Dividends are more reliable than accounts

Wednesday, Oct 15 2014 by

To say that the latest profit warning from Tesco came as a shock is an understatement. A 16% fall in the share price that was already 44% down on its high was a clear measure of the surprise contained in this news. More tellingly it is also a powerful demonstration of the limitation of active management.

Active managers claim that only by detailed analysis of the accounts, and interrogation of executives, can the true prospects for a company be discerned. This approach is questionable if even management were unaware that their profits were at least 10% adrift of expectations. The notable thing here is that it is profits that are being questioned, not obscure details in the balance sheet. To be so far out in the estimate of profits suggests that there were issues all along the line in revenues and costs.

Perhaps even more perplexing is that analysts, on both the buy and sell side, underestimated the stresses that were building up under the pressures of increased competition, weak disposable consumer income and a ballooning balance sheet. Did they not expect these forces to translate into lower profits? The sharp reductions in forecasts after the announcement shows just how much analysts rely on management guidance for their forecasts.

Tesco though is not unique in shocking investors by saying business is tougher than the market thought. The list of companies that have recently seen sharp falls in share prices after warning about profits includes; Tate & Lyle, Petrofac, ASOS, Aveva, Charles Stanley, Afren, Xaar, Aggreko, Pearson, Admiral, Spirent and Aviva.

Active managers can of course point these events out to advocates of the Efficient Market Theory (the idea that the market incorporates all knowledge) and say that they demonstrate that the market is not so perfect after all. While that is evidently true it also raises the question of what value the 23 sell-side analysts that follow Tesco have added. It is not so much that active managers are wrong, rather that there is precious little reward for all that effort and work.

Contrast that with the passive manager who accepts the rough with the smooth. He might end up with a similar return but gets there with much less effort and that means lower cost. Active managers that are on the ball and underweight troubled stocks before they fall will do relatively well. It is clear though from the price response that most did not get it right. The alternative of simply weighting by market capitalisation is undoubtedly the easiest way to allocate cash to stocks but it does rely on other active participants to move the share prices.

Although the Tesco story has demonstrated the fallibility of relying on published accounts there is one fundamental measure that has proved more resilient. Even if executives trust their own accounts they are acutely aware that business conditions are volatile. That is why dividends are typically set at less than half of stated earnings which provides a safety net against unexpected bad news. Tesco has said the dividend will be reduced and there must be the possibility that it might be passed altogether. Even if that happens it is likely that a modest distribution will be restored reasonably quickly. After all it is a company that generated £3.4 billion in cash flow from operations in its last full financial year.

Tesco is clearly going through a huge change at the moment and determining how much to hold in a portfolio right now is exceptionally difficult for active investors. Guidance from management might help, but with so many changes at the top it is hard to avoid the sense that it is as much in the dark as investors. Its current market capitalisation of £16 billion gives it a weight of about 0.8% in the FT All - Share Index, a long way from the 2% it made up at its peak. There may be more bad news to come and who knows if the share price has over-reacted, or has not moved enough. In such a fluid situation there are few signals that can be used with any degree of confidence by either active or passive investors.

At such times a fundamental measure, like dividends, is at least something tangible on which to base an investment decision rather than a volatile share price. One thing is for sure though. Active investors will be spending a lot of time and effort in the next few months trying to do two things; one is to work out what the profits might be and the second is to determine what value to put on them. It won’t be easy.



Past performance is not a guide to future returns. The value of investments and the income from them may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. For risks relating to specific products, please refer to the relevant documentation for that product.

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Tesco PLC (Tesco) is a retail company. The Company is engaged in the business of Retailing and associated activities (Retail) and Retail banking and insurance services. The Company's segments include UK & ROI, which includes the United Kingdom and Republic of Ireland; International, which includes Czech Republic, Hungary, Poland, Slovakia, Malaysia and Thailand, and Tesco Bank, which includes retail banking and insurance services through Tesco Bank in the United Kingdom. The Company's businesses include Tesco UK, Tesco in India, Tesco Malaysia, Tesco Lotus, Tesco Czech Republic, Tesco Hungary, Tesco Ireland, Tesco Poland, Tesco Slovakia, Tesco in China, Tesco Bank and dunnhumby. The Company's brands include Finest, Everyday Value, Chokablok and Technika. Finest and Everyday Value are the two food brands in the United Kingdom. The Company offers a range of personal banking products, principally mortgages, credit cards, personal loans and savings. more »

