The latest events at Lloyds Banking Group are hardly welcome but they do shed light on the thorny matters of dividend cuts and share buybacks.
The bank, we hasten to add, has not announced a cut in its divi but it has suspended a share buyback programme that was supposed to consume £1.75bn of its surplus capital. So far £1.15bn of that money had been used to repurchase its stock.
We have said several times that while share buybacks can seem annoying or irrelevant to private savers, they can in fact be beneficial for income investors such as readers of this column. Events at Lloyds this week seem, to Questor at least, to bring a new dimension to the relative merits of ordinary dividends, special divis and share buybacks.
What did happen this week? The bank announced that the weekly number of inquiries about PPI mis-selling received in the run-up to the claims deadline of Aug 29 had increased dramatically from 190,000 to 600,000-800,000. As a result Lloyds said PPI was likely to cost it £1.2bn to £1.8bn more than previously thought.
It was in response to this that the share buyback programme was suspended.
Let’s imagine what would have happened if there had never been a share buyback scheme and the bank had used its surplus capital to boost its dividend. In this event, we would probably now be reporting a dividend cut rather than the suspension of share repurchases.
This would have been seen as a major setback and a public relations disaster for the bank. In all likelihood there would have been calls for the chief executive to walk the plank. The share price would probably have fallen substantially. There has been none of this reaction to the abandonment of buybacks – they simply don’t have the same visceral significance for shareholders.
In Monday’s announcement the bank went out of its way to reassure investors that the dividend itself was safe. It said: “In line with normal practice, the board will give consideration to the distribution of surplus capital at the year end and continues to target a progressive and sustainable ordinary dividend.”
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When we have written about buybacks in the past, usually in connection with Lloyds and Next, we have stressed how they can be a fruitful way to use surplus cash, as long as shares are repurchased cheaply.
The effect then is to concentrate profits into a smaller pool of outstanding shares, with corresponding benefits for earnings per share and hence the capacity to pay dividends.
What these developments at Lloyds show is that a buyback programme can have an additional function as a kind of safety buffer for the dividend: if unexpected costs arise, buybacks can be curtailed before the divi is threatened.
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Dividends can be a valuable discipline for company boards but there is a reverse side to that argument: a determination to avoid a cut could prevent directors from taking steps that, while unwelcome, are essential for the business’s health or even survival.
An option instead to limit buybacks offers a much less contentious route to aligning what flows out of the business with what it can safely afford.
We should also mention special dividends, which are another means to give boards more flexibility, as long as they don’t become so regular as to be seen as routine.
Another option is for boards to announce a dividend policy that automatically adapts to changing circumstances, such as a commitment to paying a certain percentage of profits. This way the divi may go up and down but investors will have been alerted and can take comfort from the existence of a consistent framework.
This column sees all these tools as welcome alternatives both to dividend cuts themselves and to the “avoid dividend cuts at all costs” mindset, both of which can cause so much damage.
Edit: Questor in full. I hope 20 years or more subscribing allows me to do this once in a blue moon.