first to go were dividends paid by the largest banks, following pressure from their regulator. It was felt that with customers under pressure to meet ongoing debt servicing as the lockdown began to bite, it would be inappropriate for banks to continue paying dividends to their shareholders rather than using the cash to help cash-strapped customers.
The impact on numerous other businesses, some of which effectively had to close down operations, was less regulatory than practical, in that retaining cash which would otherwise have gone in dividends could enable them to survive. Where businesses received financial support from the taxpayer, maintaining dividend payments could be difficult to justify in an environment in which anonymous ‘big business’ could be seen as one of the villains if it could be portrayed as effectively passing taxpayers’ money through to investors. Indeed, the government banned companies which had accessed its coronavirus large business interruption scheme loans from paying dividends or, in some cases, executing share buybacks.
On 19th May, The Guardian reported research by AJ Bell that UK businesses had deferred £30bn in dividend payments and that nearly half the 100 largest UK listed companies had reduced, deferred, suspended or cancelled dividend payments. As might be expected, investors reliant on these dividends had been hit, with some experiencing falls of more than 50% in their investment income.
Although UK and continental European investors are used to dividends as a way of companies distributing returns to them, this is not something that is seen everywhere. In Asia, for example, companies tend to retain more cash while in North America, share buybacks (by which the company invests profits in repurchasing and then cancelling its own shares, thus increasing their price) are popular. Some of this is a function of cultural preference but taxation treatment also plays a part. The point is that dividends are an artificial construct which represent only one possible route by which companies can return profits to their owners. Particularly where taxation is concerned, the relative attractions of each can vary according to the environment at the time.
In the UK, despite several changes over the years to the ways in which dividend taxation is applied to investors, they are still relatively attractive, particularly for those taxpayers subject only to the basic rate of income tax, as they pay nothing on the first £2,000 of them and only 7.5% on the excess up to the higher rate threshold.
However, an investment strategy which is focused on achieving a particular income stream does involve some compromises. The first is that, as noted, not all companies, sectors or markets pay the same rate of dividends. This can lead to underweighting exposure to businesses which may generate good returns but retain or reinvest them and thus their owners receive the return through an increase in the share price. Conversely, those companies which are paying high dividends relative to their share price are overweighted. Such companies are often value stocks (whose accounting value is high relative to their market value) but focusing on these entails taking a higher risk than the market as a whole and if their dividends are reduced because they turn out to be unsustainable, expect the share price to fall.
With a certain number of investors focusing on those stocks which pay above average income, whether they buy the companies direct or via funds which have that mandate, the laws of supply and demand apply. The more buyers are after a company’s shares, the higher the price goes. Rising share prices, unless accompanied by the profits and thus dividend payouts rising at the same rate, cause yields to fall. The income investor is thus at risk of paying more and more for assets in the hope that in the future someone else will pay them even more when they want to sell.
Finally, it may not be terribly tax-efficient. While an institutional investor need have no concern with tax as it is unlikely to apply within the portfolio, private investors ignore tax to their detriment. While too much focus on tax is unwise (the most tax-efficient portfolio is one which only ever generates losses), it is always worth having an eye on the tax rules when deciding how to put together a portfolio and in which types of account it should be held.
An approach that makes more sense to us is to consider the assets in a portfolio in terms of the total return (dividend stream and capital growth) which they are likely to generate over the long term. This allows the constraint of having to disregards certain markets or sectors on the basis of their income yield to be set aside and instead a more widely diversified exposure is possible. Diversification is the only ‘free lunch’ in investing in that it can provide a reduced risk and an improved return. It also reduces the need to guess correctly about the future direction of the market, which is extremely difficult to do accurately and consistently.
What investors who are living off their invested assets need (those who are still in the accumulation phase merely need them to grow efficiently) is cashflow to meet their lifestyle objectives as they arise. In some years these will be fairly consistent from month to month but occasionally there may be higher expenditures for holidays, property maintenance, new cars etc.. Whether recurring or one-off, these expenditures need cash and whether that comes from dividends or by selling assets and realising capital gains should be immaterial. In fact, if the latter can be done without any tax at all (whether by using annual tax exemptions of currently £12,300 per individual or by offsetting against losses elsewhere), the ‘drag’ on the portfolio is reduced compared to it coming from dividends on which income tax is due. Every pound not paid in tax is one which can be either spent or reinvested to continue growing.
Dividends are a useful means for investors to receive their returns but they are not and should not be the only or even the most important one. Holding a broadly diversified portfolio from which whatever income is produced is either reinvested or spent according to your specific requirements and meeting your other expenditure via withdrawals that take advantage of available allowances and exemptions in the context of a financial plan is likely to deliver a smoother ride and a less stressful experience.