This week RSA cut its dividend by more than 30%, and the reaction from Mr Market was instant and obvious – shares fell by around 14%, sending shock waves of disbelief out across the investing landscape.
The dividend was cut in order to allow cash to be diverted towards future growth opportunities, most notably in emerging markets. In the words of the CEO,
“In 2012 over 65% of our premiums were from outside the UK and as we move more of the business towards higher growth and higher margin markets, we are optimistic about our future growth prospects.”
On the face of it this seems to be a reasonably sensible position. If cash can be reinvested within the company at a high rate of return then, according to a certain Mr Buffett, that’s where it should go.
Investors don’t like dividend cuts
The problem of course is that this isn’t just any old cash – it’s cash that was expected to be paid as a dividend, which makes many investors feel as if the cash is being taken directly out of their hands, and that’s never a good feeling.
One quote from the FT said the decision was “not good and raises question marks over the chief executive and his judgement”. Another, again from the FT, said that “It’s probably permanently damaged the rating of the shares”.
Elsewhere the response has been largely the same – that it is better to maintain a dividend which results in less future growth, rather than cut the dividend to strengthen the business and improve long-term shareholder returns.
Should the cut have been avoided?
Of course, I’m skipping over an important question which is:
Why hasn’t the company generated enough cash such that it can maintain the dividend and invest sufficiently in future growth, both at the same time?
I guess that on the one hand it does perhaps show a lack of foresight from the company’s management. They should have seen that investment returns would be low (the reason for the lack of cash is cited as being low investment returns due to the low yield investment environment); that there was little spare cash being generated beyond the dividend, and that they had access to a growth market which was ripe for investment.
Perhaps they shouldn’t have raised the dividend quite so much in recent years. We are four or five years into this economic crisis, so perhaps in that time they should have held the dividend steady. The retained cash could have been invested in or simply earmarked for emerging market growth.
Perhaps that would have been more prudent.
Or perhaps they should have invested their insurance float more aggressively to generate sufficient cash such that this dividend cut wasn’t required in the first place.
But one thing I don’t want to do as an investor is start to micro-manage the business by second-guessing every decision the board make. In almost all cases I judge companies by results, not decisions, and it’s the same in this case.
Yes, I’d rather that the dividend wasn’t cut. I would prefer that they had generated sufficient cash to grow the business and maintain the dividend. But that hasn’t happened.
So, given that that’s the case, if the dividend cut does produce additional future growth, and in particular, more future growth that I would have been able to get from the cash if it had been paid to me as a dividend – then I am quite happy for the cash to be reinvested rather than paid out.
How does it affect the investment case?
It does change the valuation of the business, of course. There is always a difference between income today and income in the future. Everybody has a different discount rate and so some prefer cash in hand today while others would prefer less cash today in exchange for more tomorrow.
But for me it won’t really make that much difference until I see what results the company can produce in the next few years.
If growth doesn’t start to pick up, then the 14% share price drop could be justified.
If, however, the higher rate of growth in the emerging market business – which is growing in size relative to the rest of the business – does come through with the help of this additional cash, then it may turn out that the dividend cut should have resulted in an increase in the share price, rather than a fall.
Until we see how things pan out I don’t think it’s possible to make an informed judgement.
I think that, at the very least, to make a knee jerk decision on the day of the cut is simply madness and has little, if anything, to do with investing. Being an investor means thinking long-term, and valuing businesses on their long-term performance, not by how much the dividend is raised or lowered in any one year.
Disclosure: John owns shares in RSA and they are also held within the UK Value Investor model portfolio.
Striver says
February 23, 2013 at 1:48 pmI agree, the kneejerk reaction to sell shares on a dividend cut is irrational. It seems nowadays investors are so focussed on dividends they completely disregard reinvested earnings and just assume management will waste them.
I try to take advantage of this as much as possible, its easier to find value in low divdend payers but with higher returns on capital invested. Just a shame that most companies that pay decent dividends are now pretty fully valued.
John Kingham says
February 23, 2013 at 2:26 pmHi Striver, yes exactly. It’s a bit like Buffett who, I think, has a simple system where he effectively says to the CEO (where buffett has control or significant influence), you can retain excess cash if you can get a return of 15% or more, otherwise send it to Omaha. That’s pretty much the RSA situation as I read it.
Nick Shepherd says
February 24, 2013 at 8:54 pmJohn – good thoughts and well presented. Wise investors look at value which is something that is developed over time – however economics are cyclical and why we may expect CEO’s and the board to get it right each time they should be forgiven for occasionally calling it wrong. After all how many CEO’s are fired or investors run for cover when a merger or acquisition goes astray where the financial impact may be equivalent or even worse? I prefer honesty and good judgment from those leading any organziation that I invest in.
