# Hester's  Instablog

Hester
Send Message
Another living human.
Jan 22, 2010 1:37 PM

Over the short term the market can be irrational and inefficient. However, over the longer term the market is efficient and the actual value of a stock will be followed by the price, despite some short term over or under valuations caused by the irrationality of some. When looking at a stock I try to determine its value, because I know price will eventually follow value. When evaluating different parts of a stock I am constantly asking myself, how does this effect the value of the business? So naturally when looking at dividends I ask myself that question. The answer, dividends have no positive effect on the underlying business and rarely if ever have a positive effect on my investment in that business.

When a company pays out a dividend, it is using cash generated from its operations. Since the cash generated by the business goes to an outside source (shareholders) not pertaining to the business, it decreases the value of the business and thus eventually lowers the price of the security by the dividend amount. The share price declines by the dividend amount that day, but it doesn't always stay there. However, over the long term the share price will decline by the amount of the dividend no matter what. The investors get that dividend money, but at the expense of owning part of a business that is now worth a little less.

Example?

Imagine there are two stocks. Both are \$100 million companies (That's their value which the price will eventually follow). They both generate \$10 million in owner earnings in one year. Company A keeps the \$10 million and simply reinvests it into their business. So their value increases to \$110 million. Company B decides to pay a dividend in the amount of \$5 million total. So they take half of the cash they generate and pay it out, and no longer retain all of that \$10 million of earnings. They reinvest the other \$5 million in their business. After that one year, company A would be worth \$110 (\$100 million plus \$10 million in retained earnings) and company B is worth \$105 (\$100 million plus \$10 million in earnings minus \$5 million in dividends), but yields a dividend of \$5 million (total). So what would you rather own, something that's worth \$110 million or something that's worth \$105 million and pays you \$5 million? They are both worth the same. The dividends that the investor in company A is deprived of will be made up for in capital gains.

In fact, if each company earns 10% of their value next year as well, company A will have \$11 million of retained earnings and company B will have \$10.5 million in retained earnings because they invested less in their business. So now company A is actually worth more.

All this is in a tax free world as well. In the real world, both companies' earnings would be taxed. Then when company B pays a dividend, that money will be taxed again. The investor in company A will only pay a tax on his companies' earnings when he sells, and he will face a much favorable tax rate. (This is assuming the company is not a REIT or any other that has favorable tax implications on dividends).

When should a company pay dividends?

The only time a company should even consider paying a dividend is when they cannot achieve higher returns on their retained earnings than their investors could, and their share price is too high to warrant a buyback. Buybacks are more favorable than dividends because they are tax efficient, but they are only positive when the stock is fairly or undervalued. Also, a company should pay out a dividend if they are a net net because in that case, the value of the cash or marketable securities could be unlocked easier.

In my opinion, portfolio strategies that focus mainly on dividends and dividend yield is foolish. Why? Well companies that pay out high dividend amounts are basically saying, "We cannot achieve satisfactory returns by increasing the scope of our operations, and our share price is too high to warrant a buyback." None of those two traits are favorable. If a company is so inefficient or unprofitable to the point where it cannot expand operation and still be profitable, then do you really want to own that company? If the share price is too high to warrant a buyback, do you want to own that company? If the management is so nonsensical as to pay a dividend when it can achieve a higher return than most shareholders by expanding operations, then do you want to own that company? Therefore I believe that a strategy of buying only companies that have one or more of these qualities(not able to grow operations, high share price, dumb management) is a poor one, which is what dividend focused portfolios are.

When is it better for you when a company decides to pay dividends?

Even if a company pays a dividend and can earn higher returns through expanding operations than their investors could, doesn't mean that you couldn't earn higher returns. If a company earns 20 or 25 percent on their invested capital, then they are earning a much higher return than the vast majority of their shareholders. However, what if one of their shareholders was a young Warren Buffet who could earn returns of 50 percent per year consistently? Then for that young Buffet, he should be happy when one of his companies pays a dividend. Certainly, if you are achieving much higher returns than the majority of investors, a company paying a dividend can sometimes be a good thing for you (and maybe only you) if you can get higher returns than the company can. That company would still be doing a disservice to the majority of its shareholders though.

