Scrip dividends: 'a dangerous conceit' every investor should know

The use of scrip dividends has rocketed since the financial crisis - and it's little wonder, as it allows a company to protect precious capital while maintaining its headline dividend.

In a low-interest rate environment, yield-hungry investors are like cats that got the cream, but they should be wary; the use of scrips typically precedes a wave of dividend cuts.

A scrip dividend issues shares to shareholders instead of the traditional cash payout, so the short-term benefits are obvious - management maintains its headline dividend, while actually reducing the cash dished out during economic weakness like the oil price collapse.

Predictably, the number of companies in the STOXX 600 resorting to this practice has rocketed from 1 per cent in 2007 to one-tenth of the index in 2015.

SCRIP LIKELY TO LEAD TO DIVIDEND CUT

Of course, this isn't a 'get out of jail free' card and investors should still be on high alert for future dividend cuts. A fifth of the STOXX 600 firms that paid a scrip in 2014 cut their dividend the next year.

This is double the volume of cuts seen across the entire index. Over three years, 40 per cent of those firms that paid scrip dividends had made cuts by 2015.

'It is easy to see why,' says Deutsche Bank analyst Sahil Mahtani. 'Firstly, scrip dividends are particularly prevalent in sectors undergoing operational stress. For instance, buffeted by the oil price decline, a quarter of Europe's energy companies chose to use them last year.

'Indeed, by using scrips European oil companies have created the illusion of retaining high overall dividends even as they slashed cash dividend payments by one-third since 2014.'

By creating the illusion that headline dividends can be maintained during economic uncertainty, investors pay for so-called income security.

DANGEROUS CONCEIT

Even though earnings have fallen by around 10 per cent over the last five years, dividends have risen by a fifth. As a result, these stocks now look really expensive, with consistent payers trading at a 16 per cent price/earnings premium to the overall index.

'This means we may currently be in the lull period after managers realise that cuts to dividends have to be made but before they are able to make them,' warns Mahtani.

'Two thirds of all the dividend cuts that happened from 2004 to 2010 occurred in the last two of those years. When they come the dividend cuts will happen all at once.

'Of course, for managers of a company that is short of cash a scrip dividend may be less obtrusive than an equity or debt raise or a dividend cut. Yet for precisely this reason the best way is to see a scrip dividend as an additional layer of obfuscation that demands greater shareholder scrutiny.

'Scrip payments allow some managers to defer tough capital allocation decisions that really matter while this complexity consumes time and resources. A futile distraction at best, a dangerous conceit at worst.'

This article was written for our sister website Interactive Investor.

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