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Tate & Lyle PLC is a provider of ingredients and solutions to the food, beverage and other industries. The Company's segments include Speciality Food Ingredients and Bulk Ingredients. The Speciality Food Ingredients segment's product categories include dairy, beverage, bakery and convenience. The Bulk Ingredients segment's product lines include bulk sweeteners for food and beverage customers, and industrial starches for paper and construction industries. The Company's portfolio of products includes DOLCIA PRIMA Allulose, PUREFRUIT Monk Fruit Extract, TASTEVA Stevia Sweetener, CLARIA Functional Clean-Label Starches, PROMITOR Soluble Fibre, PromOat Beta Glucan and SODA-LO Salt Microspheres. The Company operates primarily in two industries: corn wet milling and sweeteners. The Company operates a network of corn elevator facilities across the United States Midwest. more »

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Petrofac Limited is a service provider to the oil and gas production and processing industry. The Company designs and builds oil and gas facilities; operates, maintains and manages facilities and trains personnel; enhances production, and develops and co-invests in upstream and infrastructure projects. The Company operates through three segments: Engineering & Construction, Engineering & Production Services, and Integrated Energy Services (IES) business. The Engineering & Construction segment provides lump-sum engineering, procurement and construction project execution services to the onshore and offshore oil and gas industry. The Engineering & Production Services includes all reimbursable engineering and production services activities to the oil and gas industry. The Integrated Energy Services business is focused on delivering value from the Company's existing asset portfolio. more »

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  Is LON:TSCO fundamentally strong or weak? Find out More »

4 Posts on this Thread show/hide all

Maddox 30th Oct '14 1 of 4

Hi Rob,

An interesting article. However, it's not clear to me that TSCO is the best argument for the premise that dividends are more reliable than accounts. TSCO has cut its interim dividend by 75% from 4.63p to 1.16p - but unless I've missed it - I have seen no guidance on what the final dividend will be. We are thus lacking a key fundamental yardstick to judge the sp.

This quaint UK one third/two third dividend pay-out profile is also far from helpful - its about time we moved to quarterly dividends.

Regards, Maddox

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Rob Davies 30th Oct '14 2 of 4


The consensus forecast for the next dividend is 2.5p a share. However, with a standard deviation of 2.8p for the full year payout of 4.6p it is probably still a moving target.
Quarterly dividends do smooth out the cash flow but when disaster strikes, as with BP in 2010, they don;t help much either.

Dividends are not perfect but the point of the blog was to highlight the spurious accuracy of reported accounts.

Giving enormous detail about the financials gives investors a false sense of security. The true flexibility of published reports was revealed by Jack Welch of GE in autobiography. When Kidder Peabody, a broker it owned, had rogue trading loss it confessed in his book to getting another division in the group to report bigger profits to cover the problem.

Fund Management: VT Smart Dividend UK Fund
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eadeseri 1st Nov '14 3 of 4

I'm already sitting on a near-40% loss on Tesco, but will pile in some more cash after the Christmas trading period settles down. I expect that Lidl and Aldi will increase their market share of the premium market, (specialist Christmas goodies), further eroding Tesco's revenues- but more seriously their UK/ Ireland market share in particular. Historically Sainsburys have done very well over the Holiday period, offering a larger choice of the premium produce,than the other Big Four (Asda, Tesco and Waitrose. Morrisons, is sliding further away from the gang). However the discount German duo, have proven last year, that they can cater very well for the more Epicurean tastes, which are dusted down over Christmas in UK and Ireland. ( Lidl and Aldi hold 8.3% of UK market and are growing at an annualised rate of c.16%) . According to Moody's OCT'14 report, the German pair can expect their market share to edge towards the average European example of 12pc-15pc that discounters enjoy there. As a result of slipping market share, the Big Four are eroding their operating profit, as they have all had to engage in price slashing to regain their position of dominance relative to each competitor.
On the good side, perhaps my reduced Christmas dinner cost will leave me some left-over cash to purchase my next tranche of Tesco shares?

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Rob Davies 5th Nov '14 4 of 4

The main point is that too much capital is being committed to a sector that is hardly growing. That means returns on that capital are falling.

Fund Management: VT Smart Dividend UK Fund
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