Posts filed under 'Commentary'
November 4, 2005 - Minyanville.com /Bloomberg
Before the 1982-1998 bull market, dividends accounted for a very large portion of stock market returns. In fact, in the 1966-1982 bear market, they were the returns investors received while watching P/E compress under the market.
On a theoretical level, dividends are just a transfer from a company’s corporate account (an account partly owned by a shareholder but which he/she has no control over) to a shareholder’s brokerage account (an account which a shareholder has full control over.) Thus there is a transfer of “hypothetical” wealth to real wealth. Owning 0.0000005% of the $10 billion residing in the company’s account is hypothetical wealth since it is NOT spendable; whereas $5000 in the shareholder’s brokerage account is real wealth as it is spendable wealth.
Since it was the shareholder’s money to begin with, stocks usually drop by the amount of dividend paid, thus no value is created. That is exactly what happened to Microsoft (MSFT) when it paid its $30 billion dividend; though don’t forget the stock ran up substantially on the dividend announcement.
Interestingly, stocks have very little memory of the dividends which were paid out, thus the immediate decline is usually erased from investor memory in a NY minute.
This is where the theory and reality diverge: The majority of companies that don’t pay out a significant portion of cash flows in dividends (or stock buybacks, though I place more value on dividends, as stock buybacks could be postponed) more often than not end up destroying shareholder wealth in empire-building acquisitions or marginal capital investments (if they had better investments to begin with they would spend cash right away).
I’ve seen a study (I think it was presented by Cliff Asness at a CFA Institute conference, though I’m not 100% sure) which showed that there is very little correlation with dividend payout and a company’s growth rate. This goes against theory as theory doesn’t factor in destruction of capital by corporate management. A company that has a high dividend payout operates in a very different environment than the one that is swimming in shareholder cash, as rigid dividend payouts force management to maximize the value of every dollar retained.
Lloyds TSB (LYG) for example has a dividend payout of 80% - very few banks have that kind of payout. How is LYG different from other banks? It is not building a war chest to make an acquisition that will likely just raise the risk profile of the company and make management feel better about their ever-growing empire. LYG is looking for internal growth. It is focusing to better its relationship with its customers–a cheaper, higher-return-on-capital type of growth.
Cash that has not been paid out is often destroyed by management, thus making dividends a very important source of value creation. Microsoft’s large cash position did not create much shareholder value as it created incentive for MSFT to waste billions of dollars on “strategic” investments; a $5 billion investment in AT&T comes to mind. Or Mobil buying Montgomery Wards to “diversify its cash flows”–this qualifies as the dumbest waste of shareholder capital ever.
We are getting 8% dividend to wait for LYG stock to come back to “correct” (in our opinion) valuation. In the case of LYG, its super-sized dividend (as long as it is maintained) creates a floor under the stock, thus arguably reducing downside volatility in LYG shares. So I don’t see any problem with getting paid a dividend to wait.
My partner Michael Conn and I were discussing the issue of dividends and both came to one conclusion: A company that has a higher portion of total return coming from a dividend (everything else is constant) should trade at a higher multiple. Here is an example:
Company D (dividend) is growing earnings at 0% and pays a 10% dividend. Company G (growth) is growing earnings at 10% and pays no dividend, everything else is constant. Return from company G will be riskier relative to company D (read: lower P/E) as all of its return is expected to come from the market placing appropriate P/E (driven by a collection of external factors) on its growing earnings. Whereas all of company D’s return comes in the form of dividends–though its price is subject to the same whims as company G’s–its 10% dividend will produce a stable return in the interim. Thus company D is a less risky investment than company G.
Share buybacks are a trickier issue. I usually welcome share buybacks when a stock is undervalued. However, companies will often do anything to stimulate their EPS growth, even it means destroying shareholder wealth through share buybacks. For example, Colgate (CL) was buying back stock when it traded at 34 times earnings–that deed alone should have gotten its management and board fired.
Share buybacks when a stock is undervalued make sense as they help EPS growth and raise dividend yield at the same time. As the buyback lowers denominator, fewer shareholders own the same piece of pie. What is not to love?
