Security Analysis Part IV: Theory of Common-Stock Investment. The Dividend Factor (2024)

The original theory of investing in common stocks was based on a threefold concept:

• A suitable and established dividend return
• A stable and adequate earnings record
• A satisfactory backing of tangible assets

In other words, it was based almost entirely on the past and present. In addition investors did not expect capital gains from their stock, their return was to consist almost entirely from the dividend (which exceeded what they could obtain from a bond) and the potential of increases in this dividend. The purpose of analysis was almost entirely to find elements of weakness.

The passage of time began to show that past earnings were not predictive and intangible assets began dominating tangible ones.

“The history of industrial companies was a hodge-podge of violent changes, in which the benefits of prosperity were so unequally and so impermanently distributed as to bring about the most unexpected failures alongside the most dazzling successes.”

This led to the new theory, which stated that the value of a common stock depended entirely upon what the company would earn in the future. The argument continued, that because of this good stocks where those with rising earnings and finally that good stocks would prove successful investments. This led to the following corollaries:

• The dividend rate does not matter
• Asset value is devoid of importance
• Past earnings are significant only as a measure of the earnings trend

The fatal conceit of this theory was two-fold. First, price did not appear. Growth was good no matter how expensive the stock was. Second, it abolished the important difference between investment and speculation. Moreover, there was no particular reason to believe that the past trend in earnings was any more stable than the actual earnings which had proven a poor predictor. As well as the potential of falling prey to the ‘Turkey Problem’ — the Turkey feels the most safe (statistically) the day before Thanksgiving.

“This example illustrates one of the paradoxes of financial history, viz., that at the very period when the increasing instability of individual companies had made the purchase of common stocks far more precarious, than before, the gospel of common stocks as safe and satisfactory investments was preached to and avidly accepted by the American public."

The new theory also led to the creation of investment trusts. In theory they began on the right principles but the nature of the market soon made them go astray. Originally they preached buying in depressions and selling in prosperity, diversifying holdings across industries and countries, and conducting comprehensive statistical investigation to find undervalued companies. The problem was that demand for their services peaked during ball markets and fell in bear markets. So they always ended up buying at the top and selling at the bottom.

New Theory and Growth Investing

The premise of common stock investing requires a top down country outlook. It only makes sense if the national wealth and earning power will continue to increase, this increase will show itself in corporate earnings, and it will take place through the capitalist process of capital investment and reinvestment of profits.

Following that, an acceptable canon of stock investing is:

• Investment is conceived as a group operation, where diversification reduces risk and yields a favorable average result
• Individual issues are selected by means of qualitative and quantitative tests corresponding to those employed in fixed value investments
• A greater effort is made (than in bonds) to determine the future outlook of the issues considered

Growth investing has significant problems to be overcome. First, is that when a trend has been established over business cycles, it may be at the exact point that the trend stops. Beyond that there are three main issues, what makes a growth company, can they be identified a priori, is the growth priced in. These issues lead to the risk, that growth will be less than anticipated, that you have paid too much for that growth, and that for a long time the market will undervalue that growth.

Growth can be called truly “investment” if two conditions are met. First, that the elements affecting the future are diligently researched with a skeptical eye and understood. Second, that price paid be in accordance with what a knowledgable business man might pay for full control of the business. The best situation is when you find a growth company that doesn’t look like one as the market will not be valuing the growth. The problem with this is that almost by definition you will be building your theory on something other than the generally accepted rules and standards

Market Timing and Margin of Safety

Buying stocks with a margin of safety generally has two approaches. Buying broadly when the general valuation of the market is depressed, and buying undervalued individual stocks. The problem with the first, market timing, approach is that you need a very particular psychological makeup to be successful at it. You need to be fine with selling and then seeing the price keep going up, and buying and seeing the price keep dropping.

A successful market timing strategy could be as follows:

• Select a diversified list of industrial stocks
• Determine a base or normal value for the group based on discounting their average earnings at a rate related to bond yields
• Determine a buying point some percentage below this base and a selling point some percentage above

The best approach for selecting undervalued stocks, is to look for companies that are quantitatively cheap but that have average growth prospects. Profitable securities with boring businesses tend to get undervalued because the market obsesses with companies that have unusually good growth prospects. This is especially true if the boring stock has just had a down year.

The Dividend Factor

The three main factors in stock valuation are, earning power, asset value, and the dividend rate and record which is most confusing. Some will see a business as a partnership whose purpose is to pay out profits; but if profitable opportunities exist then profits should be reinvested. The problem arises when profits are invested poorly; instead of to the benefit of the company and shareholders they are invested to the benefit of management. This is generally seen in lavish unnecessary perks, empire building, and building reserves. If truly needed, the amount dedicated to reserves is not profit at all and should be deducted from the income statement; a compulsory surplus is no surplus at all. If unnecessary they merely make management’s job easier at the expense of their shareholders and should be a negative signal of management’s incentive alignment.

In general a dollar of withheld earnings has not been worth a dollar of market value and thus it makes sense that investors would value more highly earnings from companies with high payout rates. Dividend policy, given a certain business performance, serves as a signal of whether management cares about shareholders. Dividend policy should be well thought out and dynamic, not a result of tradition or general market policy. Stock holders should more active about reviewing it and obtaining the necessary information from management to decide whether marginal opportunities are profitable and should be funded.

Notes on Introduction: Go With The Flow

Owner earnings is the cash the owner can pocket after paying for all expenses and making investments necessary to maintain the business. To calculate this, one should start with GAAP earnings. Then, add back depreciation and amortization (which are on a historical cost basis). Subtract the true cost of maintaining and replacing intangible and tangible assets in order to keep profits stable. Adjust for items managements are notorious for misestimating, such as pension liabilities and management compensation. Adjust for long term contracts, such as underwriting loss estimates for insurance companies. Adjust for expenses that should have been capitalized but where expensed (customer acquisition costs for example).

Management’s capital allocation is one of the largest drivers of stock returns. In declining industries they should be returning money instead of investing at low rates, and when the stock is undervalued they should be buying back shares. At the same time, one needs to be careful of management using capital to ‘maintain appearances’ for example GM and Citigroup decided way too late during the financial crisis to cut their dividend. Generally, in extreme cases where management does not act in the interest of shareholders activist investors will show up and demand the return of capital.