Security Analysis Series: Chapter 29 Summary

“The Dividend Factor in Common-Stock Analysis”

Chapter Summary

  • The dividend rate and record is considered primary aspect of valuation by some, and not so by others. (pg 376).
    • These two views are summarized by Graham as follows:
      • 1. Dividend Return as a Factor in Common-Stock Investment
        • “The prime purpose of a business corporation is to pay dividends to its owners.” (pg 376).
        • Markets tend to reflect this viewpoint, paying a higher price to companies that pay out more as opposed to having higher earnings.
      • 2. Withholding Earnings Creates Value
        • Management can be justified in withholding earnings, IE not paying dividends, to strengthen the company’s financial position. (pg 378).
        • However, stock owners tend to despise this viewpoint; they prefer dividends today, as opposed to the potential of supposed future returns by withholding. (pg 378).
  • Graham generally deems that a conservative dividend policy, or withholding more earnings than not, is objectionable in most circumstances. (pg 380).
    • Saving up earning in surplus to protect the dividend rate for future bad times “often fails to safeguard even the moderate dividend rate”. (pg 380).
    • What benefits the company benefits the stockholder, so long as that benefit does not come at the expense of the stockholder. And it is not certain that plowing back earnings is typically to the stockholder’s advantage, particularly considering the compound interest forsaken on the amounts not paid out. (pg 381).
  • The “despotic powers given the directorate over the dividend policy” are extremely vulnerable to being abused. (pg 382).
    • They can also be determined by the substantial shareholders that control the company/management.
  • If stock can not be sold at par or an advantageous value, management of “watered stock” may seek to build assets through withholding earnings. (pg 393).
  • Graham’s experience in the market confirms that “a dollar of earning is worth more to the stockholder if paid him in dividends than when carried to surplus”. (pg 384).
    • However, “an extra-liberal dividend policy cannot compensate for inadequate earnings.” (pg 385).
  • Various definitions established… (pg 385).
    • Dividend Rate: amount of dividends paid per share (in $ or as a % of $100).
    • Earnings Rate: amount of annual EPS (in $ or as a % of $100).
    • Dividend Yield: ratio of dividend paid to market price.
    • Earnings Ratio: ratio of earnings to market price.
  • Graham thus concludes the previous analysis with the following principle: “Management should retain or reinvest earnings only with [stockholder approval]. Such ‘earnings’ retained to protect the company’s position are not true earnings at all. They should be…deducted in the income statement as necessary reserves…A compulsory surplus is an imaginary surplus.” (pg 386).
  • Concluding that a liberal dividend policy is attractive, Graham recognizes the paradox: “Value is increased by taking away value.” He believes this paradox is addressed in his earlier analysis. (pg 387).
  • Reiterating, dividends withheld are not true “profits”, but reserves that had to be plowed back in order to protect the business. (pg 388).

Chapter Analysis and Thoughts

  • Graham’s distaste – to put it lightly – for the North American system of management is on full display in his quote about their “despotic” powers. While I still need to conduct further research, I have been unable to find a single quote by him in which he views management teams in a positive light. And while I am unsure of his views on the value of management, I personally think there exists massive value in selecting companies with quality management teams. Human capital is not listed on the balance sheet, and it is my suspicion that investors, especially in cyclical bear markets, ignore that value.
  • I think Graham fails to address the larger issue presented by his analysis. While it is true that there exists a compounded opportunity cost to earnings withheld by a company, isn’t it also true that those same earnings put to surplus ought to generate compounded interest themselves? Moreover, isn’t the entire purpose of investing in a company to earn a rate of return above the market average, which is presumably what a dividend paid out would earn? If we are doubting a company’s ability to earn that above-average rate of return, why invest in the company at all? Thus, I believe Graham has contradicted himself in this chapter.
  • The idea of a “compulsory surplus” being “imaginary”, or without value is also inaccurate in my view. Surely it offers some cushion to bear markets, or a potential area of which management can draw funds from to invest in capital in the future; however, I think Graham is on to something. That is, if management deems it necessary to establish that protection, the investor must proceed with a certain deal of caution.
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