High dividends follow rapid rise in cash flow

The company results season is almost half- way through and, on the whole, the results have so far confirmed that the recession is a thing of the past. Underlying earnings among non-financial companies in the results to date are 18 per cent higher than a year earlier in aggregate. Headline profits were expected to bounce back higher but they have been depressed by companies continuing to set aside money to fund restructuring. Even though the economy is recovering and profits are growing once more, this does not mean that lay-offs and redundancies are no longer a threat.

However, the most remarkable feature of the results to date has been the tendency of companies to raise their dividends.

Companies did their utmost throughout the recession to maintain their dividends, and aggregate dividends paid in respect of 1991 and 1992 were broadly flat in cash terms (implying a total fall of 10 per cent or so in real terms). Underlying earnings fell about 15 per cent in cash terms over the same period and, hence, the ratio of earnings to dividends (dividend cover) fell in recession.

This is how it should be. Dividends should give a signal about companies' underlying long-term performance and, therefore, should be more stable than profits and earnings. However, by the end of recession dividend cover had come down to an all-time low of 1.7 times in the industrial sector. The historical comparisons would be even worse if newly-privatised companies were excluded to put the figures on a like-for-like basis.

EARNINGS

As the economy emerges from the recession the presumption should be that companies will want to rebuild dividend cover. Cover is generally being rebuilt, but not by as much as most analysts had expected. Dividends are rising more slowly than earnings but aggregate dividends in the results to date are almost 10 per cent higher than a year earlier, which is two to three percentage points ahead of forecast.

Stronger than forecast dividends will owe much to the rapid improvement in companies' cash flow and balance sheets over the past three years. On official data, companies have turned a financial deficit of pounds 24bn in 1990 into a surplus of about pounds 4bn last year. Balance sheet gearing has also come down thanks to pounds 30bn of rights issues over the past four years and the lack of takeover activity. UK companies are generating cash and have to do something with it.

There is little incentive to further run down gearing at today's interest rates and companies do not seem inclined to take over others or to invest heavily in their own businesses. The absence of appealing alternatives explains the tendency to pay out more than expected to shareholders (a limited few such as Reuters have also taken the option of buying back their own shares which is equivalent to paying a dividend).

This situation is unlikely to change in the near future and dividends should continue to be high. This is good news for the equity market. As someone who has been cautious on the market this year, it is now possible to see some value in a yield on next year's dividends of 4 per cent, although I would want to see the next rise in US interest rates out of the way before getting brave.

REVIEW

Another caveat on dividends is that Stephen Dorrell, Financial Secretary to the Treasury, is conducting a review of savings and investment in the economy and has highlighted high payouts in the UK as an area of concern. The market would not take kindly to another attack on the tax-exempt status of pension funds.

For now, the main implication of the better-than-expected news on dividends is for sector and stock positioning. There is a very wide spread of dividend growth rates (-51 per cent to +100 per cent) around the average of 10 per cent.

More than two-thirds of companies have paid less than the average. Those that are paying more are generally the stable consumer and service areas of the market which have performed badly in share price terms since sterling left the ERM 18 months ago.

Dividends are only now just covered by earnings in the more recovery-orientated manufacturing sectors, which have been the best performers in recent times, and these sectors are doing well to hold their dividends.

In a less predictable world, investors will give more weight to that part of total return which they can be sure is certainly dividend growth. Investors should now be favouring those areas of the market which have the financial capacity to grow their dividends strongly over the next few years, rather than those that will benefit most from recovery.

The author is Head of Strategy & Economics at Hoare Govett Securities.