COVID-19 has had a crippling impact on many companies. Economic, political, and social pressures have led some to either cut or suspend their dividends. Portfolio Manager John Tobin, PhD, CFA joins the show to discuss the varying reasons why companies could be cutting their dividends as well as the implications this crisis could have on the other components of shareholder yield. (April 16, 2020)
COVID-19 has had a crippling impact on many companies. Economic, political, and social pressures have led some to either cut or suspend their dividends. Portfolio Manager John Tobin, PhD, CFA joins the show to discuss the varying reasons why companies could be cutting their dividends as well as the implications this crisis could have on the other components of shareholder yield. (April 16, 2020)
Hello, and welcome to Actively Speaking. I'm your host, Steve b Weiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Speaker 2:Welcome everybody to another remote episode of Actively Speaking. We hope you are all well and healthy, and you are all doing what you can to help stop the spread of the coronavirus, uh, whatever that those instructions are where you live, encourage everybody to abide by them. My guest today is John Tobin. John is a managing director, portfolio manager and senior research analyst at Epic who, uh, is part of the shareholder yield team. Uh, welcome John.
Speaker 3:I see you. Thanks for having me on the show today.
Speaker 2:Uh, so it's, you know, shareholder yield is a particularly timely topic right now, given what's going on because, uh, in the news we see that, uh, there's a, a lot of companies obviously having significant interruptions to their business, that hands to their cash flow. At Epic, we sort of, one of our favorite topics is the five uses of cash flow, uh, two of which involve reinvesting in the business through acquisition or internal reinvestment or, uh, and then three involve, uh, returning the capital to the shareholders either through cash, dividends, stock buybacks, or paying down debt. So we're living through a unprecedented time here where corporate cash flows are under a lot of stress. And so we thought it would be very timely to talk to John about what they're seeing on the shareholder yield team and what the outlook is for shareholder yield going forward. So, to start with, John, is there, is there an overarching, uh, summary you could, uh, give us to start with of, of what the impact of, uh, COVID-19 is on, on dividend paying stocks?
Speaker 3:Sure, Steve. So I think, um, clearly we have to agree and admit that the abrupt economic slowdown that we're experiencing that's been caused by the social distancing protocols that have been put in place, all the stay at home orders, this has dramatically affected many businesses. And, and for many revenues, earnings, cash flows have all come to a sudden and full stop. So many of these companies will be a force to adjust their payout practices and, and many already have. But I think it's important to emphasize that not all, and not all companies cut their dividends in the global financial crisis. It's different, but it's a, it's a similar sort of extreme scenario. And, uh, for some companies the impact on the business is, I would say material, but, but manageable. And our focus in managing the shareholder yield strategy is to try to make those distinctions to try to separate, well, to separate a week from the chat, so to speak.
Speaker 2:Ok. So let's, uh, let's go into a little more color on that. Sounds like what you're saying is this is gonna vary a lot, uh, from company to company. So can you give us a sense of, uh, you know, what kinds of companies are seeing greater, uh, risks to their ability to, to return capital to shareholders and and which are seeing lower risks?
Speaker 3:Sure. So, and just to elaborate on that thought, I'd say, and this is kinda stating the obvious in a way, airlines, car rental companies, cruise ship operators, many of these businesses are profoundly affected and frankly are fighting for survival, uh, dividends and share buybacks for them simply have to go. And some of these businesses, I would say would avoid bankruptcy only by virtue of government assistance programs such as those that were just created in the United States under the CARES Act. But of course, other businesses, I think, are demonstrating that they're more resilient. And I wouldn't wanna suggest that these businesses have, are seeing no impact as a result of the Covid 19 crisis. But for example, I would point to consumer staples, companies, utilities, healthcare companies, telecom companies, information technology companies as examples, these for these businesses. The business is continuing the earnings and the cash flow is continuing. And I'd even point out that some are even beneficiaries, although maybe it feels a little bit on sportsman like to say that, but, uh, some of these companies, for example, that make materials that flow into healthcare and hygiene applications or pharmaceutical companies that are working to develop treatments for Covid-19 or the tech companies that support some of the video conferencing services that we're all using now. So it, it very much does very on unaccompanied by company basis.
