For the active UK investors amongst us, here is a short term strategy that could boost your returns in this tax year: position your portfolio for a bumper year of special dividends.
The UK government announced in July a significant tax hike on personal dividend taxes, taking effect in the next UK tax year (starting 5 April, for what are politely described as legacy reasons). This will increase wealthy investors’ dividend taxes by 7.5p in the pound. As this is a UK-only phenomenon, for the rest of this post I’m talking solely about UK companies.
What are Special Dividends?
Let’s start with dividends. Dividends are a return of cash by a company to its shareholders. They are decided by the company’s board, every year. Within certain balance sheet constraints, a company can pay whatever it likes – it does not need to be profitable, and it can even borrow money to pay it out as a dividend. The nature of Dividends as chosen by management is important and gives them some unusual qualities – stability for one (unlike, say, a company’s share price which can gyrate wildly no matter what the management wants to happen).
Dividends come in two flavours: regular dividends and special dividends.
Regular dividends are usually paid every six months, and are relied on by investors both as a source of regular income but also as a signal of management’s confidence and performance. Cutting or, heaven forbid, stopping a dividend is a major event for public companies and often leads to management being shown the exit not long afterwards. As a result dividends are planned for the long term; most companies agree and publicise a dividend policy, such as ‘paying out 40-50pc of free cash flows’, and make sure this policy is one that they can deliver on in good times and bad. They then stick as closely as they can to that policy. It is common therefore that regular dividends rise in a pretty smooth fashion over time; in difficult times increases might slow or stop, and in boom times dividend hikes might be slightly faster, but one-off changes are very rare.
In the real world, most companies have much more lumpy, bumpy and unpredictable cashflows than their regular dividend record would suggest. When bad news emerges, such as rising input costs, the pressure to maintain the dividend will trigger the search for adjustments – such as price increases, productivity improvements etc. Conversely, when good news emerges, after management has claimed credit and pocketed its bonus, a surplus of cash may build up which is more than cleanly be paid out via regular dividends. These surpluses are occasionally distributed as Special Dividends.
In effect therefore Special Dividends are a way of making unusual dividend payments without setting unwelcome precedents or straying from an existing dividend policy. They are often used after the sale of assets; the world’s biggest ever in fact was £54bn paid by Vodafone after its sale of its 45pc stake in Verizon Wireless for $130bn. This payment alone amounted to about 2pc of the entire FTSE-100 market cap that year.
Why is now the time to expect Special Dividends?
The tax increases that kick in next year are going to hit wealthy UK-based recipients of regular dividends pretty hard.
As a result companies with a significant number of affluent uk shareholders will be under pressure to bring forward whatever dividend payments they can to this tax year. The way for them to do this is via Special Dividends.
If they had any general plans to pay such a dividend in the next two or three years, you can expect their boards to be debating whether to risk perhaps running cash balances a bit lighter for a year or so by paying out early.
Which companies will announce Special Dividends?
Obviously I am not a clairvoyant. But companies to look for would be ones which:
- Are trading pretty well at the moment. Profits are on the up. No profit warnings.
- Have stable management teams. New ceos are less likely to want to ‘risk’ running low on cash. Experienced ones will have their hands firmly on the levers and will be able to steer around any unexpected shoals that might arise after a hefty cash payout
- Have large individual shareholders, such as founders. Examples would include Aberdeen Asset Mgmt (ADN), Daily Mail Group (DMGT), Hargreaves Lansdowne (HL), ICAP (IAP), Betfair (BET), Asos (ASC), and Moneysupermarket (MONY), Homeserve (HSV), Next (NXT), Zoopla (ZPLA), and Glencore (GLEN). FTSE-250’s slightly smaller companies are probably richer pickings than the giants of the FTSE-100.
- Have paid special dividends before. This suggests a willingness to do this and a slight disconnect between the regular dividend policy and the bumps in the cashflow road.
- Have shown a willingness to ‘optimise their balance sheet’ ie take on debt.
Feel free to suggest other companies which might meet the above criteria in comments below.
Why will Special Dividends boost returns?
Some investors argue that there is no investor impact whether a company pays dividends or keeps funds in the company.
Others may add that, even if there is an impact of making a Special Dividend, my argument here is well known by the market and thus has been priced in.
If however you think either that the market may be discounting the Special Dividend argument, or you are somebody who likes to track investment performance based on ‘cash in / cash out’, then you might well find that the bumper crop of Special Dividends we can expect before April 16 is rather good news for your investment returns.
Hopefully, you heard it here first.