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Daily Telegraph: Giant cash-backs aren’t turning investors on

Last Updated: 12:14am GMT 23/02/2007

Shareholders prefer higher dividends to windfalls and, as the UK payout ratio hits a historic low, increasing profit distribution would boost share prices, writes Tom Stevenson

The grudging response to Anglo-American’s $3bn (£1.53bn) share buyback promise this week illustrated the City’s voracious appetite for cash. The miner’s shares fell 66p to £25.36 after investors, who had been looking for $4bn, shrugged at the company’s largesse.
Anglo is not alone in failing to satisfy shareholders with the promise of an apparently generous one-off return of cash. BP has spent £21bn over the past six years buying back one share out of every six in issue. In theory that should have raised the value of the stock, but the shares are lower than when they started.

Since 2003, according to Citigroup, UK companies have returned £118bn of surplus capital to shareholders in the form of share buybacks and special dividends, or 63pc of the total dividends paid. Last year, the bank estimates, companies paid out as much in one-off payments as in regular dividends.

Other recent examples include Diageo, which last week promised a £1bn share buyback next year on top of the £1.4bn already pencilled in for this year. Zurich Financial Services, the insurance group, launched a £515m buyback after profits soared 41pc in 2006.

Companies are under pressure to hand money back. Merrill Lynch’s February fund manager survey found 46pc of investors think companies should hand more cash back while 38pc believe they should be investing it in their businesses. In January, the call for cash was even more strident – 53pc for money back against 37pc for investing.

In the case of mining stocks (both BHP Billiton and Rio Tinto have also been handing cash back like it’s going out of fashion) there is a logic to spending money in this apparently unambitious way. Booms in metal prices have traditionally resulted in increased investment, then oversupply and falling prices. Through pacing themselves, the likes of Anglo can maximise their long-term profits by keeping prices high.

In the case of BP, however, turning the cash spigot risks sending a different message. If a company is seen to be handing cash back because it can’t find anything to invest it in, questions arise about its long-term strategy and the sustainability of earnings.

Citigroup believes investors are unconvinced by special dividends and share buybacks because they are seen as one-offs. It believes companies should turn to beefing up regular dividend payments, now at a historically stingy proportion of earnings. “Increases in regular dividends have been more positive for share prices. Perhaps this reflects the perceived annuity value of an increase in the regular dividend,” it said.

Between 2003 and 2006, UK earnings rose by 55pc but dividends rose by just 30pc. As a result the payout ratio stands at a historic low, as the chart shows. Dividends represent just 41pc of earnings today, way below the long-run average of 59pc.

That kind of cautious payout would make sense if earnings were at a peak, as they were in 2000, but Citigroup believes any slowdown this year will be no more than a “mid-cycle pause”. It says companies should consider lifting their annual payments back to the long-run average.

Doing so would provide the UK stockmarket with significant support, even after the sharp rise over the past four years. It would take the average dividend yield to 4.9pc, much higher than the historic average of 3.5pc, and would almost certainly lead to sharply higher share prices.

Vodafone, which increased its payout ratio from only 24pc of profits in 2004 to 60pc today, has seen its share price recover strongly, and other companies could benefit in the same way. Simply returning to their long-run average payout ratio would boost the dividend yields of Shell, Aviva, Legal & General, Bradford & Bingley and BP to more than 4.5pc, Citigroup calculates.

One further reason why companies might look to their dividend is because, with the barbarians hammering at the gate, they need to do something to fend off the attentions of private equity.

Lifting the payout would make quoted equity more attractive to investors and reduce the opportunity for buyout funds to walk in to a company, gear it up and strip out a big dividend.

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