Investors: On Business Ownership, Dividends and Capitalization of profits

Shareholders attitude towards management is largely determined by management’s demonstration of performance as far as company’s strategic, operational and financial performance is concern. Shareholders has the right to demand for clear and satisfying explanations when performance results appear less than what should be, and yes shareholders have the right to demand for improvement, or even consider the removal of underperforming management (via a Board of Directors) – if it comes to that. As it turns out, poor performance has an impact on the investors’ returns, share prices, valuations, wealth creation as well as sustainability of the company. However, as the process requires, with very few exceptions, that underperforming management are changed by action of shareholders during their Annual General Meeting (AGM). Good governance standards and practices requires that it is the responsibility of the Board of Director, who are also entrusted with such fiduciary duty, to place, replace or remove companies’ management, of course on behalf of shareholders.

Investors: dividends vs. capital build up

Dividend payments are dictated by the company dividend policy, normally a frequent subject of debate between the investing public, majority shareholders and company management. In general the investing public wants a more liberal dividend policy, while management (and sometimes strategic investors/majority shareholders) in most cases prefers conservative dividend policy which allows companies to keep the earnings in the business to strengthen the company by enabling availability of efficient financial resources for future growth and expansion. And so, in a way management asks shareholders to sacrifice their present interests, benefits and preferences for the good of the enterprise and for shareholders future long-term benefits. The basic argument being by paying smaller rather than liberal dividends the company can use the money for shareholders’ direct and immediate advantage by retaining the funds for profitable expansions and growth.

Nevertheless, on a sweeping through history and time, the attitude of investors towards dividends has been undergoing gradual but significant changes, for instance years ago it was typically a weak company that was forced to hold into its profits, instead of paying them in the form of dividends, and the effect was almost always adverse to the market price of those shares. But currently it is quite likely that strong and growing enterprises will be the one that deliberately keeps down its dividend payments.

There has been always a strong case for reinvesting profits in the business where such retentions could be counted on to produce increased earnings, relative to when investors will be paid dividends and investing by themselves in other companies or asset classes. But, even then there are strong counter-arguments, such as: profits belong to shareholders, and they are entitled to have them paid out within limits of prudent management; that many of the shareholders need their dividend income to live on, otherwise why invest?; that the earnings they receive as dividend are real money while those retained might not be materialized or show up later; etc – these arguments are in some cases very compelling that stock markets shows persistent bias in favor of liberal dividend policies (and payments) as against companies that paid either no dividends or relatively smaller ones.

In these past few decades, however, the profit reinvestment argument has been gaining ground, informed/intelligent investors have come to accept a low-dividend-pay-out policy, this is so much true that in many cases for profitable and growth companies low dividend payments or even absence of any dividend seems to have virtually no effect on market prices (but the key word is “profitable and growth companies”); i.e. the case will not be the same for loss making companies.

All being said, it is fair that shareholders should demand of their management’s either a normal payout of earnings – say two-third of the profits – or else demand a clear-cut demonstration that the reinvested profits would produce a satisfactory increase in their investment valuations, wealth enhancement or investment earnings are more than alternative investment options. In many cases a low payout is clearly the cause of an average market price that is below the company fair value, and here the shareholders have every right to inquire and probably complain.

Otherwise, it is also important to mention and for us to understand that sometimes a stingy dividend policy could be imposed on a company either because of its financial position particularly in cases where most of its earnings are used to pay debts (according to debt conventions) or bolster its working capital or in cases where the company is in the sector whose regulations requires that a certain level of earnings cannot be paid as dividends, i.e. in the case of banks where there are sometimes thresholds and need for regulator’s approval on dividend payments. When this is the case there is nothing much that shareholders can say about it – except perhaps to criticize the management for permitting the company to fall into such unsatisfactory financial position, or complain as to why regulators in some cases and in such sectors are less considerate, as far as investors interest are concern.