Speaker 2:Ok. Uh, and in, in addition to, you know, sort of the direct effects of the fact that, as you say, some companies just revenue has fallen off the cliff, uh, whereas others, it's okay. There's, there's another at work here, I think, which is, uh, political pressures, uh, along with, you know, the money, you know, the support that's gonna come from governments around the world. There will, it's like sometimes there might be strings attached to that relating to, uh, what these companies can do with the money. Uh, you know, it does, it, it's not unreasonable for to say, gee, if the government's giving you money, why are you then turning around and handing out money to the shareholders? So what, what are you seeing happening on the, in terms of political pressure, uh, to reduce or restrict, uh, distributions to shareholders? And is that varying in different countries around the
Speaker 3:World? Well, we're certainly seeing it and, and I think it is varying from country to country and even within countries sector by sector. But it really is, I think, something new with this crisis. The presence of political and or regulatory pressure to adjust shareholder distributions, just to speak broadly and to kinda, as we've seen them happen in the past week or two, and it's really been that recently. But the, uh, the ecb, the European Central Bank issued a directive to banks that it regulates in the EU to halt payouts this year. Uh, and then shortly after that happened, the Bank of England, uh, made some not so subtle suggestions that UK banks should, the phrase that was used, consider the optics of distributions in this environment following which all the major UK banks voluntarily canceled their 2019 dividend in the us. On the other hand, I would say the, the major banks have voluntarily suspended their shared buybacks this year, but so far they're, they're not being pressured to cut dividends, or maybe I should say to the extent that some are calling on US banks to take that step. The banks so far are resisting in Australia the day before yesterday. I think the, uh, the regulator there, the Australian Prudential Regulatory Authority issued a statement pointing out that they expect that the Australian depository institutions and insurers would seriously consider deferring decisions on the appropriate level of dividends until the outlook is clearer. So I would say in the financial sector, we've seen a variety of approaches across different jurisdictions. I'd also point out that some companies have responded to, some financial companies have responded to this with statements that while acknowledging the concerns of regulators, that they have robust capital strength and earnings and liquidity and intent to go forward as planned with distribution away from banking and finance, I would say the pressures are much less evident. One non-financial company that I could point to as an example is Michelin, and they recently voluntarily announced a reduction in their previously announced dividend, and they said something along the lines that they wanted to optimally balance the interest of all their stakeholders, and as a result, they, they decided to reduce the amount of their proposed 29 dividend 2019 dividend. So in France, I would say perhaps there was more pressure there being exerted beyond financial companies. So Steve, as, as you pointed out, I think it's also important to recognize that there are restrictions on payouts for companies that take advantage of these emergency loans and, and grants. And that's a feature of the CARES Act that was recently passed in the United States. And it does, it does make sense. It does make sense that if your business is so challenged that you, you need to apply for assistance under one of these emergency programs that as a quid pro quo, you're required to suspend shareholder distributions during that period of time. So in short, I guess I would summarize and say it's a very fluid situation. And maybe one last point is that it's important to note that even in some of the more extreme cases where there's more pressure on companies to adjust their distributions, the requests are generally for temporary change or postpone.
Speaker 2:So, okay, so that obviously presents, uh, an interesting challenge for the shareholder yield team. Uh, I know that part of your process of looking at companies is to try to avoid companies, for example, that have, have cut their dividend at any time in, in recent years. Uh, uh, I don't remember exactly what the time period<inaudible> is, but so clearly there are going to be companies now that may, you know, sort of on an ongoing basis look perfectly good look like good candidates for the strategy, but you know, right now they may have to postpone or reduce or eliminate the dividends just on a temporary basis. Presumably you're gonna have to make that distinction, uh, going forward in, in managing the strategy between companies that are reducing dividend due to this kind of public pressure versus companies that, uh, really have a, a more challenge to their cashflow, uh, going forward and what this means for their commitment to paying dividends.
Speaker 3:That's exactly right. And you know, in the past, what we've always contended with and the shareholder yield strategy is the fact that there are, there are companies that will face business difficulties for any number of reasons, competitive pressure, product obsolescence, leverage any one of a number of reasons where we feel that that company can no longer generate the earnings and cash flows that it needs to support it attractive shareholder payouts that we're looking for. And this, this is different. This is qualitatively different, uh, because this type of pressure on what, as you said, are otherwise healthy companies that would otherwise continue with their distribution practices, they're being pressured to at least temporarily suspend them. And it the kind of thing that you can't analyze and sort of comes out of the blue. And as we think about this in real time, so to speak, on the shareholder yield team, one of the things that we're thinking is that to the extent that we have a situation where a dividend has been reduced or postponed, and our view is that other, if it were not for the, uh, the pressure being imposed on this business, that they would be able and otherwise willing to continue with their distribution, uh, we're, we're inclined to think of those a little bit differently and recognize that not all dividend cuts are the same in this environment. So we're going to be looking at each situation carefully and on a case by case basis, trying to determine what kind of a dividend cut is this and what, what's the appropriate portfolio response to that situation. So we're, we're, we're trying very carefully to, uh, to understand that that particulars of each situation and make the right, the right call,
Speaker 2:Well, it's makes the case for why you need active management, uh, in this kind of thing, as opposed to a sort of robotic approach that can distinguish between different, uh, types of, uh, interruptions to, to the dividend. So I, I said at the beginning that there are, we talked about the five uses of, of cash flow, three of which are what we call quote shareholder yield. So far we've been talking really just about the dividends, but of course there are, there are the other two quote shareholder yield uses of cash flow buybacks and paying down debt. Uh, so what's the impact gonna be on buybacks? Are they a thing of the past now?
