It was interesting to read Ethan Klingsberg’s recent article in the FT on activist investors preying on corporates who raised excess capital during the pandemic. While it is important that these companies explain clearly to investors how their capital allocation strategy will change as they move out of the COVID era, there is a larger group of companies that would also benefit from articulating their thinking on capital allocation at this time; those weighing up future investment in their business against dividend distribution.
Many companies suspended their dividend payments as conditions worsened last year, to preserve as much cash in the business as possible until trading conditions became clearer. Of those most severely affected, some have yet to re-introduce distributions and are quite rightly using this hiatus to reflect on their priorities for the future.
One of the large hangovers created by the ‘Woodford era’ of income investing in the UK was a reluctance to channel cashflow into growth investment at the expense of dividend income. Companies became fearful of upsetting large swathes of the shareholder register whose expectations were for regular and increasing dividends. Dividend income is clearly important post retirement but growing the capital pot ahead of retirement is key to maximising these future cashflows. A stand-alone dividend policy that fails to take the other capital needs of the company into account runs the risk of destabilising this important co-dependency. Also let us not forget that for many investors, CGT can be a far more attractive proposition than income tax on a dividend payment.
As a result, dividend payment decisions have frequently become divorced from, and prioritised over, opportunities to deliver long-term growth from internal investment. Many chief executives have found themselves starved of much needed capital, while at the same time millions of pounds of free cashflow has been paid out to support shorter-term dividend policies typically associated with a more mature business model. Inevitably this goes some way to explaining why the rates of investment in, and competitiveness of, UK plc has fallen short of other developed nations over the last couple of decades.
With capital still relatively cheap and future growth more valuable in a low interest rate environment, attitudes are changing. Add to that the initiatives announced in the recent budget to encourage investment ahead of planned and significant corporation tax rises, and a rethink does seem to be warranted.
While in no way arguing that fiscal discipline should be abandoned, both organic and inorganic investment in growth that clears sensible return hurdles should start to move up the priority list. If the ROIIC (return on incrementally invested capital) of such projects can significantly exceed a company’s WACC (weighted average cost of capital), then surely this is a better use of cashflow than giving the bulk of that money back to shareholders. After all, shareholders are typically on the register because they believe fundamentally in the management team and should therefore be willing to back them to execute effectively. Several companies resorted to running balance sheets at the high end of gearing ranges to deliver on both fronts, but those in more COVID-exposed sectors have discovered painfully the perils of trying to please everyone.
It is thus essential a company can lay out a clear framework that explains both the scale and returns of the growth opportunities available to it. By doing so, the size and timing of any future dividend payments can be put clearly into context.
It is at this point in the cycle, as we start to plan for recovery, that companies with finite amounts of capital at their disposal make the right allocation decisions for their stakeholders as well as the wider economy. Every company will view this challenge through a different lens, but a realistic, well thought out and articulated statement of intent, consistently applied, can help investors focus on the business models that best match the objectives of their underlying asset owners. This will also help ensure companies adopt the optimum level of growth and investment that benefits the whole economy. In a post Brexit, post pandemic world companies must be encouraged to remain competitive, creating wealth and jobs and making a positive impact on the age and income inequalities exacerbated by recent events.
John Pickard, Partner