China Cashes In

January 31st, 2013
in contributors, syndication

Investing Daily Article of the Week

by Ben Shepherd, Investing Daily

Despite the existence of funds such as Matthews China Dividend (MCDFX), steadily growing dividends are actually tough to find in the Middle Kingdom. Although a number of Chinese companies pay dividends at some level, as a rule they prefer to retain most of their cash for a rainy day or future investment.

Chinese regulators have long been aware of that tendency and have been trying to encourage Chinese companies to pay more attention to their dividend policies. When Guo Shuqing was appointed to the top post at China Securities Regulatory Commission (CSRC) in 2011, the agency announced new policies aimed at requiring companies to improve their payout ratios and decision-making mechanisms, as well the transparency of their dividend policies.

However, those reforms largely fell by the wayside, as many companies complained that the net gain for shareholders might be less than expected—or even worse—if their executives were forced into dividend decisions that destroyed value in their businesses.

Follow up:

There’s merit to both arguments.

Dividends provide much needed income, especially in today’s low interest world, and are a critical component of total return. In the US, dividends have represented more than half of the total market return since 1926. They are also important signals of a company’s health; steady dividends show that a business is successful and its earnings are sustainable or even able to grow.

Companies can be severely punished by the markets for cutting their dividends. Consequently, a sound payout policy encourages management to be responsible stewards of their resources and offer reasonable explanations of shortfalls or face the market’s wrath. It follows, then, that dividends encourage transparency.

However, if dividends are mandatory, stocks could ultimately become more like bonds and offer limited upside. Mandatory payouts could also force companies to payout cash they don’t have, weakening what might be an already ailing business.

Regardless of who was right and who was wrong—frankly, everyone was a little bit of both—the critics won the day and the dividend requirements were scrapped.

But the reformers lived to fight another day.

The Shanghai Stock Exchange released guidelines this month that require listed companies to pay dividends of more than 30 percent of annual profit or face stricter disclosure obligations.

Companies that fail to meet the 30 percent level will have to release a statement from their board of directors that explains the low dividend payout and the intended use of the undistributed cash. So far, there don’t seem to be any sticks associated with the rule, aside from the possible market repercussions. The obvious carrot is that the compliant companies avoid scrutiny.

In response to the new guidelines, a number of companies, including Global Investment Strategist holding China Petroleum & Chemical (NYSE: SNP), have announced new dividend policies. While the companies that have already revised their own policies were already basically compliant with the guidelines, the formalized statement of policy means we have a much better idea of how they will behave down the road. It will also encourage other companies to make similar moves.

But while those guidelines will definitely help to make China much friendlier for income investors, it’s not quite clear how broad their impact will be.

For one thing, there are a number of businesses that aren’t compatible with dividends. Young, high-growth companies obviously need to hang on to their cash for future investment and some businesses such as technology companies and retailers historically just aren’t big dividend payers.

Commodities companies with unpredictable cash flows could also find themselves in a bind. In fact, requiring those companies to pay dividends could ultimately prove counterproductive.

So for now, the new exchange guidelines aren’t likely to have a huge impact on the Chinese marketplace. That said, don’t be surprised to see broader dividend reforms across the market by Chinese regulators in the coming years.

Chinese social safety nets are largely nonexistent and are extremely porous where they are. Creating a reasonable and equitable system for a population of 1 billion plus and growing is a logistical and fiscal nightmare.

If you think the US faces serious budget challenges, imagine trying to fund China’s social security program, especially 50 years or so down the road when China’s demographic profile looks more like America’s. This aging profile already is one of the least attractive in the emerging markets, largely thanks to the government’s one-child policy that has been in place for the better part of three decades.

China is anxious to develop a more robust equity market to fund its domestic ventures, with less reliance on bank loans and the government. Nonetheless, I strongly suspect another motivation behind these reforms is to help the average Chinese citizen fund their retirements. Hence, the focus on dividends.

The CSRC and other regulators are also reportedly mulling a cut to the 10 percent tax currently levied on dividends paid by listed companies, another incentive to lure investors into dividend-paying stocks.

You can’t blame China for its dividend reform efforts. The Chinese Communist Party (CCP) needs to grow at least the feeling of wealth and opportunity for the average Chinese citizen to maintain its control, particularly now that the country’s economy is seeing slower growth than its historical average.

While 10 percent or better annual gross domestic product growth was never sustainable over the long haul, growing domestic wealth has largely been the heart of the CCPs legitimacy for the past two decades.

If these reforms are a backdoor method of solving China’s social funding problem, that’s all the better for the party. If it means higher payouts for investors as well, then bully for us.

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