Some common questions and concerns you might have.

Don't dividend paying companies do better on average than companies that do not pay?
Remember, dividends add no value to the company. A company is not a stronger business just because they decided to pay a dividend. Dividends don't matter in the long run. I am dividend agnostic. A dividend paid reduces capital gains by the amount of the dividend. Any statistic that shows dividend paying companies doing better than non dividend paying companies misses the point. The reason the dividend paying companies did better is not because of the dividend, but because of the strength of the business. Most strong business happen to pay a small dividend because they think they are being shareholder friendly.

I've seen many statistics of how the market only gained 7% over the last 100 years without dividends and gained 10% with dividends. So dividends do matter right?
No. If none of those companies in the market paid dividends over the last 100 years, the market would have gained 10% because the companies would of retained those earnings and bought back shares or reinvested in their company, increasing the value and the returns over time.

But I've read dividend paying companies are safe, so I invest in them to be conservative and prudent.
The dividend has nothing to do with soundness of the business. Most mature and non volatile companies pay dividends, but the dividend itself has nothing to do with the quality of an investment or the quality of an underlying business and doesn't affect returns over time. A great company can not pay a dividend, and a poor company can pay a large dividend.

I'm a retiree. I need investment income to live off of. Spending dividends doesn't harm my principle investment.
Yes it does. The value and eventually the price of your stock will drop by the dividend amount it pays, therefore every dividend you receive decreases your principle investment by that amount. It may not feel like it but it does.

Ok, but explain this. Whenever a company announces they will cut or eliminate a dividend, their share price gets hammered, and when a company raises a dividend their share price rises. If dividends don't matter, then why is this?
That's the irrationality and inefficiency of the market. Some institutional funds can only hold dividend paying companies, therefore when a company stops paying they have to sell because its in their charter, or they perceive them as a poorer business now. This just represents a buying opportunity (or selling opportunity if a dividend is raised) because the value of the business remains largely unchanged. Actually, the value can be increased or decreased in an opposite way of the dividend. If the dividend is cut or eliminated, the stock will probably sell off. However, that can be a positive for the value of the business because now the company can use the funds set aside for dividends to increase the scope of their operations, which actually increases the value of the business (usually). Vise-Versa for a company that raises a dividend.

If there is only one thing you take away from this article have it be this.

Short term, the dividend could create an inefficiency in the price of a stock, but longer term the dividend decreases the value of the stock by the amount of the dividend paid, and therefore does not matter at all.

Disclosure: no positions mentioned

Disclosure: no positions mentioned

Disclosure: no position mentioned

Back To Hester's Instablog HomePage »

Instablogs are blogs which are instantly set up and networked within the Seeking Alpha community. Instablog posts are not selected, edited or screened by Seeking Alpha editors, in contrast to contributors' articles.

• Excellent article. (I'm now following you.)
10 Feb 2010, 02:04 PM Reply Like
• What about management with itchy fingers just dying to put that cash to use, even if there is no good use for it?
22 Feb 2010, 08:57 PM Reply Like
• Author’s reply » Hello Nirav,

A company doesn't have to let the cash that they would of paid as dividends, but instead retained, just pile up. They can pay down debt, which increases book value and increases future earnings (less interest expense means more profit). If they don't have debt to pay off they could just invest it in longer term securities, increasing book value and increasing future earnings (from interest earned). If their share price isn't too high they could buy back shares as well, which is more tax-efficient.

There are plenty of companies that will "diworsify", that is, make acquisitions that do not add to sales or the profitability of the company. It is an unfortunate thing. However, there are also plenty of companies who frequently make accretive acquisitions and/or can increase the scope of their operations by reinvesting cash into their business. Coca-Cola has been paying dividends for over 100 years. If they had been reinvesting that money in their business or stashing the cash in a bank, just think what they could have done. They could of probably bought out pepsi decades ago and have a virtual monopoly on the soft drink industry.

