Tough economic conditions have prompted British plcs to slash their costs in several areas, but one thing they haven’t been cutting back on is dividend payments.
UK-listed companies distributed £84.8bn to shareholders last year, representing a 16.5% increase on 2021’s total, excluding special one-off payments, according to research published by the Link Group.
That makes the UK an attractive market for investors, but some firms may be taking an unnecessary risk in trying to maintain a progressive, but unsustainable, dividend policy to prop up their share prices.
Hugh Maule is a partner and head of the corporate, finance and tax practice groups at law firm Gowling WLG, where he helps firms seeking to float on the London Stock Exchange. He notes that “there seems to have been an increasing cultural importance over the decades placed upon large listed caps paying income to their shareholders and increasing these payments each year. They definitely don’t want to be seen to be reducing dividends.”
That is partly because dividends are a way for investors to assess corporate performance. In effect, a company announcing a dividend reduction is telling investors that it’s underperforming, which would probably harm its share price.
“If a firm’s management team or board says: ‘We can distribute this amount of cash to shareholders next year,’ that becomes a yardstick,” says Jacob de Tusch-Lec, manager of global income strategies at Artemis Investment Management. “If the company then has to cut its dividends, that sends a very negative signal.”
Why do UK companies pay dividends so regularly?
Much of the UK’s dividend culture is rooted in the fact that the FTSE 100 comprises mature companies that are attractive to income investors who rely on dividends for their revenue streams.
“Income investing is ultimately about targeting companies that have done their innovation and therefore have excess cash than they can return to shareholders,” de Tusch-Lec says.
Also reinforcing the culture is the way that corporate governance and accounting rules operate, according to Adam Leaver, professor in accounting and society at the University of Sheffield.
CEOs in the UK have quite a short lifespan in the job… That encourages short-termism
“The purpose of management is to deliver returns to shareholders,” he says. “Management compensation is therefore geared towards delivering shareholder value, which is often measured through things such as dividends and total share return.”
This can create a situation in which management teams are biased towards maximising immediate returns rather than making choices that, although they may be costly in the short term, generate more lasting benefits for their businesses.
“CEOs in the UK have quite a short lifespan in the job,” Leaver says. “So, if you’re going to be in post for only four years and much of your bonus is paid in share options or it’s triggered by your capacity to increase total shareholder returns or dividends, that encourages short-termism.”
What effect does prioritising dividends have on companies?
Maule agrees, noting that the myopic desire to push up dividends often comes at the expense of important long-term investments.
“If you’ve got an increasing dividend requirement because management feels compelled to keep paying them at a particular rate, then something is going to suffer,” he says.
A 2021 research report published by the Productivity Insights Network, co-written by Leaver, revealed that firms paying the highest dividends were more likely than average to experience slower growth. Moreover, the top 20% of dividend distributors in the FTSE 350 were paying out more in dividends that they were generating in net income.
“It sounds like that shouldn’t be possible, but it is if you’re doing things such as fair-value revaluations of assets and treating these as profits,” he explains. “Some companies are borrowing against those revaluations and then paying that borrowed money to their shareholders.”
With this combination of creative accounting and debt finance, some companies have managed to maintain progressive dividend policies despite their poor underlying performance. This unsustainable strategy is a problem that’s being exacerbated by the return of high interest rates.
“There’s a significant minority of firms that have become really quite fragile,” Leaver reports. “They’re in this state because they were allowed to book asset revaluations as profits.”
What needs to change to fix the UK’s dividend culture?
He argues that a change is needed in the way that businesses are run so that corporate stewardship seeks to maximise benefits for all stakeholders, rather than shareholders alone. This should lead to a more sensible balance between dividend distribution and reinvestment.
“That must be backed up with a greater plurality of voices at board level, which might help take the edge off the aggressive distribution culture that British management seems to be following,” says Leaver, who adds that accounting regimes may also need to tighten so that there are more limits on what can be included as profit.
“There are two ways you can grow a firm’s market capitalisation,” he says. “One is to inject it with steroids by paying lots of dividends and doing share buybacks. The other is simply to run the firm well and make good management decisions. The second would be the more sustainable option, but the big problem is that we’ve made it too easy to book distributable profits through creative accounting.”
Maule is one of many market watchers who believe that there should be more dialogue between plcs and equity investors about the importance of long-term investment.
“Companies are hamstrung by the feeling that they must keep paying more and more dividends to shareholders,” he says.
Investors don’t always want dividends
But change may well be afoot – instigated by shareholders rather than the firms they invest in. Indeed, some income investors are pushing back in cases where they consider dividend yields to be too high relative to the underlying performance of the companies concerned.
There’s a significant minority of firms that have become really quite fragile because they were allowed to book asset revaluations as profits
“Many times I’ve sat with management teams and told them that they need to reset the dividend because it’s too high and they’re not investing enough for the future,” de Tusch-Lec says. “From our point of view, we want to get the maximum benefit from a good, sustainably growing dividend. But we don’t want to be dogmatic about this to the point of starving the company of future growth opportunities.”
Reinvesting more profits would not only help to support a firm’s growth over the longer term; it would also help in the short term by reducing its tax bill through reliefs and allowances.
“In other jurisdictions, it’s much more about showing shareholders that you’ve driven down your tax rate, rather than saying: ‘We’ve met our dividend forecasts,’” says Charlotte Sallabank, a partner and tax planning specialist at law firm Katten Muchin Rosenman. “US shareholders, for instance, will look very much at the effective tax rate that the group as a whole has achieved.”
Why dividends make for a bad business environment
The UK’s focus on dividends is potentially damaging for the London Stock Exchange in the long run. Companies in high-growth industries may shun a listing here because they would rather reinvest profits into R&D and other growth-generating projects than return excess cash to shareholders. British semiconductor manufacturer Arm Holdings, for instance, recently chose to float in New York.
“For the London Stock Exchange to become a more attractive listing location for such businesses, investor attitudes towards dividend payments need to calibrate to take into account these industry specifics,” says Rajesh Gupta, CFO at OakNorth Bank.
That would require a wider cultural shift, according to Sallabank, who suggests that it’s in UK plc’s interests to develop an environment in which “a strategy for growth is valued as much as an income return”.
For that to happen, companies urgently need to start rethinking their dividend policies and finding more sustainable ways to keep their shareholders happy.