Companies that have high return on capital and don’t have a very capital intensive business–our kind of companies–usually will have substantial free cash flows, which allows them to grow earnings organically, pay a dividend and buy back stock. I do not advocate leveraging the company to buy back stock for two reasons: First, higher return comes with higher risk, thus possibly putting downward pressure on a company’s P/E and offsetting any benefits from a share buyback. Second, leveraging a company’s balance sheet has finite limitations; the company can only take on so much debt. Whereas share buybacks from free (discretionary) cash flows are only limited by shares outstanding–a nice problem to have.
In addition, share buybacks (if done at appropriate valuation) and nice, fat dividends create shareholder value on another level as they reduce the risk the company has to take to produce a total return for shareholders. Share buybacks are not a substitute for organic growth, but are often an under-appreciated bonus.
Vitaliy N. Katsenelson, CFA
Positions: LYG, MSFT
This article is written for educational purposes only. It is not intended as a recommendation (or advice) to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.
November 4th, 2005
I have a had a very interesting discussion with David Miller, a fellow contributor to Minyanville.com, on Federal government’s role in hurricane Katrina. David publishes Biotech Monthly and knows biotech industry inside and out.
I wrote the following:
I think the Federal government is to blame in part for the level of destruction caused by the hurricane. This is not a political statement but rather an economical one; remember I am a capitalist pig (not a political one)!
There is a very good reason why insurance companies did not want to underwrite flood insurance in New Orleans. The probability of a city residing below sea level being flooded is very high, and thus private insurance companies would have had to charge premiums that would make living in New Orleans unaffordable. The Federal government was selling flood insurance below its true market cost, thus tax payers have subsidized the true cost of living in New Orleans.
In the absence of Federal government intervention, people would have thought twice about building houses in a high risk flood area, as the “market” cost of insurance would have entered into economic equation of that decision.
This unfortunately is catch up time financially, as taxpayers across the United States will be rebuilding New Orleans, and yes, this $2000 is coming from their pockets. Is it the right thing to do? Yes, we have to help our own in such an unbelievably terrible time of disaster. However, we should be mindful of what impact government actions (even those which are driven by good intentions) will have on the human behavior and the resulting externalities.
According to the WSJ, Allstate (ALL) is gradually pulling out from Florida, as local insurance bureaucrats don’t allow the company to raise rates to charge local residents enough for the risk of non-recurring events - hurricanes - which “non-recur” every August and September. Allstate is a not a government entity thus it makes decisions that are arguably economically sound.
David Miller responded:
If the federal government doesn’t underwrite insurance in the hurricane areas, then it would also have to ignore the consequences of not being insured. Our society is simply not capable of that. If we “merely” assume the lack of subsidy would cause people to move, then the additional concentration of population in “non-at risk areas” (wherever the heck that is) has a significant (and almost always unintended or ignored) cost that also must be factored in.
I saw such unintended consequences occur in coastal Washington state when reliance on flawed science eliminated immense tracts of productive farm land from active production. Populations streamed to the cities to flee the resulting economic destruction, causing significant financial burdens. Education which, by State constitutional mandate, was funded by the proceeds from this farming has been chronically underfunded ever since (creating a downward economic spiral).
Those who make the pure capitalist/economic/whatever argument it makes no sense to rebuild New Orleans or other areas demolished by recurring natural disasters (Northridge, CA; tornado alley, nearly all river basins; etc.) naively assume it isn’t a zero-sum game. Those displaced folks have to go somewhere and there is a hard dollar and economic cost to that.
I replied:
David -
great counter argument! Of course the lack of Federal government intervention would have changed human behavior, but then it would have been a rational decision made without outside interference. Let me run this exaggerated, but realistic example by you.
The Federal government started underwriting volcano destruction insurance and selling it at a small fraction of the cost. Towns built on the top of active volcanoes could enjoy a spectacular view of the ocean, and have become a huge tourist attraction. The land is cheap, so why not build a house? The bank will give a loan, but will require volcano destruction insurance. By this action the government has augmented human behavior transferring the cost of the insurance to tax payers, who have not reaped the full benefits of enjoying a spectacular ocean view, and at the most visited the volcano town once in awhile while staying in an overpriced bed and breakfast.
Next time you go to Florida and see a multi million-dollar villa built on the side of the ocean, remember you are paying for that with your hard earned taxes.
