Sunday, March 18, 2007

One of the clearest signal

For most people, I'd bet you would prefer to spend time with your family and friends, doing almost anything else, rather than to actively manage your investments or working in your regualr job. Yet if you do not take care of your money, it'll never grow to the point where it can truly allow you to focus on far more important personal things which matter to you.
It's a tough predicament, really. If you spend too much time with your money, you'll miss out on enjoying the things that it can provide, including quality time with your family and missing out on the growing up years of your kids. On the other hand, if you ignore your finances, you won't have the money and time to spend on those things that will allow you to dictate on things which are important to you. What is clear here is balance is the key, and striking the right balance will let you have both the money and the time to enjoy things which are important to you. With that said, most of you would think that is a dream but who wouldn't? But it can be a reality if you seek for the treasure which are buried a little more than a foot beneath.
As you may be aware, the most optimum strategy of investment for an individual is for a business to retain all its earnings and reinvest in the business provided that the business can generate a return better than what is being returned to the shareholders. Having said that, there's only one business which I know in the world wide world that does it this way, that is Berkshire Hathaway. And the result of this is its book value grew from $19 in 1965 to $59,377 in 2005. Although clearly, this is an extreme case of an optimum investment result, the next best case scenario is how efficient a business is able to return its shareholders any excess capital. There are two ways, firstly, is through cash dividends and second, through stock repurchase. Giving through dividends is a direct method where the shareholders are able to feel its impact right away. The second way is an indirect method where it takes some time or a lag in period before an investor can feel the impact.
The extent of how these two methods are employed will also demostrate one clear fact, that is the financial strength and outlook of the business. One of the best measures of how a company is performing is through "free cash flow" (defined as cash remaining after capital expenditures required to support the growth of the business). Its virtue is its simplicity and clarity which means you either generate cash or you don't and it is not subject to many varying interpretations or accounting changes, in the words of Ralph Larsen (former Chairman and CEO of Johnson and Johnson). In saying this, I shall give one extreme example. Enron, the business that went bust in late 2001, is a prime case of how one can tell straight from the face that Cash Flow Statement demostrates what Ralph said is absolutely correct, simple and clear where the business generate cash or not. On Enron's Profit and Loss statement, year after year, their profit was on an upward slope, culmulating at more than a billion of profit in the year before they went bust. One key policy which helps Enron to show this profit is how they adopt a certain accounting policy. Enron used "Mark-to-Market" accounting treatment for its revenue. What this essentially means is if you have a contract that provides for $100B of revenue for the next 20 years, you can actually use a lot of assumptions to calculation how much profit you can achieve for the next 20 years and book the profits you assumed on the latest financial year. Of course, for a 20 year contract with $100B of revenue, you will not have the money flowing in all in one shot on the year you sign. It will come as and when the job is perform. On the other hand, Enron's cash flow statement is perpetually shown with a negative operational cash flow, which means the business consumes more capital than it is able to generate. But at that time, many were blindly when they were at a party and most were willing to look at the other end until someone shouted "Fire." In short, what this means in Enron's case is the profit shown is paper profits without real cash coming in through the door.
So if you have a strong and excellent balance sheet, it can be demostrated through a constant share repurchase program (as demostrated by Home Depot, Radian Group, Johnson and Johnson, amongst others in recent times) and a constantly increasing cash dividend scheme which is increasing year on year. More importantly, an excellent financial position will provide an enormous flexibility to invest in growing a business and to seek out and act upon new opportunities which of course is one of a much hidden significant competitive advantage one can have. Coupled with that, it brings with it much lesser pressure compared to someone else who have to leverage in order to invest. Imagine if you have the excess cash to invest in a business which is bound to be profitable, you will not face the pressure of having to settle your borrowings for the interest. On the other hand, if you borrow to invest in a business, before you count the eggs, you have to make sure that there're enough eggs to return to the lender and if it is a mediocre business, you will bound to be pressured and when pressure comes along, the natural tendency for a person is they tend to make more mistakes than when they are calm.
Here we shall focus on how a dividend-focus investing strategy can be made attractive. Companies that pay dividends to their owners do so for two key reasons. The first is to directly reward them for the financial risks they have taken by investing in the company. The second which is slightly more subtle but is even more important is to signal the likely future for the business.
By paying attention to the signals that dividends send, you can greatly simplify your investing research. Some questions about the company's dividends can help you cut through the clutter is: 1) Are they sustainable, 2) Are they growing reasonably?
A company's dividend policy can tells you volume about what the business really expects for its future. Because of the bad press and extremely negative market reaction to a dividend cut, companies don't like to cut that payment if it's at all possible. On the flip side, the magnitude of a dividend increase can really reveal how confident a company's management is in its business plan. After all, since nobody wants the bad press of cutting a dividend, a company will typically only raise its payment if it's pretty certain it can make the higher payout.
As a result, you can often determine better the real truth about a business from its dividend practices than from virtually any other statement or financial report. That's the signalling power of a strong dividend policy.
Although dividends are probably the most maligned and ignored part of the average investment strategy, more often than not, a dividend policy represents a tiny fragment of an investor's stake in a business. Given the wild gyrations in stock prices these days, the total value of a year's worth of dividends can be added or taken away from a company's share price in less than a week. It's thus sometimes a pity dividends are treated with so little respect. Dividends often seems too small to be useful, yet somehow still can manage to cause all sorts of headaches during tax time. But believe it or not, those low little payments, if used to their full potential, can help you build serious wealth. Here's an example.
Howard, in 1985, invested about $15,000 in Johnson and Johnson. His first year dividends in 1985 was about $497. Now after 21 years of dividend increases and a few stock splits, he received $9,894 in dividends for the year of 2006.
That $9,894 in annual dividend payment comes from an initial investment of $15,000. As long as Johnson and Johnson maintains its annual dividend policy and increase in dividends yearly, in about another 5 years time, he will get an annual dividend of $15,000 yearly.
While Johnson and Johnson has been an exceptional company for Howard to own, it's not unique among companies that pay and regularly raise its dividends. In fact, solid dividend-paying companies don't tend to keep their payments static. As businesses grow and mature, stockholders can expect to share in the success of the companies they own.
Here are 3 more examples. If you invested in Harley Davidson in 1989 at about $1.02, the full year dividend in 2005 was $0.625. If you had invested in Coca Cola in 1983 at $2.15, you get $1.12 in dividend in 2005. If you had invested in Wal-Mart in 1983 at $0.58, you will get $0.60 of dividend in 2005.
One of the easiest way for shareholders to get their slice of a company's ever growing pie is through dividends. Tbe larger the company's profits, the larger the dividend payments it can afford to make. In fact, well-run dividend-paying companies oftern clearly signal their expected growth by upping their dividends in anticipation of rising profits. If you hold on to a strong company that treats its shareholders well, the long-run income growth can give you some absolutely phenomenal total returns.
Having said all these, the key lesson from Howard's story, however, is the time it took to unfold. His tremendous long-run success was largely due to the fact that he had the PATIENCE to do nothing while the company continued to pay him ever-increasing amounts of cash. Doesn't this sounds like some of Warren Buffett's earlier purchase? I think it sounds so much like See's Candies, and Nebraska Furniture Mart where by now, the year profit more than pays for Warren's initial investment. If you want a shot at following in his footsteps, you too need to learn the value of such patience when you hold a great business.
Johnson and Johnson isn't the only one that provides Howard with such gains as clearly seen in the other three examples as given. Had you bought any of these businesses in those days, by now, you would be receiving at least half of your initial investment back to you - every year from now till the business disintegrate permanently. What's more amazing is you get to keep the shares that generated that income, giving you the potential for even more in the future.
As Howard's success has shown, it's a great way to invest (not a great way to fly, which by the way, I think they may be the best in their industry but it does't qualify them to be a great business with great economic strength). All you need to do is make your initial purchase of the right businesses. Then sit back and cash the checks as and when it comes in, letting your companies do the work for you. How difficult can that be?


