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When dividends can be harmful to a company’s health

 
Simon Adler
Focus On Foyles Bookshop
Pearson sold Penguin Random House sparking a fall in its share price as investors grew concerned over its dividend outlook (Source: Getty)

Pearson’s self-declared ambition to be seen as “the world’s learning company” came a little more into focus this month as the former FT owner offloaded a 22% stake in Penguin Random House (PRH).

The sale – to PRH’s co-owner, German media giant Bertelsmann – alongside a recapitalisation of the business, raised some $1bn (£767m) and was initially welcomed by the markets. Yet Pearson’s share price ended the day down. How come?

Here on The Value Perspective, we have always argued investors should avoid trying to pinpoint the reasons why share prices rise and fall.

As we have argued in pieces such as End of story, imposing a narrative on any investment situation encourages investors to think there is only one version of the future when of course nobody has any idea whether or not that is the one that will actually play out.

Not that that has stopped the press from proffering their opinions on Pearson’s share price fall – and they have all been pretty unanimous it was because the company, which has been a great favourite of income-seeking investors, had rethought its dividend policy and announced a level of pay-out that was lower than the market had been expecting.

Dividend pay-outs are up to company management

Regardless of whether that provoked the drop in Pearson’s share price, it does offer a useful opportunity to assert that we would never tell a company what its dividend should or should not be.

Instead, we prefer to afford the management teams of companies in which we invest the space and the confidence to cut their dividend if they feel it is unsustainable or the money is better spent elsewhere.

There is no doubt that dividends are an important component of long-term investment returns – but the key phrase there is ‘long-term’.

If it is better for a business to cut its dividend in the short term in order to protect its balance sheet or allow it to invest more money and so turn it round to be the kind of business we would want to invest in, then we are very comfortable with that.

After all, this will go a long way to ensuring the company is ultimately able to pay a sustainable, long-term dividend that can help generate a good return for our investors.

Far better it take that approach than overstretch its balance sheet to pay a dividend it cannot afford.

That, incidentally, is a situation in which many of the high-paying so-called ‘bond proxy’ businesses are in increasing danger of finding themselves. Currently terrified of what disappointed investors could do to their share price if they cut their dividends.

Read more from Schroders' Value Perspective team on their website.

Simon Adler is an author on The Value Perspective, a blog about value investing. It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

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