Chapter 19 : Shareholders and Managements: Dividend Policy
**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here
Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham reviews the sentiments Wall Street and the public had for dividends from common issues during the time of his writing. As we’ll see, some things have changed dramatically since he wrote but much of what he speaks about is as true now as it was then. Here’s the list of preceding posts if you’d like to get caught up:
- Intro and Chapter 1 , Chapter 2, Chapter 3, Chapter 4, Chapter 5, Chapter 6, Chapter 7, Chapter 8, Chapter 9, Chapter 10, Chapter 11, Chapter 12, Chapter 13, Chapter 14, Chapter 15, Chapter 16, Chapter 17, Chapter 18
Graham’s focus throughout The Intelligent Investor has been evaluating the business as the owner. He urges us not to speculate, but to invest in companies that meet our standards of value. In this chapter, he turns his attention to the dividend and who influences the policy of its payouts and what the Intelligent Investors should be doing while their fiduciaries make the rules.
With Graham’s emphasis on buying as an owner, there is little wonder that he saw the dividend policy in the 70’s as something that lacked even the fundamental aspects of his philosophy. Instead of investors focusing on steady payouts, they let management plow earnings back into the business to fatten their own wallets while the investors were forced to wait for justified results of the lack of a cash distribution. Graham further hammers on his points that investors should be highly demanding and critical of their fiduciaries in the businesses they own because they are the owners, therefore the management should constantly be maximizing profits for the owners.
Time and time again, Graham focuses on the idea that the investors of his day began to turn a blind eye to the dividend policy of the companies they owned, and instead relied on the management to make the decision even if there had been no validation for the reinvestment of the earnings.
He recommends:
Shareholders are justified in raising questions as to the competence of the management when results :
1. are unsatisfactory in themselves
2. are poorer than those obtained by other companies that appear similarly situated
3. have resulted in an unsatisfactory market price for a long duration
He admits that although common shareholders need to be the ones asking these questions, they rarely are. He posits that instead of the mass of shareholders swaying the decisions of the management, only a few key individuals tend to modify a management’s strategy. He even goes as far to say that sometimes where a group of shareholders should demand payouts instead of stock price appreciation or significant decline, these shareholders are often bought out by private investors who essentially “bail out” these common shareholders from a bad situation. While this style of bailout is preferred, it appears that the shareholders should have already been pursuing action from their management in the favor of the shareholder instead of management’s pocketbook.
Recommended Dividend Policy:
Graham indicates there is a delicate balance between shareholders asking management for more payouts, and management stating that the payouts really aught to be reinvested “to strengthen the company”. Zweig fills in that in Graham’s day, a standard “payout ratio” (net income that companies paid out as dividends) was 60–70% , which slid even further to 35–40% in the end of the 1990's, clearly showing the shift in shareholder attentiveness and ferocity to pressure management on whether they truly were making the right decisions to “strengthen the company”. As an owner of a small enterprise, you’d be feeling the pulse of the company daily and making sure your management was maximizing value for you. Why should this be any different with a larger, publicly held company?
Graham called this the “profitable reinvestment” theory and argues that it is a trend that has been ever-increasing as time passed. Furthermore, he cites examples where a dividend policy had been continually against further or continued dividends, while the company’s price continued to rise. Only during price downturns were dividends thought of. One might wonder whether the dividends were only used at those times to try and gain interested from the public to help raise the price.
At the time of his writing Graham argues the following:
Where prime emphasis is not placed on growth, the stock is rated as an “income issue”, and the dividend rate retains its long-held importance as a prime determinant of market price. At the other extreme , stocks clearly recognized to be in the rapid-growth category are valued primarily in terms of the expected growth rate over, say, the next decade, and the cash-dividend rate is more or less left out of the reckoning.
He concedes that while what he writes above is true, there are still many companies that hold an intermediate position between growth and non-growth enterprises, making it hard to judge whether they are , or are not using an appropriate dividend policy.
Graham offers that shareholders should demand that their management either have normal payouts of earnings (he argues of 2/3 earnings) , or else a clear-cut reasons that the reinvested profits have produced satisfactory increases in the per-share earnings.
Graham continues onto companies that are operating with mediocre results and really hits the investing public hard as he offers that there is essentially no reason that the investor should consider management in the “right” when their reasoning for withholding dividend payments in a struggling company is so that the company can continue to expand or get back into a positive state. With that, he concludes that the management is primarily at fault for poor earnings. Furthermore, they should now have a tough time explaining with any validity, the reason that they should keep any profits within the company given they mishandled any prior profits in the first place!
Commentary
Zweig’s commentary is robust and in line with Graham’s arguments. He reminds us that there are two questions that we intelligent investors should focus on when considering our position as current owners in a firm:
- Is the management reasonably efficient?
- Are the interest of the average outside shareholder receiving proper recognition?
What I liked about Zweig’s statements are that he points out a statement that is sometimes forgotten. The proxy. Using an example from Enron, he shows that while reading the proxy is necessary, you should “never dig so deep into the numbers that you check your common sense at the door” and that you should read the proxy statements before and after you buy the stock. By reading Enron’s proxy and using common sense, many investors should have been able to see the flaws in Enron before the company deteriorated. His data suggested that between 1/3 to 1/2 of all individual investors do not even vote their proxies.
Zweig delves deeper into Graham’s philosophies of management acting as the fiduciary and offers that many businesses have management that will run things with more cash in the business than it really needs. This allows management a bit more cushion in their decisions, and keeps their wallets a little fatter, the whole time the owners are missing out on cash. He recommends that each investor should be honest and forthright about their dividend wishes to their management. “Paying a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the manager’s hands before they can either squander or squirrel it away.”
As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.
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-David