musicwhiz said...

Been reading your blog and history too. Very good please keep it up ! I am also aspiring to be a value investor amid the market noise and day traders. Moderately successful so far, as I only started 2.5 years ago.

Btw, you might like to leave a line between paragraphs, makes it easier to read. Thanks !

Berkshire said...

Hi Musicwhiz,

Am glad I've got another audience. Appreciated your comments. Actually I try to leave a line in b/w. But despite my attempts to of having a line in b/w when I post online, it came out otherwise. I do not know what's the prob. Sometimes it works, sometimes it dun and btw, I'm quite an tech-idiot.

Will try to write some more things on value investing for sure and hopefully, the quality is something which is of use to helping others to get into a sustainable model in investing. I started not too long bad too, 1.5 years in fact and I gotta say I am very lucky to even discover of there is such a method called value investing.

Once again thank you for coming by.

Anonymous said...

Long time no write. Great writings. I'm surprise to hear that you have been investing for only 1.5 years. U sounded like a pro... JNJ is a company that I have been evaluating and have found it a great company to buy.

I agree with you on looking at FCF (Free Cash Flow). Something that I always look at when I value a company : )

I was hoping that you mentioned how Enron's FCF is on the years just before the collapse. Cause I didn;t find the time to evaluate them myself.

On FCF, do you reckon negative FCF is always bad? I am currently evaluating a company who is expanding and have larger capital outlay resulting in negative FCF. My thinking is that it depends on the activities of the company during the time. Trying to seek some other opinion.


Berkshire said...

Hi Jojo,

Thank you for coming by again. Generally, a good business should not consume capital more than they can generate capital. On the other hand, if the business is a start-up with a business model which is at its infancy with lots of so-called growth, maybe it warrants a situation where the business can expand larger than they are generating income.

However, having said that, it is best to extract a few years of financial statements to see if they are perpetually in negative ground in FCF.

But I learnt recently from Sam Walton that to operate a successful business, one of the attributes is to "think small", taking one step at a time. But of course at times by followin so, you'll miss out on some hot moving trains but overall, it is ok.

Anonymous said...

I totally agree that we have to look beyond just one years. Perhaps if we have 5-10 yrs history would be even better.

Did you managed to look into the free cash flow for Enron just few years before they collapse ? Was it all negative? Curious to know.


Berkshire said...

Hi Jojo, I did not have the opportunity to see. In fact, the financial statements are still available somewhere but I don't know where to search for it.

As far as I know, Enron's FCF is in negative ground from a book I read. It is called "The smartest guy in the room." A book on Enron rise and fall.