Oh, and one more thing…
I read in the Economist a couple days ago that recent reforms in Germany called Agenda 2010, which are pushing Germany from Socialism towards Capitalism, appear to be paying off.
All Germany had to do was remove the incentive instituted by the government for unemployed people not to look for a job. And yes, there was a side effect: it has lowered consumer confidence. But I’d rather live in the country with higher employment and less confident than other way around.
David Miller responded:
OK, Vitaliy. I love the illogical extreme example so let’s run with that…
I’ll grant you the government screwed up. With that in hand, we have a decision about those volcano dwellers. Do we let them suffer and figure it out themselves? How about prohibiting them from rebuilding there? If we prohibit them from rebuilding there, where exactly do they build that is immune from natural disaster and still allows them to economically prosper? Where could we move these hospitality industry workers that would have the appeal of volcano-top resorts?
The beach? Oops, hurricanes (or earthquakes). The river? Oops, flooding. The city? Oops, who want to get away from it all ten block up town? A “hill” in Kansas? Not exactly the same experience (and tornados).
My point is decisions repealing the “moral hazard” have a dollar cost and an opportunity cost. I am unconvinced those costs are less than what we are doing right now.
I replied:
Dave this is what we do. We save them, help them and than let them decide what they want to do. However, if they want to move to the volcano land they’d have to buy insurance from the private companies that would insure a true risk. Why should you and I pay for their love of ocean views and volcanoes?
You are right! Nothing (except Colorado - that is what I keep telling my wife) is safe from natural disasters. But let people subjecting themselves to the risk of those disasters pay a true cost of those disasters. Private (as opposed to government) insurance companies will do their best to gage the risk and they’ll price insurance polices accordingly.
Vitaliy N. Katsenelson, CFA
Copyright Minyanville.com
This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.
September 28th, 2005
August 24, 2005 - Minyanville.com
I wrote this article after Minyans in the Mountains conference that took place in sunny Ojai. I was one of the panelists on fundamental panel where I was in the great company of Herb Greenberg, Fil Zucchi and Jeff Macke.
JeffMacke© and I usually agree on things. (Though he recently mentioned that my four-year-old son will never meet his two and half old daughter.) However, in our fundamental panel discussion at MIM2, I discovered that Macke and I disagree on the issue of management’s earnings guidance. I’ll let Macke state his view, as my attempts would only bleach the colorful (psychedelic) way only Macke can express himself.
Here is my view: Wall Street’s preoccupation with (public) corporate America meeting and beating its earnings forecasts has had a corrosive effect. In fact management’s constant pursuit to appease a short-term minded Wall Street has spread to the ranks of the best of the breed.
This was the response of Costco’s (COST) CEO to an analyst’s question on what he loses sleep over…
“What I lose sleep over, and not a lot frankly, is more as it relates to the short-term stock price movements, because short-term stock price movement is impacted by expectations and the fact that at some point, and perhaps this quarter is a good example that we just announced, that if you look at quarters two, three and four last year we beat those by a little bit.” (CallStreet.com, Transcript of Costco’s Q3 2004 earnings call.)
One would argue, what is the harm? How do a CEO’s sleeping habits impact shareholders? A fair question. The apparent consequences of a CEO caving into the pressure to deliver the goods quarter after quarter came to light when the accounting scandals erupted at then unsuspecting places such as Enron, WorldCom, Bristol-Myers Squibb (BMY), HealthSouth, Fannie Mae (FNM) and many others. However, the hidden-to-the-naked-eye impact is morphed much deeper into the ranks of corporate America.
On a daily basis corporate management makes decisions that aim to benefit corporate performance in the short run versus the long run and vice versa. Though not all short-run and long-run decisions are mutually exclusive, to grow a tree (a long-term investment) seeds have to be planted (immediate expense). Management faces these decisions on a daily basis and unfortunately often destroys long-term value to please the short-run junkies.
A couple of years ago I had an informal breakfast meeting with the management of a wholesale club (not Costco). I asked why they did not open more pharmacies at their existing clubs, as the company had plenty of free cash flow and opening pharmacies seemed to improve traffic.
The response I received was: “Yes, pharmacies are a good investment, but it takes a while for them to reach profitability thus we’d be taking a short-term hit on earnings. Therefore, we are stretching the openings out.”
