Commentary: Why investors should look at companies’ dividend policies

Date: December 12, 2022

First published in Straits Times on 11 December 2022

The average Singaporean shareholder used to be keen on only two things when attending annual general meetings (AGMs) – free food and asking for more dividends.

That has now changed. According to many listed companies, shareholders today are much better informed than before and ask very probing questions at AGMs.

Of course, a popular question is still on dividends.

This is understandable as many retirees view dividends as their income. But shareholders should note the following points relating to dividends:

  1. First, dividend is paid at the discretion of the board of directors. While the senior management of a company can encourage the board to declare dividends, the decision to do so lies with its directors.
  2. It is important to understand that not all firms will pay high dividends, and much depends on the industry in which the company operates.

There are certain rules surrounding dividends that investors should be aware of.

Under Section 403 of the Singapore Companies Act, dividends can be paid only out of available profits. This means that a company that reports a loss is not allowed to declare a dividend, and doing so can mean severe consequences for its board.

The Singapore Code of Corporate Governance also states that “a company should have, and should disclose a dividend policy”.

If the company decides not to declare or recommend a dividend, it must expressly disclose the reasons for the decision when it releases the financial statements. This provision was inserted on the recommendation of the Securities Investors Association Singapore (Sias).

This is an explicit recognition that dividends are an important component of the investment decision. If the board decides to retain funds for future expansion and not pay dividends, this has to be stated in its annual report.

Why do companies pay dividends?

The question should be viewed from two perspectives – shareholders and management.

For shareholders, the traditional justification is that they want a regular source of current income. They could sell some of their shares each year to get this, but then they would incur transaction costs.

Many also prefer to hold on to their shares for possible long-term capital gain. Furthermore, a dollar of dividends in hand is better than a dollar of hoped-for rises in share price from retained earnings which are in the bush.

So it’s better to get the money now than wait for the retained earnings to be usefully invested and maybe push up the share price in the future.

As far as management is concerned, there are many theories surrounding their adoption of particular dividend policies.

One of the more popular is the “signalling” effect that is said to arise from information asymmetries between management and shareholders.

The argument is this: The dividend policy of a firm can be used to signal to the market what company insiders think about the company’s fortunes.

Management is usually reluctant to cut dividends, as this would have a detrimental effect on the share price. However, they will raise dividends only if they are confident that future cash flows and earnings will be able to sustain the higher payout.

From the market’s viewpoint then, because boards and management have superior inside information versus outsiders, a dividend increase functions as a fairly reliable signal that the company’s fortunes look bright. Conversely, a cut in dividends signals a dim outlook.

In most cases, however, providing signals to the market about the company’s future may not be the primary purpose of a change in dividend policy. Instead, changes are usually to establish the right financial structure for a more competitive environment.

For instance, Singtel recently declared a special dividend and said the move was to share “the benefits (of its asset recycling strategy) by returning excess cash to shareholders after setting aside capital for growth initiatives”.

Not surprisingly, the announcement led to a jump in the stock’s price.

Singtel can be taken as a good example of a company operating in a mature industry.

Such firms, if well managed, would then prefer to return excess cash to shareholders via higher dividend payouts rather than retain too much and waste that capital via overinvesting in core businesses or through risky acquisitions.

Note also that having too much cash makes a company a tempting takeover target.

On the other end of the spectrum are growth companies that tend to have much lower dividend payouts. These tend to operate in riskier businesses than mature companies, and their higher business risk means a greater likelihood of not having access to capital at reasonable cost when needed.

In such cases, a policy of high dividends may lead to an inability to capitalise on valuable investment opportunities. Thus, high-risk growth companies tend to retain rather than pay out earnings.

It therefore makes sense for investors to match their dividend-related stock purchases with their investment objectives. Retirees, for example, who do not have a long investment horizon ahead of them would usually be better off investing in mature companies that pay good dividends but whose share prices may not post large gains.

Younger investors who have plenty of time to ride out volatility and who may not need regular income might go for high-growth firms whose shares could potentially outperform over time but don’t pay regular dividends.

Whatever the case, it pays to understand the rules surrounding dividends, why they are paid, and the industry you choose to invest in.

  • The writer is Mr David Gerald, Founder, President and CEO of the Securities Investors Association (Singapore)