How will the New Dividend Tax in the UK Affect Dividend Policies and Investors?

Whilst many of us 'average Joe's' will not have had to worry about paying tax on dividends before, come April 2016, taxpayers will have to declare any dividend earnings over our tax free personal allowance (£11,000 16/17) and the £5,000 tax free dividend allowance (another tax I hear you cry out, the government always finds another way to dip into our pockets). The table below shows the changes that will be made from current dividend tax-rates to the new tax-rates. 

So how will/will this affect the common investor and company dividends policies in the future under the new laws? This is what I will be trying to evaluate in this blog.

I would first like to start with the individual common investor (as it could affect me in future, so where better to begin?). Under the new law, as a basic-rate investor, I would have a £5,000 dividend allowance before the taxman would then take 7.5% off me. So therefore I believe it will affect a common investor to an extent as before the tax-rate on dividends for basic-rate was 0% (any tax at 0% is absolutely fine with me, not 7.5% though).
Before I use an example, it must be noted that to get dividends of over £5,000 you would need a considerably high amount of investments in high dividend paying companies (£63,000 portfolio according to Clare Walsh, a financial planner from Aspect 8 (Telegraph, 2015)). Take myself for example; when I finish university I will be in a graduate job which pays above the personal tax-free allowance (a lot of other investors will be on more). Therefore I would be within the dividend allowance (as I do not have enough investments). But if I did, I would pay Income Tax of 20% and Capital Gains Tax of 18% (if I had investments large enough) on top. I really believe that for the risk I would be taking, some form of investment 'gain' should be tax free.

Of course, I believe it will affect the higher-rate taxpayer or basic-rate with a large portfolio more. I found an interesting article on Accountancy Age (I started using this when doing a placement in a Top 10 accountancy firm) which was talking about how SME owners (the individuals in the business) are "in a race against time to benefit from a special dividend pay-out" (Accountancy Age, 2016). This is understandable as the higher tax rate will really damage the value they have created if they want to take dividends out after April 2016. Of course, from what I have learnt in the module, the 'realised profits' have to be there before they can pay-out the dividends. If the owner of the SME took out £100,000 (for arguments sake, an easy number), with them being a high-rate taxpayer, they would pay £25,000, under the new system they would pay £30,875 (quite a lot more really if you scale it up).

Second on the agenda is how the new Dividend Tax will affect company's policies. In my opinion I do not believe it will affect their dividend policies and they will not switch to share repurchase schemes to help investors. This is due to many large companies' main investors being institutional investors such as pension schemes or insurance companies who would not be affected. As this is the case, I have learned that managers will use 'catering theory' to cater to the wishes of investors (such as those institutions) who want both higher share prices AND dividend payments to grow their funds.

Also, a company that says 'we are not going to give anymore dividends' will have a dramatic drop in their share prices due to their investors having certain tax preferences; known by researchers as Clientele Theory. If I have learnt something from this module it is that investors do not think rationally. See British Airways as an example, in 2010, they did not pay a dividend due to a pension obligation, this resulted in people selling of their shares and the price being reduced (I think that if a company does not have to reduce dividend payments, then they won't do it).

To conclude, in my opinion, the new dividend tax will affect the common investor and high paid investor who has a job which pays above the personal tax-free allowance, however this will not affect companies at all. I find this really unfortunate as it is always the public who suffer rather than the large companies that can afford it and will just try to avoid the taxes anyways.

References

Accountancy Age. (2016). SMEs set to take Advantage of Dividend Pay-outs. Retrieved 29th February 2016, from http://www.accountancyage.com/aa/news/2448321/smes-set-to-take-advantage-of-dividend-pay-outs/

Telegraph. (2015). New Dividend Tax: How it Works - and How to Avoid it. Retrieved 29th February 2016, from http://www.telegraph.co.uk/investing/shares/new-dividend-tax-how-it-works--and-how-to-avoid-it/ 

A Hard Balance

I have found Capital Structure and the concept of trying to optimise the WACC (weighted average cost of capital) quite hard to get to grips with. From what I understand, it is basically about trying to manage the amount of debt vs equity a company has to ensure it can make profit and continue with projects in order to grow; and of course try to reach the optimal WACC figure. It can be seen all the time, currently, Hilton hotels are going to 'spin-off' 70 of their hotels into separate company 'Hilton Grand Vacations' as it will allow Hilton "to have capital structure better suited to their needs" (FT, 2016).


