Are fortress level of capital good for dividend investors?
Manulife Financial, one of the world’s largest insurers, surprised the investing world last week by announcing it was raising $2.5 billion dollars in a common share issuance less than a year after raising $2.5 billion of common shares. The new CEO of Manulife has long maintained that it seeks a “fortress” level balance sheet; whether this quest is to protect against another downturn or as a prelude to a large-scale acquisition strategy, the small purchase in a Chinese fund manager notwithstanding, is up for debate.
What is not up for debate is that Manulife, assuming a full uptake of its offering, now has what it seeks. Its Minimum Continuing Capital and Surplus Requirement (“MCCSR”), an insurer’s equivalent of a bank’s capital ratios, is at an estimated 256 which is well above its peers at 215 (anything over 150 is acceptable). In plain English, Manulife has more money socked away than the regulators require in case its underwriting was poor and it has to pay out too many policies. Manulife merely is following the banks who have also raised their capital ratios to higher than required levels to protect against another credit crisis.
While no doubt giving assurances to the public at large, are fortress levels of capital (which I will use as short-hand for high capital ratios and/or MCCSR) good for dividend investors with large portfolios in financial services companies?
The first issue is how a financial services company arrives at fortress levels of capital. If, devoid of any ideas, a company simply hordes earnings created by organic growth, this is not a dividend, or shareholder, friendly management strategy. But it can be addressed by a shareholder revolt to replace management with one that will return money to shareholders through dividend increases or acquisitions.
However, an average dividend investor is harmed if a company builds fortress levels of capital through multiple share issuances. The foremost issue is shareholders are being diluted: for example, Manulife has diluted its shareholder by more than 10% in less than a year. The more troublesome issue is that the proceeds of a share issuance are not being used to grow the company, thereby increasing the chances of a corresponding dividend increase, but to build up capital levels.
There is a strong argument that building up capital levels should be lauded by dividend investors. In an unfriendly business climate, it may be prudent to simply retain what you have; increasing dividends on blind faith in the future, murky as it is these days, is a danger sign if one wants to invest in dividend growers. Certainly, recent history shows financial services companies should be more cautious in a highly-integrated and leveraged capital market environment.
I would not suggest that a company simply increase dividends dogmatically without watching its financial risk management. In fact, it is hard to argue that creating a fortress levels of capital is bad for dividend investors if one’s choice is either to protect the dividend or to decrease it (although in Manulife’s case, it slashed the dividend and diluated the shareholders twice; they better be issuing damn good holiday cards this year).
But the larger issue may not be the downside risk protection in creating fortress levels of capital but what happens when it is no longer needed. In 1998, the Federal Reserve Bank of New York published a paper examining the trend of bank holding companies decreasin their capital levels after building them up during the late 80′s and early 90′s.
In the abstract, this trend could be seen as alarming but, at the time at least, the author found some comfort in the fact the capital ratios were decreasing because of increasing shareholder payout. Sounds good but here’s the problem. While dividends increased 5%, share repurchases (aka share buybacks) increased 70%. In fact, while dividends increased modestly, share repurchases are often the dominant form of shareholder payout in the largest 25 bank holding companies.
Share repurchases are problematic for several reasons. While the offer is typically higher than market price, it can be seen as a means to, over time, reduce the aggregate dividend paid through reducing share capital. Share repurchase programs can also be started and ended relatively quickly. In other words, it does not signal as well to the market that the company believes its future growth prospects are healthy as compared to a large dividend increase; the stickness of dividends tend to mean that once a dividend is increased, the company is committed to paying it for long periods of time. A share repurchase is a one-trick pony which appeals more to Wall Street than buy and hold dividend investors.
Finally, as many others have often pointed out, share repurchases show the company to be poor investors- it is buying high and selling, via issuing stocks, low. It is, in the relative scheme of things, an unimaginative way to step down from fortress levels of capital.
To use the dating analogy, it is the morning after that may scare the dividend investor more than the night before. The arguments for building fortress levels of capital in this climate for is reasonable and pursasive to most rational dividend investors. However, no one knows how dividend paying companies with fortress levels of capital will act once the fortress is disassembled to a mere trench levels of capital. Recent history indicates that it will not be as friendly as a buy and hold dividend investor wants it to be. Unfortunately, this is a story that will not be unfolding for some time.
As to whether Manulife has become a value play, I am of the agreement that Manulife needs to be watched carefully. A new CEO who cannot seem to stay on message (if you are going to dilute the shareholders do it once), has not seemed to master investor relations and with large legacy issues is juxtaposed with market share in the critical Asian market and a strong brand domestically. As usual, conduct your due diligence and proceed accordingly.