With interest rates at historical lows and set to remain so for the foreseeable future, savers are drawn to equity markets to enhance their income. However, we would caution investors focusing on dividend income when investing in AIM quoted companies. This is not simply due to the large number of dividends currently at risk in the current pandemic and companies desire to save cash, but the greater investment returns on offer from investment in smaller rapidly growing companies if cash is reinvested in the business.
AIM, which was originally called the Alternative Investment Market, was launched 25 years ago on 19 June 1995 as a replacement to the Unlisted Securities Market. At launch, it comprised only 10 companies valued collectively at £82.2m, with only one survivor, closed ended investment company Athelney Trust (LON:ATY), currently remaining from the original 10.
Thankfully, the quality of companies on AIM has improved substantially over the years, with the vast majority offering considerably greater ambition and growth potential than Athelney Trust, which 25 year later only carries a value of £4m. However, this AIM pioneer, which moved onto the main market in 2008, has paid a dividend every year since 1995, distributing in aggregate 95.8 pence to the end of 2019, equivalent to just over 50% of its current share price, with last year’s dividend of 9.1 pence per share equivalent to yield of 4.9% at the current price.
While this sounds enticing, Athelney’s dividend and capital allocation policy over the years serves as an excellent guide to the dividend trap confronting investors in smaller companies.
Athelney’s dividend pay-out has indeed been attractive, representing a compound annual growth rate of 9.83%, but it could conceivably have put the cash to better use by making greater investments in its portfolio of growth companies. For the year ending December 2019 equity dividends it paid to shareholders exceeded the net income it received from its investee companies less the costs of running the Trust. This means that those dividends were effectively being paid out of capital, necessitating the sale of some of its equity holdings and possibly some of its better performing stocks.
Athelney’s actions mirror those of many smaller companies on AIM and the main stock market, who seem resigned to paying out cash as dividends as they are unable to identify suitable opportunities to invest in the business to achieve the desired return on capital.
Athleney’s predicament is illustrated by the performance of one its largest current holdings, AIM quoted Gamma Communications (LON:GAMA). Gamma was admitted to AIM on 10 October 2014 at a share price of 187p and market capitalisation of £165m. The shares have since risen over 560% pushing the valuation to £1.1bn. Over the equivalent period, the share price of Athelney has fallen 9.3% but it is has paid aggregate dividends of 46.7p, equivalent to a yield of 23% of the share price in 2014, resulting in an overall return of 13.7% (23%-9.3%).
We acknowledge that not all investments may have proved as successful as Gamma, however, on the basis that it might have got more right than wrong, this simple example illustrates how Athelney might have generated better overall returns for its own shareholders by reinvesting cash in its portfolio of companies rather than use it for dividend payments, something that is highlighted by the performance of Gamma itself over the same period.
For the year ending December 2015, its first full year on the stock market, Gamma reported post tax profit of £18.3m, representing a 31% return on equity of £59m, and generated an operating cash inflow of £28m. Gamma’s balance sheet carried no debt.
Return on equity (‘ROE’) is a measure of a company’s ability to generate income from shareholder’s capital, the higher the ratio the better and 31% was very good indeed. If Gamma was able to generate a 31% return from its shareholders capital, those same shareholders should have been very happy for it to continue to do so. It was therefore clearly in shareholder’s best interests for Gamma to retain its cash to reinvest in the business, rather than pay it out as a dividend. Gamma was ultimately able to do both, retaining sufficient cash to reinvest in growing its business and pay out a small dividend to shareholders.
While the 6.6 pence paid for 2015 was equivalent to a modest yield of approximately 1.6% at the time, it has consistently grown the dividend each year, with the 10.5 pence per share paid out in 2019 representing a compound annual growth rate of 12.3%. Of greater significance, through prudently retaining the majority of cash for reinvestment in the business and to support acquisitions, Gamma’s adjusted earnings per share have grown from 17.9 pence in 2015 to 40.8 pence, representing a compound annual growth rate of nearly 23%.
With earnings growth more than double the dividend growth, we hope shareholders eagerly reinvested their dividends into more Gamma shares, thereby benefitting from power of compounding. Gamma’s ROE of 25% for the most recent financial year ending December 2019 suggests the strategy continues to work well.
The fixation on short term dividend income too often blinds investors to the greater potential return on offer from reinvesting cash in the business, especially if that business is generating a high ROE.
