Practice and theory – Eating into Peter’s capital to pay Paul’s income is no way to add value
Why is the Investment Association reviewing the definition of which funds can and cannot sit within its UK Equity Income sector? One possibility, The Value Perspective recently suggested in Theory and practice, might be a reluctance on the part of the trade body to be seen to be driving investment or for it to be thought fund managers could be changing their portfolios to fit in with its rules.
In the interests of consistency therefore, it seems only fair to consider the related question of whether equity income fund managers could be seen to be driving the dividend policies of listed businesses – or at least whether listed businesses could be changing their dividend policies to fit in with what they believe equity income fund managers want from them.
In both cases, the short answer is – spoiler alert – ‘Yes’. Here on The Value Perspective, we could point to a number of instances where this is arguably happening – indeed, we have done in the past, in the context of US businesses in Thanks but no thanks– and we may well return to the topic with other examples in the future.
Today, however, we will zero in on the case of UK aerospace and defence specialist Cobham, which on 29 April issued a second profit warning in the space of six months. The same day, the company announced it would be asking investors to back a £500m rights issue designed to prevent the debt it took on to finance a series of acquisitions in 2014 from bumping up against its banking covenants.
Before we go any further, full disclosure. Here on The Value Perspective, we own a small amount of Cobham in some of our portfolios, more for historical reasons than anything else. As it happens, the business had been doing quite well – at least until its latest announcements – and we had been looking closely at the company’s situation and considering what to do next.
Ultimately, for value investors, that sort of question tends to resolve itself in one of two ways – the company’s shares either become much too expensive and you sell your stake or they fall heavily and, all other things being equal, you have the opportunity to buy in at cheaper levels. Where then does that leave us with Cobham?
On the whole, our concerns about the business are ‘one-off’ in nature – the debt, the acquisitions, the covenants we mentioned earlier – rather than having to do with any broad-based slowdown. Of course, such a slowdown may still materialise but, as things stand, the real red flag fluttering above Cobham is that, having just announced plans for a £500m rights issue, it still intends to pay a dividend.
Think about that for a moment. What it means in practice is the company wants to take money off its investors today to help it pay down debt and then return a chunk of it to them in the form of dividends – roughly £90m later this year and £120m in 2017. Even before you factor in the tax that will be payable on the dividends and all the fees that will be due on the rights issue, how does that make sense?
Well, take a look at the company’s register and it certainly begins to – because then you will see that many of Cobham’s biggest shareholders are income funds. So while it may make no economic sense to plough on with a dividend, the fact is that, were the business to do the rational thing and cut its own pay-out, then those funds would probably have to cut theirs.
A not unrelated fact, meanwhile, is there is little income fund investors hate more than seeing their income cut. They may forgive, say, a 20% or 30% fall in an individual stock holding but they are likely to be a good deal less merciful about a 2% or 3% drop in a dividend pay-out. Their cash distributions are important to them – after all, there is a good chance they will be living off them.
To be fair, Cobham is by no means the only company ever to consider persisting with its dividend in the wake of a rights issue – National Grid and Rexam, to name but two, have done something similar in recent years. Letting the income fund tail wag the corporate dog, however, is not how things should work – even if, given the size of the income fund space in the UK, that tail is now worth some £80bn.
We accept it might sound odd to hear income fund managers suggesting companies should not feel they need to maintain their dividends at a certain level. But note the word ‘fund’ in that sentence. As managers of equity portfolios, we understand some businesses will do well and others less so and, in an income context, some will be forced to cut dividends while others will grow theirs.
Furthermore, we are not just income fund managers, of course – we are value investors and we do not like to see the sort of value leakage that occurs from giving money to a company through a rights issue only to see it later returned minus tax and fees. Eating into Peter’s capital account to pay Paul’s income may serve to avoid an unwanted conversation with some investors but it raises the prospect of another, equally awkward, chat with those who take a similar view to this issue as The Value Perspective.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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