Comment: Retreating stock markets pay dividends

A key reason for the existence of a stock market is that it enables companies to raise capital for investment and expansion. This is said to be particularly important for firms developing new technology and wishing to fund their business development.

The cash in hand from dividends, as well as the long-term view, shows the stock market is still worth investing in. Picture: Bill Henry

Investors can be tapped for capital via stock market flotation or equity capital offers by way of share placings and rights issues.

But does this rationale still hold? I was struck on reading some startling figures in the latest annual report from Polar Capital Investment Trust – a £530 million UK-based trust specialising in investment in technology companies round the world – that the opposite appears to be the case.

It is not just the UK where companies are sitting on enormous cash piles and where share buy-backs by companies rather than new share issues are the norm. Fund manager Ben Rogoff points out that in the past year, US non-financial companies are today sitting on more than $1.7 trillion in cash.

And far from this being devoted to new business investment and expansion, much of it is likely to be spent on share buybacks – companies buying in shares from investors to improve the appearance of earnings per share performance.

Just when we needed the world’s biggest economy to be investing in future growth, buybacks totalled $375 billion (£241.8bn) over the year to September 2012, representing 65 per cent of aggregate free cash flow.

Compounding this retreat from quoted equity is the re-emergence of private equity activity and leveraged buy-outs. The first six weeks of 2013 alone saw the $24bn management buy-out of Dell and the $23bn acquisition of Heinz. In the tech sector, leading companies are estimated to have $512bn of cash, while capital spending as a percentage of GDP is at the lower end of the range that has prevailed since 1947. Technology shares outstanding shrank by 4 per cent last year, while there is more than $1 trillion of tech shares available for purchase under announced buyback plans.

Now, these statistics come at a notably low ebb in business confidence and in investor appetite for risk. Companies generally have had to batten down and concentrate on survival, not expansion.

As for investors, stock market volatility – and in particular the three sharp falls in equity values since 1999 – has profoundly soured public perceptions of shares as a reliable haven for savings, while the “help yourself” behaviour of company boards and senior personnel, particularly in banking, has raised searching questions on corporate governance. But regulatory reform – and an improved economic outlook – should help bring a revival in confidence.

And Mr Rogoff stresses the upside for investors. Equity investors have no reason to burst into tears: a contraction in quoted equity should help support the price of shares that survive this shrinkage. But it hardly suggests a healthy state of affairs, still less the return of “the cult of the equity”.

In the UK, the low volume of equity issues is a feature of the investment landscape. Chris Dillow, in a perceptive article in Investors Chronicle questioning the uses of the stock market, quotes Bank of England figures showing that, in the last ten years, net equity issues by UK firms averaged only £8.7bn a year – just 4 per cent of total capital. And most comprised bank recapitalisations after the financial crisis. So does the Stock Exchange today fulfil its function of raising money for companies to undertake investment? You can’t help but wonder.

Here in Scotland, we have also grown accustomed to the declining relevance of the stock market in the financing of companies. The number of Scots companies quoted on the UK stock exchange has collapsed by a third since 2007 – even including listings on the junior AIM market, the total is now down to just 58. Overseas takeovers (which took out Scottish & Newcastle, Thus Group, Dana Petroleum and Axis Shield), private equity activity and mergers have denuded the list. Other factors cited are the expense in terms of adviser fees and the regulatory requirements that divert management from the underlying business.

Overall, it is a dismal and dispiriting picture. But set against this are some enduring positives. Stock market listing enables the owners of family business and venture capital funds to realise some or all of their capital for re-investment. It provides an alternative to bank capital which will not always be as inexpensive as now. And through dividend payouts they provide a stream of income for investors.

Figures from Capita Registrars show that total dividends distributed by UK companies rose to a record high of £25.3bn in the second quarter. Year-on-year, dividend payouts are up 7.6 per cent.

It is dividend income that provides the basis for the superior long term total return performance of equities over bonds and fixed interest. And judging by the inflation risks gathering like dark clouds on the horizon – the Bank of England’s forward guidance of “lower for longer” interest rates and incipient signs of a house price bubble – it is dividend income that remains the compelling counter-inflation argument for equities. And that in turn helps keep the Stock Exchange in business.