Why Sebi's 'Dividend Policy' for listed companies will make stock picking easy

Indian markets have seen their biggest reforms and policy changes happening after a scam reminds policy makers of the loopholes in the system. Open outcry system gave way to electronic exchanges after the Harshad Mehta scam. The dematerialisation scam resulted in strict KYC (Know Your Clients) norms being implemented by brokers. The latest Jignesh Shah--NSEL scam has resulted in tighter norms for commodity exchanges and the commodity regulator FMC (Forward Market Commission) itself being merged with market regulator SEBI.

This time around however, it is not a scam but a rather blatant or some would say a bold act by InterGlobe Aviation promoters of sweeping the bottom of the barrel by withdrawing the accumulated profits as dividends and leaving the company with a negative net worth, albeit for a day as per the management.

This act has probably stirred market regulator Sebi in contemplating a publicly stated dividend policy by the company. The report says Sebi would steer clear of any directive being given to the companies to pay any particular dividend amount as it wants to focus on disclosures rather than being intrusive into financial decisions of the companies. Rather, it would require the listed companies as also those looking to get listed through Initial Public Offer (IPO) route to state the circumstances under which their shareholders can or cannot expect a pay-out.

If implemented this will be a good step in bringing clarity and transparency for the investors as well as broaden the investor base in the country. Manish Bhandari of Vallum Capital in a newsletter three years back had pointed out the need for a compulsory dividends pay-out policy or around 25% or more for corporate’s if we want to foster equity culture in India. The compulsory pay-out of the profits will ensure that accounting profits are aligned with the cash generated by the company.

Bhandari adds that other measures should also be taken to attract retail investors to the market. Providing an incentive to equity shareholders in form of Allowance of Corporate Equity (ACE), a form of allowing nominal interest on equity capital tax deductible should be introduced. ACE, allows deduction on shareholder funds (long term bond rates of Govt. Securities) from corporate taxability.

Generally markets reward companies with a high dividend pay-out ratio by giving then higher price to earnings (PE) multiples. Most of the multinational companies have high dividend pay-outs, mainly to their parent companies, they always trade at a higher multiple as compared to their domestic peers even if their growth rates are slow and profitability is lower. Investors generally tend to hold on to shares of companies which reward their shareholders with high dividends.

Companies hold back on announcing dividend if they are in a growth phase or simply prefer to pileup on their cash for a rainy day in future. But Bhandari points out that there is empirical evidence which suggests just the opposite. The point of saving capital for future growth holds mainly for Indian mid and small size firms where the cost of raising equity is quite high. Bhandari points out that study in Brazil, where compulsory dividend policy is in place, has suggested that this had no impact on long term reinvestment capabilities of the firm. Moreover, cost of equity improves dramatically, as inflows from institutional investors spreads across market capitalisation thereby increasing the investible universe, which is usually quite concentrated in large cap stocks.

Implementation of the policy would also create long term shareholders in a company and make stock picking that much easier. Those companies who are willing to share their profits even during bad times will attract quality investors. The policy will be a statement of intent and would be one of the best indicators of corporate governance.

As for Indigo which has probably triggered the thought process, it has stuck its neck out by announcing a very high dividend pay-out just before the IPO. If it continues with the same policy of distributing its profit to the shareholders, all will be forgotten and the company would be a blue-chip within a short time of its listing.