By Richard Jones, director and portfolio manager focused on Asia Pacific equities at FSSA Investment Managers, part of First Sentier Investors.
In boom times like today, when cash costs nothing and capitalisation rates are zero, everybody is focused on growth and the future. But valuations are most often anchored by current profitability, while businesses are theoretically worth only the present value of the cash that can ultimately be returned to shareholders. In practice, it is largely a matter of risk appetite, which has lately been in retreat.
Recent rotation has witnessed the markets shift from their obsession with the vanity end of the spectrum to a more considered interest in profits, but there is still not that much regard for cash. These moves have been prompted by a very modest (from nothing) uptick in interest rates in response to inflation pressures. The political and economic environment has deteriorated too.
There is really nothing much to see. But, these moves have prompted us to think all over again about cash generation as a leading signifier of quality. How did companies behave collectively through Covid? After all, in terms of stress, a pandemic is surely many multiples beyond a sharp negative reversal of the inflation and interest-rate cycles. In particular, I am interested in how companies treated shareholders.
Portfolio resilience and quality markers
Dividend payments should tell us a lot about a company’s underlying resilience and persistency. Emergency cash-calls would suggest cyclical and lesser quality balance sheet businesses, providing something of a scorecard in terms of quality.
Out of roughly 40 companies we reviewed over the fiscal year 2020, only four cut the dividend entirely. Three of these were Indian banks which, as around the world, were regulatory driven with policy-makers fearing another financial implosion. The remaining cut was by a the company with net cash and the reduction reflects prudence, as well as the fact that it is an SOE (state-owned enterprise). That, as we have remarked before, is a double-edged sword. The state stands behind the business, but clearly shareholders are not necessarily always in the vanguard of decision-making.
Limited capital raisings, but only by banks
Through the very worst of Covid, globally, the Indian banks collectively fell to 10-year valuation lows. We have always regarded these banks favourably in terms of risk appetite and lending prudence. This seems to have been borne out by their subsequent bad-loans experience. That said, many of them raised capital during this torrid period. In hindsight, this was probably unnecessary and somewhat dilutive, though perhaps urged by the regulator. Outside of the banking sector, none of the companies we looked at had to resort to highly dilutive rights issues and capital calls.
Obviously, this is somewhat due to governments coming to the rescue across the world, with sharply-higher fiscal deficits a consequence of employment and rental subsidies. We do, however, regard the lack of capital raisings as a quality-marker in terms of balance sheet strength.
Though cash is reality, it is true that dividends have always been something of an afterthought in Asia as well as in emerging markets generally. This is unsurprising, because investors rightly look to this part of the world for growth. There is not much point diversifying and taking on more, or at least different risks (currency, political, policy and legal to name some), without recompense. That said, we always engage on dividends, particularly if we believe companies are being churlish.
The historic contribution from dividends for companies in the Asia Pacific region has been much lower than in the West. In a market like the UK, dividends are a very substantial component (40-50%) of overall returns. That said, capital returns have powered the US markets in the last decade.
Of course, we have no idea what happens next. That said, we would not be at all surprised to see markets continue to tilt more broadly in favour of reality over vanity. This trade-off is after all what makes us human, as markets always move from greed to fear and back again. We hope that by being firmly anchored in reality, we are well positioned irrespective of the coming market season.