It all comes down to management, good management will retain free cash and increase book value, thereby making dividends meaningless or even negative for shareholder value. Bad management may lose free cash thereby making dividends better. However, Paying a dividend is usually not going to keep management from losing cash. There will usually be plenty of cash left over after dividends are paid for management to lose. If management is terrible, the only solution would be to pay out all the free cash flow as dividends, but that results in a dangerously rigid cost structure. Most dividend investors look for a lower dividend payout ratio, which means they want less cash flow to be paid out as dividends, which is backwards from the argument that those same dividend investors make that dividends discipline management so that they don't lose dividend money. If the payout ratio is low, it means there is plenty of separate cash around for management to lose!

The point is, I only invest in good companies with good management that can retain earnings. Dividends do matter when management cannot retain earnings, but I don't want to own those companies. So dividends just do not matter to me.
22 Feb 2010, 10:39 PM Reply Like
• "Most dividend investors look for a lower dividend payout ratio, which means they want less cash flow to be paid out as dividends, which is backwards from the argument that those same dividend investors make that dividends discipline management so that they don't lose dividend money. If the payout ratio is low, it means there is plenty of separate cash around for management to lose!"

Superb point, Hester.
14 May 2010, 02:01 AM Reply Like
• Hester, a quick point: Note that paying down debt can be inefficient in terms of tax and long term returns. Remember all that financial theory about the optimum mix of debt and equity?
14 May 2010, 07:26 AM Reply Like
• Author’s reply » I concur,

However, a lot of dividend investors demand even companies with high debt levels pay a dividend. As long as a company's debt is callable, paying it down will increase future earnings, increase book value, and decrease risk of insolvency if earnings/revenues slump. So the advantages are there if debt levels are even a little too high.

If a company can realistically generate, say 12% (which is about the average) return on invested capital, and they have outstanding debt with a fixed interest rate of, say 6%, then they shouldn't pay a dividend or pay off debt, they should reinvest!
14 May 2010, 10:49 AM Reply Like
• Nice analysis hester- I do have two critiques of it though

you mention price raises/drops due to dividend increases/decreases as a market inefficiency to be taken advantage of. While I do think the market over reacts to a dividend cut (i'm invested in a situation, DHT, like this and plan on writing an article shortly), the reaction can be warranted (i.e. correcting a previous market inefficiency or oversight). Dividend cuts and raises are generally suggested by management, who tend to know more about the true value and trend underlying the business than investors. Management normally only suggests a dividend raise when they are confident in the future of the business AND believe the business can safely sustain paying out that cash permanently into the future. Management hates to cut the dividend (knowing the market will see it as a sign of weakness), and will often do everything they can to keep from doing it.... so when they do cut the dividend, it's normally because the company really needs that cash. Think of the banks circa 2007/2008. They saw their capital and credit freezing when investors were still betting on a short term hiccup. When the banks cut their dividends, it sent a signal to the market that they really needed that capital. Also, any company that raised their dividend after Lehman went bankrupt really sent a signal to the market that they were confident in the strength of the business.

Also, in general, I, like you, prefer stock buybacks to dividends (more tax efficient, i am generally invested in a stock because i think it's undervalued so the increase in ownership is a nice plus, etc.). However, especially in small caps, it sometimes is nice to see dividends instead of buybacks. Compare one of my recent write ups, RSKIA, to your write up of LOAN (i believe both are undervalued, own RSKIA, and am strongly considering investing in LOAN). LOAN has a share repurchase program, while RSKIA has a dividend. Both programs return capital to shareholders, and if you're convinced a company is undervalued, you can take the dividend and go purchase the shares, effectively turning the dividend into a share repurchase program. LOAN, however, has not really followed through on the share repurchase program, so in actuality they are not returning capital to shareholders and increasing shareholder value. RSKIA has to return that capital once they declare the dividend, and I can then go buy the stock to increase my ownership. True, it's not quite as efficient tax wise, but I know the company has to follow through on the capital return.

I, like you, never invest in a company because of a dividend. However, sometimes dividend policy can provide me a hint that management is concerned with shareholder value, or provide evidence that further strengthens or weakens my investment thesis.
13 May 2010, 08:21 PM Reply Like
• You write, Whopper: "Management normally only suggests a dividend raise when they are confident in the future of the business..." Now how do you know what "normal" is? And if you do--or don't--how confident can you be that the payment of a dividend is a good sign--and substitute for the kind of analysis Hester advocates? Isn't it about as useful as relying on a credit agency to tell you, rather than doing your homework, what the credit worthiness of an investment is?
14 May 2010, 07:10 AM Reply Like
• Author’s reply » Whopper, you make some good points, however I disagree with some things you wrote.

