Higher dividends: Be careful what you wish for

With interest rates falling as the economy slows, companies are responding to shareholder demands to increase dividends.

Unlike in most other countries, Australians benefit from the dividend imputation system where you receive a franking credit for dividends received from companies that have paid company tax on their profits. It's a great system that eliminates the double taxation of company profits and encourages people to save and invest.

Several years ago I remember Curtis Jensen – Small Cap portfolio manager at legendary US funds management firm Third Avenue – castigating CSR for unnecessarily raising capital. In the US companies are chastised for diluting shareholders with capital raisings.

But in the land down under it's customary for management to do almost anything to preserve dividends, including raising capital at the drop of a hat and making short-term decisions to boost earnings and appease shareholders that aren't interested in the long-term consequences. While I don't have any stats to back me up, I believe once management passes the hat around once they're more likely to do it again, which is why I prefer to own companies that either keep their share count steady or reduce it over time.

At Intelligent Investor Share Advisor we also seek out shareholder friendly management, such as the Brown brothers who founded ARB Corporation, but there's a thin line between shareholder friendliness and reckless or imprudent capital management.

Laundry list

I can think of four instances where companies should've reduced dividends or cut them altogether, although this is just a tiny sample of a very long list of Australian companies that should be retaining more of their profits for various reasons.

Pokie manufacturer Aristocrat Leisure was producing so much cash prior to 2007 that it didn't know what to with it. Share buybacks and dividends were well intentioned, but when the boom turned to bust the company's lousy research and development expenditure was exposed and earnings crumbled. The company was then forced to raise $200m and, to add insult to injury, just over a year later had to pay damages of $212m in regard to a past bond issue. The share price currently remains over 75% below its all time high of above $17 from February 2007.

A couple of years back Intelligent Investor Share Advisor had been recommending Metcash due to the strength of its IGA distribution business and because it paid out virtually all its profits as fully franked dividends. Under pressure from price wars between Coles and Woolies, last year management announced a highly discounted capital raising to modernise its distribution system and make several small acquisitions.

While reinvesting in your business is vital, it's far better to retain some profits to do so rather than raise capital at a large discount and maintain the dividend. What's the point of raising capital at a discount and diluting the value of the business and some shareholders and then turning around and paying part of the proceeds straight back out as dividends? Despite raising capital Metcash's balance sheet still looks stretched and dividends could eventually be cut, especially if the acquisitions don't work out.

Billabong International embarked on an acquisition frenzy that triggered several capital raisings as debt (and lease liabilities) increased while earnings were falling. If Billabong was a genuine growth company with plenty of options to invest at high rates of return, then it doesn't make sense to pay (high) dividends. Billabong's share price is currently 99% below its all time high after trying to be a growth company that also pays attractive dividends.

I explained why QBE also falls into this category in an open letter to management Dear QBE: Cut the bloody dividend! published in November 2012.

Risky business

Right now the big four banks are (considering) distributing more of their profits as dividends despite bad debt provisions being at or near record lows, the economy slowing and the cracks in China's economy and (shadow) financial system becoming more obvious.

Resources titans BHP and Rio are also aiming to increase dividends at the expense of investing in new projects. Extremely capital-intensive businesses like this pair often need to raise capital when commodity markets turn down. While I'm not implying either of these two companies will need to raise capital, paying out too much in dividends and then waiting until your share price is in the toilet to raise capital, as many companies did during the GFC, is dreadful capital management. If the Chinese growth story crumbles it's a real risk.

This sounds all too familiar to the investors that cheered on the steadily increasing distributions from listed property groups in the lead up to the GFC. They lost far more than they had received in distributions when the sector collapsed. While companies drowning in cash like ResMed have room to return capital to shareholders (ResMed has over US$600m in net cash), be careful what you wish for.

There are currently scores of companies boosting dividend payments right when their businesses are potentially about to face their biggest test for a long, long time. Better to do that from a position of strength when having ready access to cash could allow you to take advantage of some incredible opportunities to set your business up for the next decade.