The Dividend Investor: A practical guide to building a share portfolio designed to maximise income

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Part A. Dividend Basics

Chapter 1. Companies and Dividends

The purpose of companies – to pay dividends

Let us be quite clear: the whole purpose of companies is to pay dividends. It goes like this:

a company is set up

the company makes a profit

the owners share the profit

we all live happily ever after.

The payment of dividends is, or should be, the raison d’être of all companies whose shares are quoted on any stock exchange. Dividends are the reward paid to shareholders who have invested their money in the business.

Yet in a sense dividends come last in the pecking order. They are funded out of what is left over after a whole range of bills and obligations have been met, such as:

staff wages

trade creditors

tax

interest and repayments on bank loans

pension fund contributions

bondholders

cash to meet day-to-day needs (working capital)

investment in the company.

There are two factors that affect whether a dividend is paid at all:

The company must have made a profit, either in the current or in previous years.

The company must have some cash to fund the dividend.

Companies do not normally pay out all the profits as they arise. Some cash is retained to fund the day-to-day operations of the company and some is held to fund expansion or new plant and machinery. Profits that are thus retained in the business build up in what are known as ‘distributable reserves’, so called because this is the amount of cash that can legally be distributed to shareholders in dividends.

If the company makes a loss, that will reduce the size of the distributable reserves. If losses persist and all the distributable reserves are used up, the company cannot pay dividends. Any accumulated losses must be fully offset by subsequent profits before the dividend can be restored unless the company receives permission from the High Court for a capital restructuring.

Cash is king

To emphasise, the company must actually have cash available to pay dividends. Profits on paper are no use in this respect. Your house may be worth twice as much as you paid for it but you cannot spend any of that gain unless you actually sell it. Similarly companies may make profits on paper, say from the revaluation of assets, but cash is king.

These rules apply to all companies, irrespective of their size or sector. You may find that companies with heavy capital costs, such as manufacturers and plant hire companies, build up larger distributable reserves to conserve cash. Companies with erratic profits will also want to keep sizable reserves so that they can maintain a steady dividend in good years and bad.

In contrast, companies with strong cash flow and low debts will find it easy to dish out the dosh.

Dividends can grow even in hard times

Total dividends paid by UK quoted companies actually grew in 2008, after the scale of the credit crunch had become only too apparent, to £67.1 billion from £63.1 billion in 2007. That is a lot of money for non-investors to be missing out on.

Admittedly, dividends were scaled back in 2009, to £58.4 billion, and again in 2010 to £56.5 billion. However, the fall in 2010 was entirely due to the suspension of BP’s dividend for the first three quarters of the year, according to figures compiled by Capita Registrars, which keeps the shareholder records of well over 1,000 quoted companies up to date.

Companies apart from BP increased their dividends by an average of 7.5% in 2010 as their shareholders received an early boost from the nascent economic recovery.

Even better was to come, for in 2011 UK-quoted companies paid £67.8 billion in dividends, more than they had ever handed to shareholders in any one year.

It is true that Capita’s data showed a heavy dependence on a few dividend payers. For instance, in 2010 just five very large companies – Shell, Vodafone, HSBC, GlaxoSmithKline and AstraZeneca – paid 38% of total dividends, while the top 15 companies paid 61% of all dividends.

So anyone investing in the largest companies would have received solid dividend payments notwithstanding the misfortune at BP, which in any case restored its dividend, albeit at a lower level, in the final quarter of 2010.

Spreading investments without increasing risk

However, there was plenty of scope for investors to spread their investments much more widely without significantly increasing risk because:

Fund managers invest disproportionately in the largest companies, leaving many medium-sized and smaller companies undervalued and offering higher yields.

The credit crunch left larger companies paying a disproportionate percentage of total dividends, a distortion that would be addressed as smaller companies came through the economic squeeze.

It is smaller, not larger, companies that bounce back soonest and furthest in the early period of recovery.

As Table 1.1 illustrates, smaller companies sensibly conserved cash and reduced debt in the immediate aftermath of the credit crunch. Soon, however, they were returning to paying dividends and taking up the slack caused by the fall in the BP dividend. Thus the top dividend payers were responsible for a declining proportion of the total paid.

