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.