"Management hates to cut the dividend (knowing the market will see it as a sign of weakness), and will often do everything they can to keep from doing it.... Think of the banks circa 2007/2008. They saw their capital and credit freezing when investors were still betting on a short term hiccup."

The problem is, dividend policies are very rigid. As you said, management hates to cut the dividend and will do everything they can to keep from doing it. This can be fatal for some companies. It is interesting to mention the banks, because a lot of them were paying dividends right up to the point of insolvency. Check out AIG's 5 yr. chart on google finance (where they show the dividends paid) They paid basically right up until their equity lost most of its value and the business had to be saved by Uncle Sam. Some companies really need capital to grow or maybe even fight insolvency, and yet these companies keep their dividend policy just to preserve their dividend record and keep their dividend "investors happy.

It all boils down to this, can the company generate more than a dollars worth of value for each dollar retained (after inflation)? If the answer is yes, then no dividend. If the answer is no, then pay out all the dividends you can. For most, if not all the stocks that I own, the answer is theoretically yes. They can either reinvest in their business and create substantial more value, or buy back their stock (which is undervalued, or else I wouldn't own the stock). Buying back your own stock that is selling for 50 cents on the dollar is a very tax efficient way of achieving a 100% cumulative return. However some choose not to buy back an obviously cheap stock (LOAN), to their detriment. A dividend in LOAN's case would be great, because they may lose retained earnings investing in outside ventures as they have done in the past.

A dividend taken not from earnings, but from assets is also a good thing if the stock is selling below liquidation value. If LOAN wanted to, they could just slowly liquidate assets and pay a few dividends over the next year and investors would recieve more in dividends per share than the cost of one share.
14 May 2010, 11:15 AM Reply Like
• Hester, excellent display of thinking. The dividend lovers are gnashing their teeth! But, as Charlie would say, What the hell!

I have a couple of comments: standard exchange practice is to discount a stock price ex dividend by the amount of the dividend. This has always puzzled me. We should not take this to imply a one to one relationship; it is instead an arbitrary adjustment.

Here's why: the value of a company as a going concern is driven by the marginal return on capital. Thus price ultimately reflects marginal return. So a high marginal return would suggest a high multiple of price to book value, and the payment of a dividend would clip that multiple proportionately as it clips the amount of marginal capital available to generate a marginal return. So, dividend lovers excepted, one would expect that the payment of a dividend lowers the potential compounding, and the effect on share price would be more or less than a one to one ratio and depend on the marginal return.

An explanation of this conundrum might be that earnings at the margin are cash and that the payment of a dividend comes out of cash; hence, a one to one relationship. But cash is reinvested at a marginal return, and this ultimately determines value and price.

Unfortunately, as much as growth in intrinsic value and ultimately price is determined by marginal return on capital, determining what the marginal return of a particular company is is difficult to impossible to assess. One has to look to signs, and here the payment of dividends is a useless sign. A careful analysis of management and corporate culture can be. But this is Charlie Munger territory, not Ben Graham territory. The latter lived at a time when hard assets selling at a discount were littered all over the landscape--cigar butts. Charlie recognized that the truly great company was one that allows you to sit on your ass (a fine position from which to think and read!). To be truly great a company has to have the capability of generating high marginal rates of return persistently well into the future.
14 May 2010, 07:49 AM Reply Like
• Author’s reply » Briar, great points, you practically read my mind.

One of my pet peeves is people thinking a dividend paying company is automatically of high quality. Recently a poster to one of my articles accused me of "misleading" readers because I called my company "investment grade." He argued that investment grade companies were large and paid dividends. This is how most people think. They see a large company that pays dividends and they think, "Ah a safe blue chip company." Then they look at a small company with no dividends and think, "Boy, this is speculative."