Table 1.1 – Company size profile of UK dividend payers

More data from Capita reinforces this point: dividends from the medium-sized companies in the FTSE 250 Index rose 16.3% in 2010 while those from the FTSE 100 increased by only 6.8% (and it should be said that for investors to see their income rise by 6.8% in one not particularly promising year shows the potential benefits of dividend investing).

The trend continued. In particular, manufacturing companies that had struggled to remain competitive with cheaper production areas in Asia and Latin America rebuilt profits as the falling value of the pound on the foreign exchange markets gave UK exporters an edge.

Companies as diverse as ceramics specialist Cookson, which had not paid a dividend since the middle of 2008, and aviation services and newspaper distribution group John Menzies returned to the dividend lists early in 2011.

How is the size of dividend decided?

Technically the size of the dividend is decided by the shareholders in a vote at the Annual General Meeting (AGM). Interim dividends, decided by the board of directors, can be paid during the course of the year but the final dividend is not paid until approved by the AGM.

The agenda for the meeting may include a motion for shareholders to confirm any interim dividends already paid and to approve a final dividend recommended by the directors. Often, however, the dividend is not even mentioned on the agenda and shareholders are simply asked to approve the report and accounts, which includes details of the dividends.

It is clearly impossible to try to vote down the interim dividend and attempt to claw the money back from shareholders, some of whom will have subsequently sold their shares, although in theory the proposed final dividend could be rejected.

In reality, the board of directors decide on a figure for the interim and final dividends and this recommendation is nodded through by the shareholders.

As Table 1.2 covering AGMs held in 2011 shows, the dividend is almost invariably passed by a very large majority even where shareholders express their disquiet over, or openly revolt against, an issue such as directors’ pay.

Table 1.2 – Sample shareholder votes at company AGMs

In fact, for such a major matter there tends to be very little debate of any kind over the dividend. Although boards of directors meet every month, the dividend will be on the agenda only twice a year (or four times if there is a quarterly dividend) and then probably only as an item among the half-year or full-year results.

The finance director (sometimes called the chief financial officer) will draw up the results to be presented to the board and will suggest the size of dividend that is justified by the results. He or she will take into consideration:

the amount of profit that has been made in the relevant period

how much cash the company has in hand

the level of company debt, in particular whether any debts are due to be repaid

the amount of capital spending required in the current financial year

the extent to which income covers interest payments on debt

whether the company has a policy of maintaining or increasing the dividend each year.

Because these are all financial matters, the view of the finance director on what the level of dividend should be is of considerable importance and he or she will almost certainly have a figure in mind. This proposed dividend will usually be discussed with the chief executive, and possibly the chairperson, ahead of the board meeting to see if there is a broad agreement among these key directors.

The finance director’s proposal will be put to the board meeting and if there is no alternative suggestion then that is that. If the chief executive feels strongly that a different amount is appropriate then a second proposal will be put to the meeting for debate and a vote will be taken on the rival amounts. In the event of a tie, the chairperson’s casting vote will decide.

Very often there is no debate, and any discussion would almost always be reasonable and courteous, however good or bad the results. A heated row is highly unlikely and would happen only if the results are disastrous and the dividend has to be reduced or suspended.

In the end, most dividends are agreed unanimously. The scope for manoeuvre is limited by the parameters set by the results.

One item that may be discussed is whether to rebalance the dividend. Sometimes a company may be cautious after the first half and hold down the interim dividend; if all goes well the final dividend can be raised. Thus the final dividend may become disproportionately large compared to the interim. In such a case the board may debate raising the interim dividend by a larger amount than the final to bring the ratio between the two dividends into line with the generally accepted norm of 33:67.

Case study: Wynnstay

According to Paul Roberts, the finance director of Wynnstay, the most important point in setting the dividend is to maintain balance.

His company, supplying agricultural products and pet foods, was floated on the Alterntive Invesrtment Market (AIM) in 2004 after two years on Ofex, the third tier trading system now called Plus. By August 2011 it had a stock market capitalisation of £54.5 million.

Initially it paid just one, final, dividend a year to keep down costs but introduced an interim dividend in 2006, roughly in the ratio of 1:2.