John Kingham says
February 27, 2013 at 2:13 pmHi Nick (sorry for the delayed reply, your comment must have slipped through the net). “Wise investors look at value which is something that is developed over time” – I couldn’t agree more. Although I’m not a buy and hold investor, that philosophy has much merit, especially when applied to sound businesses. If only more investors would look at both the past and the future in terms of years instead of months.
And regarding CEOs, even when they do get it wrong it’s not clear whether selling is the right thing to do. Look at Aviva. Although there is much to do to get the company going again, the failures of the last few years now seem to be resulting in much hard work and restructuring, which may in time produce significant returns. But again, only time will tell, and that requires patience.
Eugen says
February 24, 2013 at 9:45 pmJohn
For me UK insurers were a no go area for years. They don’t make their money from car insurance but from high charges investments oe savings plans sold by salesmen around the word.
Unfortunately commission was banned in UK and it is going to be banned in EU and other countries will follow. Cheap investments are in fashion now and these are sold by discount brokers.
With the meerkats – the last drop of profit is gone. Anyway people will still buy their shares as they get cheaper.
John Kingham says
February 25, 2013 at 12:26 pmHi Eugen
I guess it won’t surprise you to find out that I see things somewhat differently. Perhaps five years from now we can pick this thread up again and review the intervening period.
John
Eugen says
February 27, 2013 at 10:24 pmJohn
I can only wish you luck on this one. At the moment the share price is 120p twice the value per share of tangible assets.
You know that I am mad about free cash flow and the rate of return on profits reinvestments. At the moment they invest the money in emerging markets but when you look at the profits and where these come from, there aren’t any coming back from emerging markets.
Two thirds of underwritting result (profit from insurance) came from Scandinavia last year but unfortunately it is the first year when the level of premiums dropped in Scandinavia. Yes, premiums increased elsewhere (expecialy in EM) but there were no real profits made there. Emerging market people are very, very savvy people, they will compare prices and haggle three times before buying car insurance.
Aviva realised that and now is pulling off from some EM countries like Turkey. I don’t want to think how much is the write off on this single pulling off for Aviva but it is a three figures millions. Wasted shareholders’ money.
With regard to RSA investments, these were wrongly positioned with only 3-4% in Equities and 90% in bonds. With bond yields so low and discussions of negative interest rates the investment result won’t get any better.
John Kingham says
February 28, 2013 at 10:38 amHi Eugen, I agree with much of what you’ve said, especially about RSA’s bond investments, but I don’t think that means it can’t find a way to grow or at least maintain its earnings power in the years ahead, or that the share price won’t get an upward re-rating from some random series of good-news stories.
Eugen says
March 1, 2013 at 1:00 pmJohn
I can’t figure out what will happen in 5 years time. But for me it is clear that RSA will have lower profits next year and another dividend cut will follow. The investment profits will certainly be lower this year than last year and I don’t think RSA will increase the underwritting result, in my opinion that will be lower as well.
You know that we discuss a lot about margin of safety but I can’t see your margin of safety here. I did check with Dimensional to see if this is a value company based on their BtM factor and the answer is No.
I do need to do some more research (and I don’t have time for it) to compare with Hiscox figures to get a sense of margins made in this business. Hiscox is one of the most profitable insurer. I used to hold their shares until 2010 when people started to spill the wine on the carpets to get new ones at the insurer expense 🙂
Although I am not a fan of shorting and I did not short anything from 2008 when I shorted banks, I am tempted to short RSA.
Eugen says
December 13, 2013 at 12:46 pmJohn
It looks I was right on RSA. You don’t need to be smart to see it comming.
What are going to do now, hold, sell, buy more?
John Kingham says
December 13, 2013 at 2:18 pmHi Eugen, the news today doesn’t change my position at all. My question as always is where will we be in 5 years, and the answer is that I don’t know. Given RSA’s history, market positions and current price, I think that out-performance is more likely than not over that time frame.
Looking at Aviva which has had similar difficulties, the annualised returns since I bought it have been 15%, which is good enough for me, and the returns have been more than 40% in in the 9 months since the lows after the dividend cut.
The future is too uncertain to make any statements like “this is a good/bad idea based on what happened today or last week”. In my opinion the markets are very efficient so there’s no point worrying about the short-term ups and downs.
Eugen says
December 15, 2013 at 5:17 pmJohn
It depends if RSA will be around in 5 years time as I don’t think this will happen. Don’t take me wrong, I didn’t say it will go belly up, but probably because it is so cheap it will be taken private.
I am not keen in Aviva either, I know quite well their business with the good and the bad. Markets can be wrong in the short time as in the long time.