In reality, size and dividend history having nothing to do with business quality. Since the value of the business lies in the future, only quality assets and/or reliable and consistent future cash flows measure a company's quality. Many large dividend paying company's proved terrible investments in recent years. GM, GE, BAC, AIG and many others either went nearly went insolvent, or had to receive federal aid to not go insolvent. In either case the common stockholders lost big. Yet all those companies were large and had a long history of dividends.

I think a lot of dividend investors invest in stocks because they need money to live on, and still want the excitement of owning a stock that could potentially appreciate in price. They are comforted by the illusion of safety that a long dividend history provides, sometimes failing to see future risks. They argue that dividend paying stocks outperform, but this compares stocks with positive earnings to stocks with AND without positive earnings. They never think about what kind of performance stocks with positive earnings (or companies that could pay a dividend but don't) would have against dividend stocks. I personally think most of them should be in corporate bonds, where they could probably get twice the yield on their capital, and take substantially less risk.
14 May 2010, 11:34 AM Reply Like
• Hester, you and I have little to disagree about! Your willingness to think flexibly and to question conventional wisdom puts you in Charlie Munger's camp, where we all should be. There is much to be gained by having the willingness to question the assumptions we tend to collect. You will not persuade the dividend lovers, but you will sharpen your own thinking. Don't let up! And your contributions to SA might spark a few converts.
14 May 2010, 08:55 PM Reply Like
• dopexile
, contributor

When you rely solely on capital gains to make a profit you are at the mercy of whatever price Mr. Market offers when you want to sell.

At least with dividend stocks you have two ways to make a profit... either from the capital gains or from the dividend payment.
7 May 2013, 10:38 AM Reply Like
• Dopexile: I would encourage you to read and ponder Ben Graham's allegory on being in business with Mr. Market. And consider also that payment of dividends comes straight out of book value. Most companies shares trade at multiples of book. So why, pray tell, should you be eager to accept \$1 when the market is offering you 1.5, 2.0 times that? Why accept the lower price?

The answer, of course, lies in our cognitive biases: we anchor our decisions to some higher price, which might come the day after you sell. A dividend does not confront your cognition in this way. But shouldn't be worth figuring a way around our cognitive shortcomings, rather than accept what is obviously a lower price?

Consider also that the receipt of a dividend is the equivalent of sell a zero-cost-basis lot.
8 May 2013, 09:07 AM Reply Like
• dopexile
, contributor

You bring up some very valid points but companies do not necessarily trade for premiums to book value.

The value of a stock is simply the value of its future cash flows discounted today after taxes. It is very likely that taxes will rise in the future and that interest rates will rise which will reduce the present value of stocks. In those scenarios any retained earnings could be valued at a discount.

One of the positives of dividends is that it instills discipline into management and align interests. They are far less likely to engage in risky behavior because they know they have a quarterly obligation to shareholders.

On the other hand, share buybacks create a moral hazard because management objectives for determining incentives are often tied to per share performance... a company may not be doing much to improve a business but management gets a large payout because they've been buying back shares to meet goals. All too often the retained earnings get used for foolhardy investments when it would be better returned to shareholders.

This often motivates companies to buyback shares when they are overpriced, and that ultimately destroys shareholder value. When stocks were low and the market crashed hardly any companies aggressively bought back shares because of fear. Now that stocks are richly valued every company is buying them up.
9 May 2013, 12:33 PM Reply Like
• dopexile: if you own companies whose managements you don't trust, then some of your points make sense. But I would encourage you to invert and to ask what kind of a company would I really want to own for a long time. That would be an enduring business with a moat, which you can understand. It would also be a company whose management you trust: managers who would instinctively do what you would do if you were in their shoes and had their knowledge of the business. Then you would leave it to them to allocate capital in the most efficient way they can find.

If you accept such a description then spend your time hunting for companies that come closest to living up to the standard you have set. Don't worry, you won't find many, but that makes life easier for you--and likely more profitable than putting constraints on managements because you don't trust them.

Count me as a skeptic. I have seen too many companies that pay a dividend--and increase it when they shouldn't--to through a red herring in the way of unquestioning investors. I have also seen too many companies that don't have a clear discipline in buying back stock. So look to see if a company has discipline.
9 May 2013, 03:41 PM Reply Like

### StockTalks

• Shorted VIEW last week
Jul 23, 2011