There is a lot of debate as to which is best and if an optimal structure exists. If I was the CEO of a company and followed Modigliani & Millar's (1958) ideas, I would chose debt over equity as the first port of call as it is cheaper and that is surely a good thing, right? Cheaper capital equals more projects the company can undertake and better profit for the company due to less tax and transactional costs. They believed there was no impact on the WACC, so therefore as CEO I would go for debt over equity. A measurement of the debt/equity is the gearing ratio. I find the gearing ratio really useful when assessing the 'riskiness' of a company and have used it at work and in University when doing an assignment to conclude whether I would invest in a FTSE 350 company (the answer was no as their gearing was over 400%). In theory, the concept using gearing that I have learnt is the 'trade-off' model where you can have gearing up to an optimal point before problems will be seen. In the case of the FTSE 350 company I analysed, 400% was obviously over that threshold.


However, when you get your capital structure decisions wrong financial distress signals can be released, especially in the way of high debt and it will not only be the lenders who know you are in trouble. Shareholders will be aware that their share value may be destroyed through auditors giving a going concern report a long with the accounts. I was an auditor for a year during my university placement (exciting accountant I know) and we had to give going concern reports which made nobody want to invest in that company. This unfortunately will have stopped them from gaining investments they needed in order to expand and grow into new markets until they got their affairs sorted. Look at Areva in France (FT, 2016) currently, they delayed their results to try finalise a 1.1bn euro loan so their shareholders would not lose confidence. Now becoming 4 grades below investment grade status, Areva will find it hard for new investments. I touched on Anglo American mining in a previous blog, but they are a good example of what I am trying to explain. They have too much debt and now have junk bond status which will hold them back in the future (have they made wrong decisions on capital structure? Or is it industry factors?).


If I was the CEO of a company, I think it would be a really hard balancing act to make sure you always had an optimal level of debt to equity. I don't think there can be a theory that can be put for all companies to abide by and the level of debt vs equity that is optimal for one company will not be optimal for another company. I think that it really depends on the industry, the level of long-term debt in a pharmaceutical company would not be optimal for a company in the service industry.

Empty Vaults - The RBS Collapse

The Royal Bank of Scotland (RBS) which found notoriety in 2008 when it was apparently '2 hours away from running out of money' and losses of £24.1bn (I can't even comprehend this figure). It was clear from my own viewing that I could conclude RBS had serious problems which included to rate of acquisitions, due diligence of these acquisitions and Fred Goodwin's leadership. As you can see below, this is the result of RBS management decisions.

RBS Share Price (Yahoo! Finance)

Acquisitions
RBS I feel really fell down on their rate of acquisitions, I think they over expanded too quickly and this can't be good as they ultimately had 'a finger in too many pies'. They were involved in Insurance, Hospitals, Airports, second-hand cars and asset finance (I can't see where some fit into banking). I thought that these acquisitions were a waste of money and there was no need to diversify from their core business of banking. The acquisition of ABN-Amro was obviously their biggest downfall. They had no idea about the level of sub-prime mortgages ABN held and therefore I do feel I can reach a conclusion that this was why they failed.

Fred Goodwin said "we don't do acquisitions for fun", but I thought that them buying a second-hand car company, this did not seem like it was done to 'better the core business'. RBS was not the only company undertaking failing acquisitions; HSBC's acquisition of Household (2003) fell victim to the sub-prime collapse and AOL's acquisition of Time Warner took less than 2yrs to fail.

Due Diligence
Watching the part where Fred Goodwin said that there was no real scrutiny of ABN-Amro's books really made me annoyed. I would have thought someone with all that business knowledge wouldn't have gone with the 'we did Natwest well, so this will be fine' mentality. Even myself, a final year business student looks into everything I buy; if I purchase a TV, I will be looking into it for a week at least to see if it is worth it (and that only costs £300 not £49bn).

