When Investors Put Too Much Stock In Dividends

Foreword from ShareInvestor

This article “When Investors Put Too Much Stock In Dividends” by Goh Eng Yeow was first published in The Straits Times on 05 Oct 2015 and is reproduced in this blog in its entirety.

In a world desperate for income it’s no surprise that investors plough into stocks of big banks and oil majors to reap the fat dividends many of them offer.

Yet what used to be their advantage over the rest of the market – those mouth-watering payouts – is fast turning into a big liability as stock markets everywhere head south.

Pointed questions are being asked over the big players’ ability to continue doling out such generous dividends in an environment rocked by falling oil prices, a strengthening greenback and stalling revenue growth.

There is also the concern that, as regulators go on the warpath against companies for their past transgressions, the fines meted out may affect their ability to sustain dividend payouts.

Take the oil majors. The fear that the collapse in crude prices may force them to slash dividend payouts has caused their share prices to plummet as investors demand a higher yield to compensate for the risk.

The slide in the companies’ stock prices raises questions as to whether the industry-wide cost-cutting, asset sales and deferral of billions of dollars in spending on new projects to boost cashflow will be sufficient to protect the dividend payout.

There are also questions as to whether their generous payouts will be sustainable over a longer stretch of time – beyond this year –if oil prices continue to struggle at US$50 (S$72) a barrel or slip even lower.

In turn, that is casting a pall over Singapore’s offshore and marine sector, which relies on the oil majors for much of its business.

UOB Kay Hian noted in a recent report that, in the face of capital expenditure cutbacks by oil majors, the global demand for drilling rigs has stayed muted. This year has so far seen only six new orders compared with 28 last year, and they were mostly won by Chinese shipyards.

No doubt, the dearth of orders has been a big dampener for rig-builders Sembcorp Marine and Keppel Corp, which were used to winning contracts worth billions of dollars.

But there is also the risk that, as the oil price slump deepens, their profitability may be affected by potential rig contract cancellations – and that this may impact their dividend-paying ability.

Yet despite the gloom and doom projected by analysts, history has shown that oil majors such as Royal Dutch Shell have never cut dividends, even during the oil slump in the mid-1980s when prices plunged in similar percentage terms as now.

But putting aside concerns such as falling oil prices and China’s slowdown, one big worry confronting investors – as British fund manager Neil Woodford puts it – is “fine inflation”, or the size of the penalty levied by regulators in the United States on companies that violate US regulations.

Mr Woodford dumped his stake in HSBC Holdings last year only two months after acquiring the shares on concerns about the then on-going investigation into the historic manipulation of interest rates and foreign exchange markets by some global lenders.

He was worried that the penalties being meted out to banks were increasingly based on their ability to pay, rather than on the scale of their transgression.

Whether his concern was valid or not, his decision to exit turned out to be prescient, given the whopping fines that have been meted out to banks.

These include French lender BNP Paribas, which paid an eye-popping US$8.9 billion for processing over US$30 billion of transactions for groups in Sudan, Iran and Cuba between 2002 and 2012, and Deutsche Bank, hit with US$2.5 billion in fines for its involvement in the Libor rate-rigging scandal.

Because the penalties were so hefty, each time a huge global company is accused of some alleged wrongdoing by US regulators, the reflex action for investors is to scramble for the exit.

The latest example to send shivers down investors’ spines is German car-maker Volkswagen, which lost €10 billion (S$16 billion) of its market value when its shares plunged by 35 per cent in just two days on fears over the scale of the fines it might have to cough up after it admitted to doctoring the emission tests on some of its cars.

Another example is Standard Chartered Bank. In addition to having to confront the mounting problems it is facing in emerging markets where it is a big lender, it also has to contend with accusations from US regulators about possible violations of sanctions designed to cut Iran off from access to the greenback.

Although Stanchart has very small operations in the United States, it needs the US dollar clearing licence to facilitate the trade and cross-border activities that have become its main business.

It has already paid almost US$1 billion in penalties to settle earlier allegations over sanction breaches and failures in its anti-money laundering system.

So what should a yield-hungry investor do?

When we make an investment decision on a stock, we tend to analyse it in terms of its business prospects and take into account a host of factors such as oil prices, the US dollar, the global economic cycle and China demand.

Perhaps we should also consider factors such as potential exposure to US regulatory concerns and compliance costs, which may all add up to crimp a company’s ability to maintain its dividend payout.

Across the globe, there are many blue chips that may look cheap after the recent bruising sell-off but, before you go on a buying spree, ask yourself if the dividend yield on offer is sustainable.

Don’t take the payout for granted. We live in uncertain times.