Management has given up a good investment opportunity in favor of the short-term gratification of Wall Street.
During the break between the session at MIM2 (more in later posts), I had the pleasure of speaking with
Professor Neal Dingmann (what a great, modest, sharp guy). Neil pointed out that in the oil industry, results choosing short run in lieu of the long run may have grave consequences on the company’s long-term profitability. As companies strive to make the production numbers (and thus revenue) they may abuse the wells and potentially undermine their structural integrity and long-term profitability.
The pressure spills far beyond the retail and oil industries, for example, to a well-known beer maker. According to a CFA friend of mine, (an industry insider) often when the company feels the pressure to deliver the “expected” numbers, it sells beer to liquor stores at large discounts to its regular price. Beer has a limited shelf life (I try to explain this to my wife quite often), thus if it’s not sold by the expiration date it must be returned back to the beer maker. By artificially stuffing inventory channels (demand did not warrant it) the beer company has cut into its next quarter’s sales and increased its expenses as expired product will make it back to the warehouse.
As Macke mentioned in the panel discussion, Sarbanes-Oxley did not fix things because you cannot mandate ethical behavior.
However, it did enrich an army of consultants and imposed a great cost on public companies (especially smaller ones). The true cost of meeting the numbers game is truly impossible to measure, as we’ll never know what projects companies have foregone to please the Street’s crowd.
Over time the Street’s obsession with short-term goals has shifted management focus from creating long-term value for shareholders to becoming Wall Street’s lap dog trying to jump every quarter to the plank that was raised by its masters. I understand the pressure that companies face every quarter, as for many of them a declining stock price means an exodus of option-linked talent. However, there are creative ways to compensate their employees, where stock options and (short-term) stock performance are not the only solution to employee retention.
John Succo noted that Citigroup (C), the world’s largest bank, has fiddled with its asset gains to make its numbers for the quarter. And he asked me, how do I deal with it? I tear a company’s financials apart, trying to arrive to core operating performance–The Good, The Bad, and The Ugly series are a good example of that. In the case of Citigroup, I’d simply avoid the stock (Todd Harrison: not advice) as it’ll consume the whole quarter for me to analyze the very complex financials of the giant conglomerate.
Every time I stumble on a company with complex financial statements, I remind myself that I want to only own companies whose financials (and business) I can understand. To make a rational decision one has to be able to analyze (in a timely manner) the information.
Vitaliy N. Katsenelson, CFA
Copyright Minyanville.com
This article is written for educational purposes only. It is not intended as a recommendation to buy or sell securities. Author and/or his employer may have a position in the securities discussed in this article. Security positions may change at any time.
August 24th, 2005
By Vitaliy N. Katsenelson, CFA
December 12, 2004 - TheStreet.com: Street Insight
A couple days ago, I briefly visited San Francisco (I left my heart there). I had several hours of free time to kill, so like any self-respecting tourist, I went on a tour of Alcatraz — what a place! I don’t have a frame of reference, since it was my first prison visit (and hopefully my last), but it must have been the most awful and unpleasant place in U.S. to be sentenced to.
This Alcatraz visit brought me to a realization that the U.S. government is misusing this national treasure. In fact, I strongly believe the National Park Service should turn Alcatraz back over to the Department of Corrections. Alcatraz could single-handedly restore investors’ faith in financial statements and markets. My proposal is very simple: First, all executives of publicly-traded companies that commit a white-collar crime (i.e. lie to investors, manipulate a company’s financial statements, do insider trading, steal money from their company, etc.) should serve their time at Alcatraz, not in a minimum-security country house.
Time served doesn’t have to be very long. After seeing the horridness of Alcatraz, the reader will agree that six months to a year is plenty of time to make an honest person out of even the most crooked executive.
Second, the SEC should require every executive of a publicly-traded company to take a guided tour of the functioning prison at least once a year — with Eliot Spitzer as a guide. This once-a-year field trip would eliminate even a trace of temptation to commit a white-collar crime. If the aforementioned suggestions are implemented, our children will think that white-collar crime is when your dry cleaner did not remove the stain from the dress shirt. Wouldn’t that be nice?
Copyright TheStreet.com 2004
December 15th, 2004
RSS 
Send Email