Due Diligence is key when acquiring a business. It makes sure you're not buying 'junk' and will reassure you that you are not paying over the odds. I am currently looking to buy a car for work, I wouldn't want to pay £10,000 for something that is actually worth £6,000 or a car that has been written-off in the past. This is why you undertake due diligence. Anglo American mining is another example, they have really underestimated the challenges they would face when going to Brazil in 2009 and other projects where now their share price has dipped below 1999 listing level and have been given 'junk' bond status by credit firms such as Moody's (FT, 2016) (would they have been more successful if undertaking more due diligence?).

Leadership
One thing that was apparent when watching the documentary to me was Fred Goodwin's management style. Morning meetings were called 'morning beatings' and managers were intimidated to say if they believed something was wrong. I don't think you can run an organisation like that. Listening to others is the most important thing, especially when dealing with a public interest sector.

When I was in my placement working in the audit department, listening to what I was doing wrong and what I could do better was important to help me do a quality job and make sure every part of the audit was correct. This helped shareholders/stakeholders base decisions on true and fair information. If not, I could have been misreporting values and making wrong decisions which may have lost people money. This is exactly what Fred Goodwin did with RBS and definitely I believe another reason for their demise.

A Final Note
I think what really hit me the most when watching the documentary was that ordinary people (which I probably know a few) who have saved for years and were unfortunate enough to invest in RBS (where they thought their money would be safe) lost around 90% when RBS collapsed. These are the people who I really feel for.

References
Financial Times. (2016). Anglo American’s credit rating downgraded to junk, retrieved from http://www.ft.com/cms/s/0/1f989c28-d409-11e5-829b-8564e7528e54.html#axzz40cHUmspG 
BBC. (2011). RBS - Inside the Bank that Ran out of Money (documentary).

Can I Spread the Risk for better Returns? Portfolio Theory

The most common phrase uttered when someone wants to invest in the stock market is one of ‘how can I get high returns guaranteed with low risk?’ (I could probably find a top Google search with something similar). To be honest, I have probably searched this myself before attending sessions on Efficient Market Hypotheses (EMH), learning about such things as ‘random walks’ and that investors irrational behaviour makes stocks difficult to predict for even seasoned investors never mind the average Joe.  


Those who (apparently) have….

Some new investors think that there is a way to have guaranteed returns after they see such people as Warren Buffett get a compounded annual rate of 19.7% from 1965-2012 (luck or skill?) or Bill Miller beating the market for 15 consecutive years, which is something we as investors could only wish for.

Some ways to hopefully get a better return….

Those famous words ‘Don’t put all your eggs in one basket’ (who doesn't love a cliché) could actually be the way to mitigate losses in your investment portfolio and come out with a not so bad return (well, you hope more than the risk free return rate of 1.44% (based on UK 10yr Gilt 9/2/16)). Spreading your portfolio will help in reducing your risk of putting all your money in one industry. If you had your entire portfolio in the banking sector (e.g. Barclays) when it collapsed in 2008, you may have seen up to a 40% loss. However, if you had part of your portfolio in banking and some in say, gold, then you would have been able to mitigate you loss and come out with a ‘zero sum’ at worst (the win may cancel out the loss, but at least you didn’t lose which is good, right?). I think sensible people don't invest all of their money in shares anyways, even Markowitz (the creator of modern portfolio theory) said that he puts at least 50% in 'safer' bonds.

An interesting article appeared on the FT (link here) about China and how their reliance on Saudi Arabian oil could lead them to become vulnerable to any instability and other factors in that region. The quote that really sums up what I am trying to explain with portfolio theory above and ‘not putting all your eggs in one basket’ is “it’s all about diversifying risk. It’s less about picking winners and more about modern portfolio”.

Correlation is key when trying to spread your portfolio, you do not want to invest in an industry that can be effected by another one as it will mean your return may increase in one, then decrease in another ('zero-sum'). Let me give you an example:

• The Oil and Airline industry are quite closely correlated (planes use oil; therefore airlines are heavily reliant on the oil price). Between August 2014 and January 2015 the oil price went from $97.27 to $48.36 (a considerable drop), however, American Airlines share price in the same period went from $30.78 to $55.69 (there may be other reasons of course). What I am trying to say with this example is that if you had an oil company investment that would have gone down, but an airline investment would have gone up (probably giving you a low return as the decrease cancels out the increase).

As a final note, I believe the world is more unstable now than ever before so there is a low probability of being able to predict or beat the market, but diversification of your investment portfolio will at least help mitigate losses in my eyes.