Dividend cut from RSA

Dividend cut from RSA for RIRP

Dividend cut from RSA. Barely a month after subscribers had been treated to my self-congratulatory New Year review of the Rising Income Retirement Portfolio’s performance, I was rewarded with a nasty dose of hubris.

Despite “solid performance” including a 5% growth in net premiums, a strong balance sheet and a strategy expected to deliver strong premium growth, somehow profits at one of my biggest holdings, RSA, were down a fifth, and the company decided the dividend was unsustainable and cut it by a third.

The effect of the dividend cut from RSA is to knock nearly a couple of hundred pounds off my projected income for the year ahead, and this reduces the projected percentage rise in RIRP income for the year ahead by a couple of percentage points.

In principle there is no place in the RIRP for any share which isn’t earning its keep by paying out more each year. But in practice I have previously found reasons for retaining Lloyds — which has never paid a penny since we bought it — and for not jettisoning United Utilities or Legal and General when they “rebased” (slashed) their dividends.

To an extent this is a luxury resulting from the inflation-beating performance of the rest of the portfolio. But as I described when justifying my maiden purchase of BP, buying into a company which has just cut its dividends can produce a good starting yield with expectations of above-average dividend growth.

This was certainly true with Legal & General, which we happened to start buying just before it announced a dividend cut. As Figure 1 shows it since has delivered some of the fastest dividend growth of any of our holdings, and is now paying out 28% more than it was before the cut, and twice the 2009 payout. Generally speaking the bigger the cut, the bigger the subsequent increases, as Figures 2 and 3 show.

Dividend cut from RSA
Legal and General’s accelerating dividends

Avoiding losses – for now

The argument for retaining a share in which the RIRP is fully invested when it cuts its payout is less easy to justify, as was the case with United Utilities and is with RSA. The problems are compounded when I have a capital loss on the shares, as I do to a small extent with RSA and to a much larger extent with another possible trouble-maker, FirstGroup.

This is a portfolio for investing retirement savings, so my assumption is that we do not have the salary-earners’ luxury of being able to replace investment losses from earned income.

And while capital gains are mostly only of academic interest to me, crystallising a loss causes me grief and might force me to make up my losses by taking some capital profits elsewhere.

I have convinced myself I can avoid these unpleasant choices because two white knights have ridden to the rescue. Firstly Standard Life has said it will pay a special dividend which will almost double its projected income this year, raising the return on the capital I invested in it to double figures, and more than wiping out the loss of income this year afetr the dividend cut from RSA.

I accept that this is completely hypocritical — after all, last year I railed against the special dividends paid by Vodafone and Glaxo on the grounds they artificially inflate income and store up problems for the following year.

My view on special dividends remains the same, but in deciding what to do after the dividend cut from RSA I have to work out what the investment alternatives would be if I cut my losses. The board has made it clear the interim dividend next November will also be slashed by a third, which will cut the return on my investment in the company from nearly 7.5% to just under 5%. So the right way of deciding whether to junk RSA or retain it is to ask what else could I buy yielding nearly 5% with as good dividend growth prospects as RSA.

I am sure some exist, but I suspect RSA’s still relatively new CEO will be keen to outperform in much the same way Legal & General did. On balance I conclude that jettisoning RSA now constitutes a greater risk than the possible lost opportunity of investing elsewhere.

In coming to this conclusion I am also comforted by the projection of an overall rise in income for the RIRP for the year ahead of at least 5%. A lot of this is of course due to the Standard Life special dividend, but also to the 8% increase over previous expectations in the sterling value of our maiden dividend from BP, owing to the weak sterling/dollar rate.

Dividend cut from RSA
RIRP purchases and dividends to date

BP has also announced an $8bn share buyback programme following the sale of its 50% interest in TNK-BP to Rosneft.

This is my least favourite way of “returning cash to shareholders”, since it usually benefits directors on earnings-per-share bonuses rather than dividend-receiving shareholders: I would prefer the cash in dividends, even if they are “special”!

Despite a further $4bn provision against the Gulf disaster — bringing the total to over $42bn — I take this as evidence of the company’s confidence in its future strategy and ability to deliver earnings and dividend growth. So the RIRP makes its second £1,000 BP purchase, which will qualify for the second quarterly dividend payable in June, yielding a little over 5% at the current exchange rate.

I am acutely aware that these are sticking plaster solutions which I cannot hope to be repeated if FirstGroup also makes the dividend cut which the market is expecting. The RIRP’s dividend growth since inception is more than double the near 18% rate of inflation over the same period, which could in theory enable us to suffer some years with below inflation dividend growth. I am keen to avoid such an outcome if I possibly can.

My aim for the portfolio — as for myself — has to be year-on-year increases in the cash generated to keep ahead of inflation, regardless of past over-achievement. This is a challenge which is likely to become increasingly demanding.

I suppose it is some consolation that the longer it takes for the UK to get its annual budget deficit down, the more desperate the government will be to keep the interest rate it has to pay on its sales of gilts as low as possible for as long as possible, which will continue to make shares look more attractive than bank deposits for the longest period since the 1930s.

First published in The IRS Report on 6th April 2013.

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