By Dr Cédric Poretti
The current dividend drought
The COVID-19 crisis is putting the global economy under pressure in an unprecedented way. Companies worldwide have been forced to cut their dividend payouts. Based on the Janus Henderson Global Dividend Index (August 2020), global dividends fell by 22% to $382.2bn in the second quarter of 2020. However, significant variations appeared across regions and industries. North American dividends barely changed on a year-on-year basis, while in Europe, 54% of firms reduced their dividend payouts. In France, payouts dropped by 57%, in Spain by 70%, in Germany by 19%, while no change appeared (on a year-on-year basis) in Switzerland.
Regarding industries, only communications and healthcare remained stable. Financial payouts dropped by 40%, while the decrease for consumer discretionary firms approached 50%. At the firm-level, the top 10 dividend payers (with Nestlé SA, Rio Tinto and China Mobile Limited on the podium) represented 12% of all dividends paid, which is a 20% increase from the second quarter of 2019. Regarding hospitality firms, Accor, in its H1 2020 Results (published on August 4, 2020), announced that “share buyback and dividend were suspended until further notice”, while NH Hotel Group cancelled the proposed dividend from 2019 profits. Another example is Marriott International, which suspended its quarterly dividend beginning in the second quarter. Clearly, most firms need to hang onto cash until there is more clarity that business will return to normal and one way to do this is to reduce dividend payments.
Why are dividends so important to investors?
Dividends and share repurchases are the principal mechanisms by which corporations disburse cash to their shareholders. Dividend payments represent an important source of cash for many private investors (retirees in particular), but also for stakeholders such as pension funds and foundations. This has become even truer in recent decades amid a declining interest rates environment. When yields on fixed-income instruments are low, dividend-paying stocks become even more attractive to “income investors”. Indeed, on top of providing eye-catching yields, the prospects of netting a capital gain are also enticing. Because investors are hunting for yield, many companies even borrow money (e.g. increased leverage) to pay dividends.
Looking at the big picture, understanding why firms pay dividends (the so-called dividend puzzle) is a widely researched topic. We know that dividend policy varies across firm characteristics, industries and countries, but also that there is a trade-off between redistributing cash to shareholders and not missing growth opportunities. On the one hand, dividend increases generally lead to share price increases as market participants perceive it as a signal that management is confident about its ability to meet future cash outflow requirements. On the other hand, dividend cuts usually trigger a negative market reaction in response to the signal sent by the management about the firm’s future ability (and difficulty) to generate cash. However, a dividend cut might also indicate that the company needs cash to seize investment opportunities that have positive net present value, in which case the share price might also increase and lead to capital gains that are taxed at a lower rate than dividends.
There also exists a more corporate governance-oriented way to look at dividends. Dividends can be used as a tool to mitigate conflicts of interest between managers and shareholders. For example, when a company generates substantial free cash flows, these cash flows might not be used in shareholders’ best interests (e.g. investments in sub-optimal projects, managers maximizing their private benefits). Distributing more dividends will thus reduce the cash flows available to managers, which decreases ‘private benefits expropriation’ and limits over investment. Indeed, pushing the company to distribute dividends forces managers to find alternative financing through the capital markets, which induces additional monitoring.
How are dividends related to the business strategy?
If the hospitality industry had to be characterized by three dimensions, most investors would mention competition, capital intensity and sensitivity to changes in the economy. Moreover, an interesting aspect – which has been a hot topic in hospitality research recently – is the major shift in some companies’ business models that has occurred in recent decades. Indeed, some corporations have been divesting from hotel and restaurant assets, while focusing more on management and/or franchise business models. This is what we call the shift to asset-lightness. The literature tells us that this type of business model enables firms to grow fast with less capital investments, allowing for greater flexibility, as well as stabilizing and increasing cash flows. In other words, the asset-light strategy allows companies to take advantage of growth opportunities without having to bear the underlying real estate risk.
In a recent article published in the International Journal of Hospitality Management, focusing on a sample of large hotel and restaurant firms worldwide, Poretti & Blal (2020) investigate how asset-light strategies impact dividend policy. The underlying idea is that if asset-lightness has a positive impact on cash flows, this in turn should affect dividend policy. They document that an asset-light business strategy leads to larger dividends for firms with substantial growth, and more specifically when institutional investors do not serve as monitor. Indeed, it is well documented that institutional investors, such as mutual funds, pension funds or hedge funds (among others) holding a significant stake in the company substitute as a monitoring device which reduces the need for external oversight. When asset-light firms with significant growth opportunities have low levels of institutional investors, they tend to distribute more dividends to prevent managers from investing in sub-optimal projects or adopting opportunistic behaviors. Overall, we can say that adopting an asset-light strategy only leads to higher dividend payouts in specific contexts.
Understanding why companies pay dividends is not an easy task. In the context of the hospitality industry, fast-growth asset-light firms’ top managers and board of directors should be aware of the fact that opening up their capital to institutional investors might increase their financing capabilities and prevent the distribution of dividends for monitoring purposes. Keeping enough cash on hand sends a strong signal of financial soundness to the financial market, which may impact investors’ perception of the firm.