Corporate governance: To Distribute Or Not Distribute… That is the question

Many New Zealand commentators criticise New Zealand companies for their high payout ratio (dividends paid to reported profits). They argue that by not reinvesting they are holding back the development of their business and leaving themselves under-capitalised and vulnerable to takeover. All of this is true, but it is also true that company should not hold back profits unless the board can see reinvestment opportunity within the business that will provide shareholders with better return than shareholders can make for themselves – ie, better than, say, bank deposit rate return.
If boards are behaving rationally, and in the absence of ‘balance sheet’ (ie, solvency) need, the decision on dividend policy should be predicated on this question:
“If we [the board] cannot reinvest our profits and deliver return greater than the return that our shareholders can derive from an alternative investment, we should return our profits to shareholders for them to invest themselves.”
So there are two things that drive our high dividend policy in New Zealand. The first is high interest rates – thank you Dr Bollard – and secondly, lack of clear reinvestment opportunities.
Mostly our listed companies are domestically focused and very few are true global players. Those of our companies that are global are small in global terms. So most of our companies have to find reinvestment opportunities from within New Zealand, an economy that has slipped to the bottom end of the OECD over the past 25 years.
The convergence of these two factors underpins our high distribution policy and rather than criticising boards for behaving rationally we should applaud them. But the sad thing is we should have the opportunity to invest in companies that are run by people who can create rewarding reinvestment opportunities. This is about talent, New Zealand is short on talent, particularly talent that is prepared to be bold. Worse, those who do try become tall poppies and then society tries to mow them down.
Now to measure boards’ effectiveness of investment is not too hard either. Consider the table on right.
The first ratio, profit to sales, is measure of competitive effectiveness. If it is declining over time competition is taking toll, and if this ratio has moved significantly over time it is worth checking if this is due to changes in tax or interest rates or financial gearing. better measure is earnings before interest and tax to sales.
The dividend cover ratio is measure of dividend risk, and the equity ratio is measure of capital risk. This said, you have to look closely at what has been treated as an asset. Intangibles can distort things, but as simple exercise this is start.
Return on equity and marginal return on accumulating retained profits and the dollar-for-dollar ratio are the acid test on the ‘distribute not distribute’ question.
Generally if the business can preserve or increase its return on equity over time it is good indicator that the board has profitable reinvestment opportunities. This ratio can however be manipulated by changing the businesses gearing, ie, increasing debt at lower cost than equity.
The second ratio, which is calculated on the sum of all earnings not distributed over time, against which the increase in profits over time is measured, is harder to manipulate. Still it is worth measuring the increase in profits against the equity ratio: if the equity ratio is declining then even this measure may have been manipulated by changes to debt strategies.
The dollar-for-dollar ratio is Buffett special. If the board cannot produce at least one dollar of value on any dollar that they do not pay out to shareholders they are inefficient in the allocation of capital.
Don’t forget however that if you find one company with good history it doesn’t mean it will have good future, it just means that those who presided over the past were rational in the allocation of capital.

Bruce Sheppard is chair of the NZ Shareholders’ Association.

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