We recently started writing a series of articles to provide a practical look at how our investment management team deal with real investment situations. For part 2 of this series, we look at the ever popular question about dividends.

The following information does not take into account your personal objectives, financial situation or needs. You should consider if the relevant investment is appropriate having regard to your own objectives, financial situation and needs. 

 

Our investment team have all spent a number of years working overseas before returning to Australia. What we all found coming home has been the tremendous interest in dividends among listed share investors and their advisers. We would go so far as saying some investors may even show signs of addiction to dividends.

Like all addictions, we certainly don’t think this is healthy. In fact, when we invest we actively avoid what we sometimes internally call the “Pocket Money Syndrome”

“Pocket Money Syndrome”

We’ve all been there. Cash is transferred to your bank account on a regular basis in the form of dividends from your share investments.

Does it feel rewarding to have passive income?

Yes, but unfortunately some investors may also start focusing more on the regular dividend income rather than how the shares generating those dividends are performing. Similar to a teenager worrying about how much pocket money they are getting rather than their parents’ real financial situation. This “pocket money syndrome” can lead investors into dangerous investment situations.

Focus On Cash Generation Not Dividends

When we assess an investment, the ability of that company to generate cash is a key performance measure. In contrast, a company’s potential dividend yield and management’s official statements on future dividends are factors we attach less value to. Let’s look at BHP Billiton which is a topical example:

  • For financial year 2015 BHP had free cash flow (after paying for operating expenses, capital expenditure costs, interest and tax) of US$6 billion. The company paid out approximately all of this free cash flow in dividends to shareholders. At the time of its annual general meeting in August 2015, BHP committed to its “progressive dividend” policy. We thought that was a brave move given falling commodity prices were already negatively impacting cash generation. This should have raised some alarm bells for BHP shareholders.
  • Fast forward to today, the cash flow situation has deteriorated further with the sustained falls in commodity prices. From our calculations, BHP may end up with free cash flow (including reductions in capital expenditure) of up to US$4 billion less than the previous financial year. To pay out US$6 billion in dividends again for financial year 2016 would effectively mean the company is borrowing money to pay its dividends. That is not a sustainable strategy even for a company like BHP against the backdrop of severe commodity price weakness. We believe a prudent board of directors will need to substantially reduce BHP’s dividends.

The decline in BHP’s free cash flow should have been and should still be a major concern for shareholders. Any impending dividend cut will hurt but more importantly the lower cash flow generation will also reduce BHP’s ability to pursue longer term growth. Unless commodity prices increase significantly in the next few years, BHP shareholders might well be invested in a company that will just be defending its market position (e.g. cutting costs, reducing capital expenditure, protecting its balance sheet and repeat). Not awful but certainly not where you might want to invest your money for the next few years.

Focusing on BHP’s current and future cash generation would have revealed the above issues perhaps 12 to 18 months ago. In contrast, waiting for the official change in dividends is usually too late. From experience we know board directors of large companies are notorious for not wanting to change stated dividend policies in order to cater to investors with a pocket money syndrome. When their hand is finally forced, it is usually after the share price has dropped significantly. This way the board can say a reduced dividend still provides a reasonable dividend yield for investors.

In the meantime, shareholders have suffered a major decline in the capital value of their shares (in BHP’s case approximately -50% in the last 12 months) all to hang on and hope for a 5% to 6% dividend yield. Therein lies the danger of investing in shares driven primarily by a thirst for dividends without carefully considering the parent company’s broader cash flow situation.

Many parents teach their kids about not being overly reliant on pocket money as they grow up. We could all do worse than apply the same lessons when investing in shares.

 

AtlasTrend has just launched a 4 part series on the listed stocks you should get exposure to in 2016. Register to become a member HERE (it takes less than 1 minute) to start receiving the AtlasTrend series of reports exclusive to our members.

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