Benel Lagua l July 13, 2023 l Manila Bulletin
In a regime of high interest rates, sticky inflation and a slumping Philippines stock market, the bond market surged as the offer of pre-determined fixed coupon payments attracted traction. At least, the conservatives believe, the payments are predictable. The downside is if interest continues its upward
trend, bond prices will go down. Unless there are unanticipated liquidity calls, bond investors must hold until maturity to conserve value.
Analysts however are saying that compared to the US and other developed economies at risk of recession, the Philippines is less vulnerable. Domestic inflation appears to be on a decline, from 8.7% in January to 5.4% in June. The Philippine stock market should be in the late stages of the bear cycle.
This may be the right time to demonstrate “Love the Philippines” and consider investing in equities.
While the recommendation is to invest in Philippine stocks, the general expert view is to focus on larger capitalized stocks that provide cash dividends as these companies shall spearhead the anticipated market recovery. The emphasis on cash dividends is to appease investor impatience in the light of the volatilities
of stock market prices.
Dividend payouts have been the subject of a lot of research as it affects firm valuation. In the ideal world model theorized by economists Modigliani and Miller, one with perfect capital markets, rational behavior and a frictionless environment, the dividend payout is irrelevant to a firm’s current valuation. When a company pays out a dollar more in dividends, the firm is worth a dollar less, or it must raise a dollar with more securities.
Most of the big companies who pay dividends regularly have some kind of debt. Why payout to shareholders with the left hand and borrow with the right hand? Bankers who intermediate the sale of new shares or who arrange debt get paid, and ultimately the shareholders bear the cost.
The essence of irrelevance is that shareholders can achieve the effect of any corporate dividend policy by costlessly reinvesting dividends or selling shares of stock on their own. There is such a thing as homemade dividends. Its major proposition is that value is independent of capital structure and dividend payouts. Value ultimately comes from the investment decisions by the firm.
This irrelevance conclusion comes with drastic simplications used in economic model building, but the framework is very useful. By acknowledging the number of real-world frictions, dividend policy can affect shareholders’ wealth.
Studies show why dividends needs to be paid out. One, dividends have clear information content and is a signaling device. It implies that dividend increases predict future profitability and are considered a signal of management’s view of future earnings. Two, dividends are a form of income subject to taxation. Three, a company that does not have projects that can earn better than what investors can handle themselves should distribute the free cash flow. Finally, there is the bird-in-the-hand argument that says dividends are sure returns as opposed to the more uncertain stock returns.
A survey of senior executives in the US cited by Brealey and Myers reinforce the information content theory of dividends. Managers are reluctant to make dividend changes that may have to be revised. Managers “smooth” dividends. And managers focus more on dividend changes than on absolute dividend levels.
When the economy is going great and the stock market is in bull territory, investors will naturally be rewarded with both potential stock price gains and periodic dividend releases. But in the world today where uncertainty reigns supreme, companies must choose the best way to convey information to the
public.
One can argue that when company does not have worthwhile projects to pursue, it distributes excess cash flow to shareholders by way of dividends. Information can thus be subject to alternative interpretations. However, the more dominant view established by many academic studies is that dividend payout policy is positively affected by profitability. Higher profitability increases the likelihood as well as the magnitude of dividend payout. Even in the Philippines, a study by Pamela Lloren-Alcantara confirmed existing literature findings that the more profitable firms pay higher dividends.
Cash dividends matter especially for listed firms where there are investors who do not have access to all information available inside the firms. This is the principal-agent argument. Cash is an expensive signal because it will have an impact on available liquid assets for working capital needs. It is not something that a firm can manufacture out of thin air.
Aside from profitability, we should consider other variables like the following: managerial conservatism, rating agency, financial flexibility, control, business risk, financial leverage, market conditions, tax regime, firm size, ownership structure, life cycle, etc. Firms need to pay close attention to the dividend decision.
*** (Benel Dela Paz Lagua was previously EVP and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs. The views expressed herein are his own and does not necessarily reflect the opinion of his office as well as FINEX.)