SINGAPORE (Dec 17): Against the backdrop of heightened volatility, it is understandable that investors will seek lower-risk stocks as a safe haven. Typically, these would be companies with stable businesses, that pay consistent dividends (that will at least give investors a dependable stream of income in the absence of capital gains) and that have strong balance sheets.
Last week, I noted an interesting divergence in market valuations for companies in net cash positions and those with net borrowings. I have reproduced the table here (see Table 1), which shows net cash companies trading at steep discounts, on average, compared with those with net borrowings.
Notably, this phenomenon is not specific to Malaysian stocks. We see the same difference for valuations in Singapore-listed companies (see Table 2).
Such valuations, on their own, suggest that management can maximise shareholder value by paying out excess cash and, if need be, take on some borrowings. It will have minimal impact on profits but yields will boost investor interest and share prices (through higher valuations).
The hypothesis is intriguing enough that this week I decided to take a closer look at select individual companies. Does their share price performance, for the year to date and over time, support the above
theory?
Table 3 shows the 10 companies listed on Bursa Malaysia with the highest net cash in hand, their current valuations and share price performances. For comparison, I selected six companies that are well known for a high dividend payout and/or actively manage their capital structures (see Table 4). I performed the same analysis for select Singapore stocks (see Tables 5 and 6).
To be sure, certain companies underperform because of their unique industry landscapes, and there is a risk of over-generalising. On average, however, the numbers do support the proposition that companies paying high and sustained payout ratios are being accorded higher valuations by the market and their share prices performed better, in both the short and longer terms.
For instance, Petronas Chemicals is sitting on net cash of nearly RM9.4 billion ($3.1 billion), by far the highest of any company listed on Bursa. The stock has done well, as a big-cap component of the FBM KLCI, gaining 22.7% in the year to date and 38.1% and 75.5% over the past three and six years respectively.
I guess the question is, could it have done even better? The company pays just about half of its profits as dividends annually, giving a yield of roughly 3.2% at the prevailing share price. The stock is priced at a little over nine times EV/Ebitda and less than 16 times earnings — well below the valuations for companies in Table 3.
Companies have their own reasons for keeping high levels of cash on their balance sheets. In most cases, it is because they believe they are best-positioned to make the decision on how much to distribute as dividends and how much to retain for the rainy days as well as building the war chest for future investment opportunities.
Warren Buffett, for instance, famously eschews paying dividends on the reasoning that his company, Berkshire Hathaway, can create greater long-term wealth for shareholders through reinvestment in existing businesses and acquisitions.
The market, on the other hand, appears to be telling us quite the opposite — that investors do not trust management to make that decision. In fact, they are willing to pay premium valuations to companies that pay out all of their earnings. If and when companies do require funds for major investments, they could easily make a cash call (rights issue).
It is worth noting that while Berkshire does not pay dividends, Buffett himself loves companies that do. The biggest of his portfolio investments are companies that give dependable income streams, which can then be redeployed as the company sees fit.
This is consistent with finance theory, which states that shareholders are the best able to assess and determine their individual risk-return appetite based on the many choices of investments available.
Berkshire’s case is an exception to the norm. The market gives it a premium over net assets because Buffett’s investors believe he can do better than they can with the funds. This is partly due to his long and successful track record as well as reputation. And as we know, reputation and integrity are huge assets in investing. In such a situation, it makes sense to keep the funds within the company for reinvestment.
This is not the case, generally, as much as many want to believe they too can be Warren Buffet. And if the companies are valued at steep discounts to net assets, it makes little sense to hold on to the excess cash.
The Global Portfolio ended flattish for the past one week, but fared better than the benchmark index. Total portfolio returns now stand at -11.6% since inception. The portfolio is underperforming the benchmark index, which is down by a lesser 4.3% over the same period.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
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