Capital management and corporate policy

Capital management and corporate policy

Standard investment theory suggests a wealth-maximising investor should have a tendency to invest in a company that can continually reinvest its earnings at high rates of return, rather than one that will simply pay dividends. In practice, such behaviour has worked out pretty well – just ask those who invested in Berkshire Hathaway (NASDAQ:BRK/A, US$205,880.00) in the 1960s at US$40.00.

However, should that firm not require further capital to grow (either because its growth is not capital-intensive, or earnings prospects for profitable expansion are slim) then as much profit as possible should be returned to investors.

Today’s trend towards increasing dividend payout ratios risks under-investing in the economy of tomorrow.

Of course, another way that this could be interpreted is that the boards on various listed Australian firms see little prospects of adequate returns stemming from further investment (and hence elect to return capital to investors). I think it’s a combination of the two. After all, large miners and mining service firms are doing it tough with depressed metal prices and have dull prospects for further reinvestment; and other large ‘divvy’ payers such as the banks have demonstrated an ability to maintain their payments whilst still producing acceptable growth.

This kind of capital management should be encouraged so as to reduce the risk of boards reinvesting in low-returning ventures that destroy investment value (or for that matter, grow in size so that management may justify a bigger pay cheque, yet offer negligible returns to investors).

One commentator recently wrote: “Unless the addiction to dividends can be kicked, Australia is likely to suffer a chronic shortage of capital investment and the corporate sector will not grow to the extent it should.”

It’s important to think about this claimed shortage of capital, because it presupposes that money returned to investors doesn’t come back. History, however, shows that capital raisings have been fully subscribed with monotonous regularity.

There is plenty of equity capital for businesses to grow should they ask for it – and low interest rates on cash ensure investors are willing to invest in alternatives. Those low rates have also rendered debt cheap.

The commentator also noted that: “Venture capital and infrastructure are hopelessly under-invested and despite constant searches for the answer to moving more of the nation’s vast superannuation pool into them, nothing much happens. Instead, dividend payout ratios go up.”

It’s disingenuous to link the payout ratios of Telstra, the banks or BHP for example, with a claimed shortage of capital for Australian infrastructure or venture capital. The recipients of the large dividends, for the reasons already cited, are more than able to reinvest in infrastructure bonds or CPI-linked government bonds if made available.

Naturally, higher returns are also part of the equation for any super fund willing to accept the additional risk that is inherent in, for example, start-ups; but as Jessica Gardner points out in BRW, the returns aren’t all that exceptional.

Should an opportunity in the economy arise where the public benefit is clear, but it’s clearly not optimal for private investment, this is typically where public financing is required (or at least a change in legislation to make the environment more suited to private investment). It seems clear that Australia would benefit from new ways of doing business (and new ways of making money aside from selling our farms, businesses, brands and non-renewable minerals and energy) but whether we can capitalise on our entrepreneurial ability like other nations do is another question.