The intelligent investor
The other day I was exposed to “The Intelligent Investor” by Benjamin Graham. It is the definitive book on value investing.
The book has been described by Warren Buffet as “By far the best book on investing ever written”. It was first written as far back as 1950 but has been revised and re-printed numerous times since then. It is as fresh and relevant today as it was in 1950.
I found Chapter 19 ” Shareholders and Managements: Dividend Policy” of particular interest because it expatiated on a subject that I have written about from time to time for many years, ever since 1978 when I was Chairman of the Ceylon Chamber of Commerce. Broadly my viewpoint was that boards of directors in this country tended to minimize their dividends rather that maximize them within the limits of prudence. These views were (in some ways understandably) not shared by many other chairmen. There are many reasons why boards of directors prefer to minimize their dividends, and I have written at length on them. I shall touch on the subject again because it needs repetition.
I found to my delight that Benjamin Graham’s ideas were close to mine. I shall quote from him for the benefit of doubters:
(page 492) “It is our belief that shareholders should demand of their managements either a normal payout of earnings – on the order, say, of two-thirds, or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings”
I have underlined some extremely significant comments that are made almost in passing: Graham considers a 60 per cent payout as normal (I have been recommending a modest 50 per cent as desirable, and am probably looked upon as a maverick).
(page 489) “In the past the dividend policy was a fairly frequent subject of argument between public, or ‘minority’ shareholders and managements. In general these shareholders wanted more liberal dividends, while the managements preferred to keep the earnings in the business “to strengthen the company”. They asked the shareholders to sacrifice their present interests for the good of the enterprise and for their own future long-term benefit….But there were several strong counter-arguments such as: The profits belong to the shareholders, and they are entitled to have them paid out within the limits of prudent management; many of the shareholders need their dividend income to live on; the earnings they receive in dividends are ‘real money’ while those retained in the company may or may not show up later as tangible values for the shareholders. These counter-arguments were so compelling that, in fact, the stock market showed a persistent bias in favour of the liberal dividend payers as against the companies that paid no dividends or relatively small ones.”
“In the late 1990s technology companies were particularly strong advocates of the view that all of their earnings should be ‘plowed back into the business’ where they could earn higher returns than any outside shareholder could possibly by reinvesting the same cash if it were paid out to him or her in dividends. Incredibly, investors never questioned the truth of this patronizing Daddy-Knows- Best principle – or even realized that a company’s cash belonged to the shareholders and not its managers.”
“A niggardly policy has often been imposed on a company because its financial position is relatively weak, and it has needed all or most of its earnings (plus depreciation charges) to pay debts and bolster its working capital position. When this is so there is not much the shareholders can say about it – except perhaps to criticize the management for permitting the company to fall into such an unsatisfactory position. However, dividends are sometimes held down by relatively un-prosperous companies for the declared purpose of expanding the business. We feel that such a policy is illogical on its face and should require both a complete explanation and a convincing defense before the shareholders should accept it. In terms of the past record there is no reason a priori to believe that the owners will benefit from expansion moves undertaken with their money by a business showing mediocre results and continuing its old management.”
This last paragraph should strike a chill into the hearts of managers that have blithely deprived their shareholders of reasonable dividends in the helter-skelter pursuit of expansion.
I do not wish it understood that Graham recommended high dividend payouts for all companies regardless of other circumstances. He grants that in the case of growth companies lower payouts may be acceptable. There have been periods in America when it was fashionable to have lower payouts.
But I believe he has articulated the case for higher dividends with great clarity. My long-held views have been bolstered by his analysis. My present view is that our country is in a stage in its development when it would be a great benefit to our economy if ordinary shareholders – not Mafia Dons with enormous resources who manipulate the market to make huge killings – begin to look upon shares as a worthwhile investment to look after their income needs when they have retired; nest eggs on which they could depend. They would be satisfied with a steady income stream without being forced to sell their shares to earn a return on their investment. Capital appreciation is a tangible benefit only when the shares are sold.
I shall close with a brief reiteration of the motivations for directors to minimize dividends. One is their stance that higher payouts will prevent them from expanding to the degree they desire. This has been shown to be untrue by numerous companies that enjoy a good reputation, a sine qua non. This year more than 50 companies had payouts of more than 50 per cent. They have all had no difficulty in expanding as they desired. If earnings are insufficient to meet the desired capital expenditure, the company can get loans from banks, or raise funds through debentures or rights issues. For these all that is required is winning the confidence of bankers, shareholders and the general public. It is only boards with dubious reputations that would have difficulties on this score. Or those with uncontrollable expansionist urges.
Another reason why boards like to ‘plow back’ profits is that it makes their task easier. Here they are more concerned about themselves than their shareholders. It is obvious that the ability to make a profit is easier when there is more money to earn interest, without having to lift a finger. Life for the directors becomes cushier; at the expense of shareholders. The process is called ‘strengthening the company’.
There is another more sinister reason why some boards depress dividends. Shareholders get tired of holding onto shares that give them no worthwhile return. They get ‘shareholder fatigue’ to use the phrase of K.C. Vignarajah, a lone activist in the share market. They sell their shares in disgust at very low prices. And here is where the criminality comes in. The directors themselves buy up the shares for a song. It happened to me in the 1970s. I discovered by researching the records of the Registrar of Companies that the directors of the public company concerned (a very well known one) had bought up the shares in the names of nominees – all at the same address! At the end of the exercise more than 90 per cent of the shares of a so-called public company were held by the directors. All this happened before the Securities and Exchange commission (SEC ) came into existence. However, it is sad that the lethargy of the SEC is such that something similar may be happening even today. There are lone activists like K.C. Vignarajah who would be in a position to brief the authorities – if they are interested.