Speaker 3:Well, that's a good question. It's a question that others are asking as well. And, uh, I would have to say my short answer to that question is I don't think so. And more importantly, and, and I'm, I would suggest maybe a better way to pose this question is to ask, are companies going to abandon sound capital allocation practices? And at Epic, one of our foundational principles for investing is that we wanna identify companies that are good capital allocators, companies that invest when they can generate a return above the cost of capital and otherwise return excess cash flow and capital to the owners of the business. And I think if we think of it this way, I think we could have more confidence that the post coronavirus world will not be one where businesses hoard cash and capital and management teams no longer care about earning an appropriate return on the capital entrusted to them by shareholders. So will we see fewer share repurchase programs perhaps? But on the shareholder yield team, we've often said there are good buybacks and bad buybacks. And for example, when a company borrows to fund a share of purchase program to us that doesn't generate any shareholder yield. We want companies that, again, are good capital allocators and that use excess free cash flow, not debt to fund their shared buyback programs. Maybe as a result, after we get through this, we'll see fewer but better share of purchase programs.
Speaker 2:That sounds like that would be a good outcome. Uh, and how about the other shareholder yield use of cash flow, uh, debt reduction is, is there any room for that, uh, in this, in the era we're living through now?
Speaker 3:Well, exactly. I would say right this minute, right this minute, probably not. Uh, you know, as we've just noted regarding share repurchases, we expect companies to continue to behave rationally about capital structure, including leverage. Then I would say that once the crisis has passed, we will again be cash deployed to reduce leverage to the extent that management views current leverage is above what it is optimal to be for that business. So yes, perhaps in, in, in the days and weeks to come, we'll see companies much less inclined to pay down debt on their balance sheets. But I think again, if we, if we believe that company management teams will continue to think rationally about what the appropriate capital structure is, then we will continue to see as we get through the crisis, a, a return to that form of shareholder distribution, that form of shareholder yield as well.
Speaker 2:Now, you know, we always talk about that epic, the, the five uses of cash flow. And of course there, there really is a sixth quote use, although maybe it's, it's not a use, but it's, it's just hold onto the cash. You know, you don't, you just let it accumulate in the bank. In, in the past that has always seemed, uh, like a, a bad idea because again, if, if you have opportunities to invest it and earn a good return on capital, you should. That's how you create value for the owners of the business. And the thought has always been, if you have run out of such opportunities that you funded all the good ones, well give the money to the shareholders because they always have something they can do with it. But, but perhaps, uh, you know, a fixed use is to hang onto it for, in essence use on a, in a rainy day and sort of the rainiest day we've, we've ever seen in, in our careers. Do you think that's a likely outcome that companies that are still generating positive free cash flow might just decide to hold on to more cash in the future?
Speaker 3:Well, I, I think again, in the very short term, it's pretty clear that liquidity is highly valued. And we've seen this with companies actively drawing down bank revolving credit facilities in order to make sure that they are in as strong a liquidity position as possible during the course of the crisis. But again, I think holding cash on a balance sheet in an excess of what is needed to run the business is clearly suboptimal. It's clearly not constructive for generating a return on capital. It's idle and it's inefficient. And so I think, yes, perhaps in a very short term we'll see companies actively trying to be as liquid and cautious as possible, but I think this is not likely to be a long lasting trend, and hopefully it will only be something that lasts for a few months.
Speaker 2:Okay. Uh, well I think that's all been, this has been very good, John, uh, thanks for joining me.
Speaker 3:It's been a pleasure, Steve. Always happy to chat with you and, uh, look forward to talking to you again soon.
Speaker 2:Well, we'll definitely wanna do that. And, uh, thanks to our listeners for tuning in and we'll talk to you again soon.
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Speaker 4:The information contained in this podcast is distributed for informational purposes only, and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but is subject to change any performance information. Reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this podcast are forward-looking statements and are based on epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur, and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returns or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.
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