Corporate Governance Through the Eyes of Dividends

Kalim Aziz
May 18, 2016

For all non-financial companies/businesses that we look at, our primary focus is to get a real sense of a business’s ability to generate sustainably equity free-cash flow (‘E-fcf) given a view of macro-economic and competitive scenario. ‘E-fcf’ yield relative to the cost of ‘funds’ (debt) is one of the primary benchmark to sense the relative attractiveness of the investment under consideration.

To us, sustainability of dividend is of paramount importance, and we use our estimate of ‘e-fcf’ to assess sustainability of dividends: ‘e-fcf’ > dividends is the key. We are okay with the companies retaining some ‘e-fcf’ for ‘rainy-days’ or deleveraging for cyclical cushion. However, companies where we see dividends consistently above ‘E-fcf’ we believe are of poor quality and more akin to ‘equity-release’ rather than ‘equity-return’.

We would like to take the opportunity here to summarise our thoughts and views on corporate governance, a substantial element of this being dividend policy.

Our main valuation ‘sense check’

For all non-financial companies/businesses that we look at, our primary focus is to get a real sense of a business’s ability to generate sustainably equity free-cash flow (‘E-fcf) given a view of macro-economic and competitive scenario. We simply define basic equity free cash flow as EBITDA less CAPEX less financial costs, less taxes and minority interest payments. We then punctuate ‘e-fcf’ with level of leverage (too much debt would mean this ‘e-fcf’ does not belong to shareholders). For businesses which require significant working capital investment to grow their business, we adjust ‘e-fcf’ by taking an additional charge for working capital consumption (the process is more ‘art’ than science).

‘E-fcf’ yield relative to the cost of ‘funds’ (debt) is one of the primary benchmark to sense the relative attractiveness of the investment under consideration.

For financial companies, instead of ‘E-fcf’ we look at capital generating capacity and returns (topic for another newsletter).

Dividend Policy Mantra:

‘E-fcf’ forms the basis for us to evaluate ‘dividend policy’.

To us, sustainability of dividend is of paramount importance, and we use our estimate of ‘e-fcf’ to assess sustainability of dividends: ‘e-fcf’ > dividends is the key. We are okay with the companies retaining some ‘e-fcf’ for ‘rainy-days’ or deleveraging for cyclical cushion. However, companies where we see dividends consistently above ‘E-fcf’ we believe are of poor quality and more akin to ‘equity-release’ rather than ‘equity-return’.

Corporate Governance – through the eyes of dividends:

Excluding outright fraud, misappropriation and misrepresentation, corporate governance is not a simple black or white metric: it is a scale punctuated with degrees of separation starting from exceptional corporate governance, where the business operates fairly in the interest of all stakeholders, to poor corporate governance where the management team and a large proportion of the personnel’s interests subjugate those of other stakeholders - be it owners of the company, lenders to the company or suppliers or customers or government or other agencies.

Dividend policy is a mechanism which demonstrates a management’s willingness to accept the discipline to abide by the rule of ‘agency-principal’ relationship => all shareholders are the owners of the business and the management is entrusted to manage the business on behalf of the shareholders. The true level of corporate governance excellence is based on dividend policy transparently based on a critical evaluation by the management of expected returns from the use of cash, and on every instance where it sees excess cash does not meet the hurdle rate, it returns it to shareholders in the form of dividends (or share buyback which is essentially the same).

In our limited time associated with the capital markets (cumulative experience of over 50 years), we have yet to come across a company or business which has been transparent enough to qualify as excelling in corporate governance. What we have come across is ‘norms’ or peers’ benchmarked dividend policy => some do better, some do worse and this passes for ‘good corporate governance’ dividend policy. The norms sometimes are ‘ring-fenced’ within a sectoral, regional or ‘basket’ remit. Sometimes, the activist shareholder or majority shareholder places a dictat on dividend payment, and once this becomes ingrained in the business over the years (markets have short memory), this becomes good corporate governance.

We think corporate governance, shareholder rights (and respect of shareholder rights) as minorities or majority owner is a ‘jerky- evolutionary’ process which is usually triggered by some necessity or un-altruistic motive and eventually becomes a norm associated with the company/business.

For example, Apple refused to pay dividends and/or return cash to its shareholders via buy-back until an activist investor forced the management’s hands. It is listed in the US and is subject to US law, corporate governance regulations and the whole lot, it still sat on cash in excess of US$100bn (it ‘optimised’ its tax payment by keeping profits and cash in the most tax friendly nations so much so that the US$100bn+ of cash was not accessible without a tax hit, so it borrowed money to pay dividends when it did). Come to think of it, it ‘optimised’ its tax bill, i.e. did not want to pay its fair share of taxes to the government, do you really think, unless it was forced into a situation, it would distribute enormous hordes of cash it does not need sitting on its balance sheet to shareholders? Who talked about Apple as weak or poor corporate governance?

We are not Apple bashers! The point here is to demonstrate perspective. Just because a company is incorporated in the US (or UK or France or Germany or Japan) and it is large-cap and is followed by a large number of analysts and investors, it cannot be construed to have good corporate governance. Conversely, a company which is not so big and is incorporated in Russia does not necessarily mean that it has poor corporate governance. What matters is the change from no consideration to the minority (and sometimes majority) shareholders to serious consideration to all stake-holders.

With this decree in Russia, we believe a shift is taking place (it’s not going to be smooth, and the companies’ management will go kicking and screaming towards this) where the main/sponsoring shareholder which is a public entity is putting pressure on SOEs to deliver cash to ‘owners’ (the motive is not altruistic, we know). But it’s a start. With SOEs doing this, there will be significant pressure on privately sponsored companies to follow suit as well. The corollary benefit of dividend dictat is the instilling of discipline of sorts (the management is left with less money to proceed on projects as the like – or overspend) and eventually leads to better capital allocation and returns.

Even ignoring this seismic change in Russia, our region is still the highest dividend yielding region in the EM context. Our region is yielding 3.9% (MSCI Emerging Europe) versus 2.8% MSCI Asia, and 3.5% MSCI Latam or the average for MSCI EM as whole at 2.9%.

Kalim Aziz
Kalim Aziz
Senior Analyst at Duet Asset Management LLP, London
Mr. Kalim Aziz spent more than 20 years analysing companies in the global emerging markets. Kalim served as a Head of EMEA Research managing over 30 analysts at ING Groep in London and later headed Equity Research of the EMEA Region at UniCredit Banca Mobiliare in London together with Centralny Dom Maklerski Pekao in Warsaw and Koc Yatirim in Turkey, altogether covering more than 100 companies in the region. In 2006, he moved to the buyside as a Co-fund Manager of Kairos Eurasian Fund with Guido Brera. Kalim now helps managing equity fund at Duet Asset Management in London. Besides, he owns a consultuancy company Kiradvisory Limited, an affiliate of Helgi Library on various analytical work.