Small AIM companies also often require additional equity injections from shareholders to support their growth aspirations. This scenario often sees companies pay out dividends to shareholders only for them to effectively ask for it back in the future as they require more equity to support their growth. The resulting fund raise incurs further costs to shareholders, which could have been avoided if cash had been retained. In many cases those dividends received will have also been taxed in the hands of the recipient adding a further layer of cost to the shareholder.
Many small shareholders may seek the reassurance from their investment in small companies that the company is paying a dividend, but ultimately actually have little immediate requirement for it. If they had considered themselves more like the business owners they are, they may have appreciated the wisdom of their respective investee companies retaining the cash for a future use. This of course assumes they have confidence in management’s ability to responsibly allocate cash.
Some small AIM companies necessitate little ongoing capital investment yet generate substantial cash which can support a growing dividend. We would argue that many companies of this nature have modest growth aspirations and should be viewed with a degree of caution and what growth there is could quickly reverse. Many small companies also remain controlled by members of the founder’s family and there is therefore pressure to pay a large dividend, with the need to balance this with the necessary reinvestment to support growth.
Nevertheless, a progressive dividend policy does engender a sense of cash flow discipline and responsibility by management to shareholders and should be followed by small companies if the cash flow supports it. But investors should primarily focus on a company’s ability to support a growing dividend from earnings, rather than simply the dividend yield at a single point in time. Many of AIM’s best performing companies have adopted this policy, offering a small dividend to encourage, but retaining most of cash for growth.
A small company offering an apparently enticing high dividend yield all too often ends up as a value trap.
Selection of AIM’s largest companies – share price return, dividend yield and growth
|Ticker||Company||Sector||Market Cap £m||3 Year|
Share Price RTN (9.6.20)
|Dividend Yield||Dividend Growth|
|DTG||DART HOLDINGS||Leisure travel||1,750||48%||0.85%||18.20%|
|RWS||RWS HOLDINGS||IP support and localisation||1,720||56%||1.49%||16.67%|
|DATA||GLOBAL DATA||Business Information||1,450||190%||1.09%||36.36%|
|PRSM||BLUE PRISM||Robotic process automation||1,290||50%||0.00%||n/a|
|KWS||KEYWORD STUDIOS||Video game service provider||1,250||112%||0.09%||Reduced|
|GAMA||GAMMA COMMUNICATIONS||Communication services||1,180||126%||0.93%||12.90%|
|FDEV||FRONTIER DEVELOPMENTS||Video game publisher||766||373%||0.00%||n/a|
The table illustrates how many of AIM’s largest and best performing companies have only paid a very small dividend or no dividend at all, preferring to retain cash to reinvest in the business.
Boohoo Group, AIM’s largest company, has never paid a dividend and always carried a large cash amount of cash on its balance sheet. It recently raised a further £200m to take advantage of the numerous opportunities that are likely to emerge in the global fashion industry over the coming months.
Video game developer and publisher Frontier Developments, the best performing stock in the above table, has chosen to retain cash to reinvest in developing its portfolio of video games. In recent months demand for Frontier’s immersive and creative games has increased as a result of Covid-19 lockdowns around the world resulting in full year results that are materially ahead of estimates.
Gamma Communications has been a consistent dividend payer and, having also made significant investment in its business since listing, it is also one of the few companies that has developed a suitably robust business model able to support an increased dividend over the pandemic.
There are always exceptions to the rule and another much smaller AIM company, Jarvis Securities (LON:JIM), has chosen to focus on dividend growth despite generating a very high ROE. With a current market capitalisation of £61m, Jarvis provides retail stockbroking and outsourced financial administration services to investment firms. It has a very simple and focused business model generating very high operating margins and a ROE exceeding 60%. The group operates from a low capital base and its core platform technology is outsourced. It therefore requires very little capital investment to operate and grow with excess cash swiftly returned to shareholders in the form of a growing dividend.
Much like Gamma, it has been one of the few companies able to grow its dividend over the crisis as it benefited from heighted market volatility, with the forecast pay out of 30p equivalent to a yield of 5.3% at the current share price. While the yield is extremely attractive, there are clear grounds for Jarvis increasing investment in the business given the very attractive returns it generates.
Chris Boxall, is director of specialist investor in AIM quoted companies Fundamental Asset Management
Further reading: FTSE Small Cap vs AIM