Speaking to Markets Part II
Stock splits and dividends
SHARE MARKETS are smart because share prices contain valuable information about a firm’s expected future performance expressed as the growth in EVA (Economic Value Added). Management and the board can obtain this valuable information simply by subtracting the net asset value (NAV) from the enterprise value (market value of debt and equity). I call this Listening to Markets (7 December). Speaking to Markets (8 February) described how to use a share buyback signal unlike any other buyback in traditional practice.
Today deals with two other approaches that can be valuable in speaking to the market: share splits and dividend policy.
Share splits significantly increase the costs of trading. In the US the costs of trading are greater than even in SA, because broker commissions are greater if the price per share is lower for a given amount invested.
On a global basis, two other costs are borne by shareholders, which make splits an important signal everywhere. First, liquidity falls substantially, because for liquidity to remain unchanged the volume of shares traded must keep pace with the split. For example a 3 for 1 split must be accompanied by a tripling of the share volume in order for the rand amount of trading to remain unchanged. This rarely happens. Typically, lower volume translates into greater friction in the trading booth, costing buyers more to buy and sellers more to sell, shareholders thereby receiving less when they sell.
I recall only too well when IBM last split its shares 4 for 1 from $300 per share down to $75. The volume of shares traded doubled, which meant liquidity dropped by half.
Second, on the floor of the stock exchange, the so-called bid-ask spread as a percentage of price normally rises dramatically for lower priced shares. This is a direct increase in trading cost. Both the liquidity and trading costs hurt shareholders for sure.
These are the reasons why Warren Buffett in America has refused to split his company’s shares, each now trading well above $100 000.
Then why do boards split shares? The reason is to signal undervaluation. If share prices recover rapidly after a split, because the market believes management’s signal, the aforemen- tioned trading costs return to more normal levels fairly quickly. Management expects the pain to be of short duration.
Dividend policy offers a much more financially sophisticated signal. For decades researchers have been puzzled about why boards declare dividends at all. The reason is that shares fall by the amount of the dividend paid on the ex dividend date never to recover the lost value, which simply means that if shares rise after the dividend is paid, they would have been that much higher had the dividend not been paid. The reason is that dividends gained equal capital gains lost. The research indicates that risks and rewards are highly correlated so that the form of distribution between dividends and capital gains does not affect the total return to the shareholder.
Furthermore, dividends can be harmful to those shareholders who are subject to income tax. In addition, if the shareholder has no immediate need for cash, a trading cost must be incurred to simply reactivate the funds back into the market. The broker’s turnstile must be turned.
In SA, dividends have been popular for two reasons. First, strict capital controls that existed until the Nineties had few exceptions, but dividend payments to offshore investors were one of them. Thus, it was normal to find family-dominated firms with children living abroad to receive the dividends paid. This was a sanctioned leakage from controls. Also, dividend distributions were a way to take some cash out of the firm without altering the family’s proportional ownership. Absent dividends, the only alternative would have been to sell off some shares, thereby reducing the ownership stake.
In the Eighties, my friends Irvine Brittan, CEO of Boumat, a dealer in building materials, and one of his largest shareholders, Sidney Borsook, CEO of Saficon, a distributor of motor cars, tested the market’s so-called love affair with dividends. With Boumat earning close to 30% after tax on capital employed, well above the required return for risk (then estimated to be about 14%), Mr Brittan gave his shareholders a choice, a cash dividend or a bonus issue of equivalent value. More than 90% of shareholders selected the shares. So much for dividend preferences.
Whenever managements expect to increase EVA, which means return on capital exceeds the required return for risk, you can be confident that as a group, shareholders will prefer to let their money ride on share ownership. Furthermore, dividend payments can be viewed as a partial liquidation of the firm, an admission of failure to find worthwhile investments. Besides, if shareholders want cash, owning loan stock with high current yields well above the dividend yield is preferable, or a combination of loan stock and non-dividend-paying shares. Then, only the shareholders who want cash now receive it; the remaining shareholders bet on management. That’s the rule.
There’s a huge exception to this rule, once again in the world of signaling. Capitalintensive firms, those with capital exceeding turnover, such as paper, steel, autos, cement, landline telecommunications and electric utilities, often pay dividends only to borrow back the dividends paid out. After all, these firms need the money. Why go through a circle of wealth, out with one hand, back into the firm with the other hand? What is happening?
The answer is fascinating. Because shareholders are highly dispersed, they need to have an agent represent them, especially to evaluate the quality of investment opportunities within the firm. Shareholders need to know if projects are likely to earn at least the required rate of return for risk. Steven Ross, the distinguished professor at the MIT Sloan School of Management, has suggested that by having capital-intensive firms pay dividends, the firm is forced to reacquire the cash through a capital raising exercise. The cost to shareholders is the underwriting spread, typically as much as 1% in the US and often twice as much elsewhere, but it’s well worth paying this cost because the underwriter will have certified the quality of the investments by placing its own reputation at risk. This is why firms vie for Goldman Sachs, Morgan Stanley and Merrill Lynch as top bracket firms. Certification has real value for dispersed shareholders.
Joel Stern is chairman and chief executive of Stern Stewart & Co and a visiting professor at the University of Cape Town.