As the man in charge of the coffers, Paul is conscious of the need to retain sufficient cash to develop the business while providing some rewards for shareholders.

He says:

We have had a long term strategy, both prior to flotation and since, to give a clear view to the markets what our dividend policy would be. Because we are a small cap company we have a requirement for capital so retained earnings are an important part of our strategy. However, the message that we put out was that the dividend policy would be progressive, all other things being equal.

The directors were conscious that larger companies usually try to cover the dividend two or at most three times with earnings but Winnstay made it clear from the start that it would probably be targeting a higher dividend cover policy. The board felt a cover of about four times was appropriate.

Paul says this openness has been well received by the stock market – indeed some shareholders indicated that they would be willing to forego dividends in the early years to allow more cash to be invested in the company.

However, Wynnstay has stuck to its intention of increasing the dividend by 5-10% each year since it changed its financial year from the calendar year to the 12 months to 31 October in 2006.

Table 1.3 – Historic dividend payments by Wynnstay

Paul says:

The dividend virtually sets itself. If we were unable to extend the dividend by the expected amount we would probably find it necessary to give an explanation to the market.

He says that the board effectively only has to decide the odd decimal point in the dividend level and there is rarely a big discussion. As finance director he has an understanding of what the market is expecting and proposes what the dividend should be, possibly after chatting to senior colleagues, before presenting the results to his fellow directors.

Different types of dividends

Besides straightforward cash dividends (which is the main topic of this book), there are some other types of dividends – which are briefly described below.

Scrip dividends

Many companies offer you the opportunity to take your dividend in the form of more shares in the company rather than cash. This is known as a ‘scrip dividend’. The company will say in its results announcement whether it offers a scrip dividend.

Not all companies offer this option and it may not be available to you if you run an online account where shares are held in a nominee account. Check with your broker whether you will be able to elect to receive scrip dividends.

Basic rate income tax will still be deducted from the dividend before the number of scrip shares due to you is calculated according to the level of the cash dividend and the stock market value of the shares. New shares will be issued accordingly.

If, as is likely, the amount of the dividend is not divisible exactly by the share price and there is a fraction of a share left over, the difference is – depending on the particular terms of the scheme – paid to the shareholder, added to the next dividend, retained by the company, or given to charity.

If scrip dividends are issued to a company in your ISA account, the new shares qualify for tax relief under the ISA scheme.

Scrip dividends are attractive if:

You want to build up your investments.

You have a range of investments and are not looking to diversify into more companies.

The company is doing very well and you are happy to keep on investing in it.

You do not consider the shares to be overpriced.

Scrip dividends are not attractive if:

You want income to live on now.

You want to widen your portfolio.

Your portfolio is already weighted too heavily in shares in this particular company or the sector it operates in.

You feel that there are more attractive prospects elsewhere.

Dividend reinvestment plans

If a company you invest in does not offer scrip dividends, it may still be possible to take dividends in shares through a dividend reinvestment plan, known as a DRIP – an appropriate acronym not because dividend reinvestment plans are stupid, but because they allow you to drip more shares into your investment pot.

The difference between a scrip issue and a DRIP is that no new shares are issued with a DRIP. Instead, participants in the scheme have their cash dividend paid directly to the scheme administrator, which is usually the company’s registrar. The administrator then calculates the number of shares to which each participant is entitled and buys the shares on the stock market. Shares are then distributed to the participants.

The administrator will obtain the best price it can for the purchase and because the share purchases can be aggregated, the dealing costs tend to be relatively low.

The arguments for and against DRIPs are exactly the same as for scrip dividends. If you elect to take scrip dividends where possible you will almost certainly be keen to take advantage of DRIPs as well. DRIP shares issued into an ISA account remain within the ISA wrapper just as scrip dividends do.

A list of companies that have a DRIP scheme can be found on the Equiniti share registrars website at:

www.shareview.co.uk/Products/Pages/applyforadrip.aspx

Where companies offer neither a scrip dividend nor a DRIP, your stock broker may offer a dividend reinvestment scheme, automatically reinvesting the cash dividend into the relevant company’s shares. Again, the arguments for and