Blog 4- AA, Driving in the Wrong Direction?

Are dividends irrelevant? It’s hard to believe so after AA’s shares dropped by almost 30 percent following the news of dividend slashes and lower expected profits; due to investing in new technology. AA want to invest in technology which would essentially help them to spot breakdowns before they happen through vehicle monitoring systems. Seems like a good idea… however, to be able to invest in this new technology, AA are having to upset some shareholders by cutting dividends.

There are conflicting views on this kind of situation, about which direction AA should go in. Modigliani and Miller on one hand would be all for investing in the new project; they believe if there are any projects that would generate a company a positive NPV they should do it and that dividends should only be issued if there is left over money from the projects. I agree with aspects of this theory: companies should look to the future and think about making themselves more money in the long run, however, the people who are actually funding your business now are your shareholders, so I think it is very important to keep them happy and try to maximise their wealth.

A conflicting view is that of Linter and Gordon. Their opinion talks about imperfect capital markets- people external from a company don’t know correct information. They said that it is better to have money now because future gains are uncertain, therefore, they think shareholders should be given dividends now, rather than waiting for some uncertain date after an investment has taken place. They suggest that companies should be valued higher if they have a high current pay-out threshold, rather than on companies investing for the future. In this case, the advice to AA would be to NOT slash shares- it is important to give the shareholders their dividends and keep them happy. I disagree, if shareholders think that having their dividend every year is more important than future investments, I would advise them to sell their share and go invest elsewhere. I personally think investors should be both physically and financially invested in the business and want to see the long term goals met.

Although this is my view, for some investors long term returns are not in their best interests. For investors that are older and maybe retired, long term returns may not be important, rather they are looking for higher dividends. This could also be the same for managers, if they are older and looking towards retirement themselves, they may be looking for steady job security- not risky investments.

Another thing AA need to consider when making decisions such as these is the clientele effects. Certain groups of investors are looking for certain types of characteristics in the shares they buy and the companies they are investing in. AAs’ investors have been used to a 9p dividend and it has now been cut to 2p, the change in this has evidently sent investors elsewhere with a 30 percent share price drop down to 83.6p. The new chief executive Mr Breakwell wants to ‘reinvent’ the company as a technology and product marketing company. If AA is to be ‘reinvented’ with new goals and values, this may scare off old clientele who were just looking for a steady dividend. However, on the other hand, AA may acquire new clientele who like the idea of higher investment and the long term effects. In the long run this could be positive for AA, as they will then have shareholders who are invested in their new goals. I think the important thing for AA to do is pick a strategy and stick to it. They cannot cater to all clientele and if they try to, they could end up losing all types; now they have decided to invest in the future, do this and the new clientele will follow.

AA need to think about the message they are sending to the public about their company through the dividend cuts. For a company, investing in the future means smaller dividends. Investors don’t have access to asymmetric information therefore, they take signalling from dividend pay-outs on the company’s performance. For AA, in terms of signalling, their low dividends portray bad news- high dividends, good news. Although AA are doing something positive and investing in the future, the public and investors may suggest there is something else going on for the dividend cut; unless the cut is fully explained and evidenced.

One theory that would agree with what AA are doing is agency theory. Agency theory suggests that there should be separation between who owns the business and who runs the business: placing managers in a position to justify their spending to shareholders, so the shareholders have more control of where their money is going. Shareholders may insist on high pay-outs to gain control over their money and avoid managers investing in poor projects. However, it means that managers have to justify their spending to the shareholders, this adds value because investors are more able to monitor managers’ investment decisions. So for a seemingly good investment- like that of AA- investors could be on board and happy with the managers’ decision, leading to less investors selling their shares.

I personally think AA are going in the RIGHT direction with their choice to invest in the new technology and cut dividends. From this week’s lectures I have learnt how hard it is to make an investment decision, when you have investors relying on your company for the dividends they expect. I can see where each theory is coming from, however, I think the one that has the most points I agree with is Modigliani and Miller’s; I know that they have some gaps in their research with this theory and only really look at perfect capital markets. However, the basic concept is what I agree with: investing for the future is more important and dividends should be given with the additional money left over from investing in positive NPV projects- obviously not in all scenarios.