On the horns of an exquisite dividend dilemma
The wobbles in equity and bond markets triggered by the start of the US Federal Reserve board’s tapering of its quantitative easing program will be causing some furrowed brows among chief financial officers and corporate strategists.
For the past five years corporates, and not just in Australia, have been following a very simple strategy of risk aversion. After the massive, $200 billion or so, recapitalisation of corporate Australia in the wake of the financial crisis, companies have been focused on balance sheet conservatism and cost-cutting.
Meanwhile, investors have been pushed by the meagre fixed interest yields on offer into pursuing yield wherever they can find it, pushing up the share prices of dividend-paying blue-chips and equity markets generally. Price-earnings multiples have expanded faster than the underlying growth in earnings alone would normally justify.
While the market is about 4 per cent off its peak last year it is still at near post-crisis highs and while bond yields have also been edging up they are still at historically low levels. From a CFO’s perspective, both debt and equity are cheap but the volatility sparked by the Fed’s actions means there is no guarantee that they will remain so.
The outlook of modest growth in the Australian economy suggests that generating strong organic growth in earnings and satisfying shareholders’ expectations of returns isn’t going to be easy this year.
Conventionally, re-leveraging balance sheets by taking advantage of the cheap debt available – around 3 per cent after tax -- to fund buybacks of shares trading on price-earnings ratios in the high teens would be an obvious strategy, but it isn’t one that is compelling if there is a question mark over the sustainability of share prices.
Companies have, in the post-crisis environment, responded to shareholder demands for increased cash returns by lifting dividend payout ratios but that, too, is a questionable strategy going forward if earnings growth is likely to be more modest within relatively subdued economic settings.
Special dividends might be a way of satisfying shareholders in the near term without permanently lifting payout ratios – it was something the banks were doing until the Australian Prudential Regulation Authority warned them to conserve capital to meet a more conservative set of prudential requirements – but doesn’t provide longer term growth in shareholder returns.
Using retained earnings to reducing debt further would deflate companies’ performance statistics -- there is a potentially significant opportunity cost to not taking advantage of the co-incidence of cheap equity and debt given the starting point of conservative balance sheet settings.
Since the crisis there hasn’t, by historical standards, been much conventional merger and acquisition activity within the bigger end of corporate Australia because of the introspection and risk-aversion. The exceptions tend to have been driven by private equity or foreign buyers.
There may never have been a moment where both debt and equity have been so relatively cheap and blue-chip balance sheets have been in such a conservative state. If companies believe that the settings are aberrational, the temptation would be to take advantage of them to fund growth by acquisition.
The argument against an outbreak of strategic activity is that the environment remains volatile and risky.
The out-workings of the Fed’s tapering and the gradual winding back and ultimately the withdrawal of the massive post-crisis stimulation are unknown, although the initial impact has already caused some chaos in developing economies’ currency markets and economies.
The US recovery remains relatively weak, the eurozone’s response to the structural flaws revealed by the crisis remains a work-in-progress (with only minimal real progress made) and minute shifts in the level and nature of China’s economic growth send shivers through global financial markets.
Thus there are continuing reasons for companies to remain risk-averse, which creates the dilemma for CFOs and corporate strategists.
The prospect of declining returns to shareholders if the cost of debt rises and share prices fall as the unconventional monetary policy of the US is unwound will, however, increasingly pre-occupy boards and managements if 2014 unfolds without any major new outbreak of crisis.