Speak­ing to Mar­kets Part II

Stock splits and div­i­dends

Finweek English Edition - - Companies & markets - BY JOEL STERN

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.

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