Saturday, June 23, 2007

Dividend Policy

When it comes to dividend policy, it is seldom explained on the logic. A company will say, “Our goal is to pay out 40% of earnings and to increase dividends at a rate at least equal to the rise in the CPI” and that’s it. There’s no explanation or analysis as to why that particular dividend policy is best for the owners of the business. Yet, allocation of capital is crucial to the business and investment management. Thus, it is important for both owners and managers to think hard about the circumstances under which earnings should be retained and under which they should be distributed.

The first point to understand is that all earnings are not created equal. In many businesses, particularly those that have high asset to profit ratios, inflation causes some or all of the reported earnings to become unreal. The unreal portion – otherwise known as “restricted” – cannot be distributed as dividends if the business is to retain its economic position. Were these earnings to be distributed, the business would lose ground in one or more of the following areas: 1) its long-term competitive position, 2) its ability to maintain its unit volume of sales, 3) its financial strength. No matter how conservative its payout ratio, a business that consistently distributes restricted earnings is destined for oblivion unless equity capital is injected.

Restricted earnings are seldom valueless to owners, however, they must be heavily discounted. In effect, it is conscripted by the business, regardless how poor its economic potential. This retention-no-matter-how-unattractive-the-return situation is reflected in many so-called undervalued stocks that are selling well below its book value. For instance, A is selling for as low as one third its book value because of its economic reality. Every time, a dollar of earnings retained for reinvestment in the business, that dollar is transformed into only 25 cents of market value. But despite this gold-turn-into-lead process, most earnings were reinvested in the business rather than paid to owners. But this is inevitable as long as the business wants to survive in the industry.

Now, let’s turn our attention to the much more valuable unrestricted portion of the earnings. These earnings may, with equal probability, be retained or distributed. Management should chose the course that makes the greater sense for the owners of the business.

This principle is not universally or commonly accepted and practiced. For a variety of reasons managers like to withhold unrestricted earnings from shareholders. This may be to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, to enhance the value of his share options, etc. But in the view of the shareholders, there’s only one valid reason for retention. Unrestricted earnings should be retained only when there’s a reasonable prospect that for every dollar retained by the business, at least one dollar of market value must be created for the owners. This will only happen only if the capital retained produces incremental earnings equal to or more than those generally available to shareholders.

To illustrate, let’s assume an investor owns a risk-free 10% perpetual bond with one very unique feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e. a perpetual life and coupons offering the same cash or reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting his cash should instead take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.

If, however, if interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were zero. The opposite course – reinvestment of the coupon – would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they’ll be available at a large discount.

An analysis similar to that made by the hypothetical bondholder is appropriate for owners in thinking about whether a company’s unrestricted earnings should be retained or distributed. Of course, the analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond example, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them to paid to you if low returns are the likely outcome of reinvestment.

Many corporate managers reason very much along these lines in determining whether their subsidiaries should distribute earnings to their parent company. At that level, the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level are often a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.

Following this approach, the CEO of a conglomerate will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO will accept no lesser behavior and will have no problem following through on this in his parent-subsidiary relationship. But if his own long-term record with incremental capital is 5% and the market rates are 15%, he’s likely to impose a dividend policy on the shareholders of the parent company that simply follows some historical or industry-wide payout pattern. Moreover, he’ll expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But ironically, he will seldom supply his owners with a similar analysis pertaining to the parent company.

When judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total increment capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of its excess cash in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns beings earned by the portion of earnings incrementally invested in the core business. The situation is similar to a basketball game: even if 11 of the 12 players are hopeless scorers, the team’s best scorer will be respectable because of the dominating skills of the star player.

Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. But most times, they don’t.

In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners’ interest in the exceptional business while sparing them participation in sub-par businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held responsible for those allocation decisions, regardless of how profitable the overall enterprise is.

Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, thus, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distribution earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.

We know excellent businesses throw off a lot of excess cash and somehow this excess cash must either be put to good use or to distribute back to owners. By distributing to owners, there’re two ways – by dividend or stock repurchase. However, what is more important is how management put the excess cash to good use through purchase of new businesses.

To illustrate, Conglomerate A owns many subsidiaries of which B is one of those. In 2006, B earned $72 million pre-tax compared to $8 million pre-tax when A acquired B 15 years ago. While an increase from $8 million to $72 million sounds terrific – and usually is – one should not automatically quantify that to be the case. You must firstly ensure that earnings in the base year were not severely depressed. If they were instead substantial in relation to capital employed, an even more critical issue must be examined: how much additional capital was required to produce the additional earnings. If a dollar of additional capital produces a dollar of earnings, it is no great feat – putting in a saving account will produce the same desired result.

In our case, B did exceptional well in both respects. First, the earnings 15 years back were excellent compared in relation to capital then employed in the business – earning $8 million on $40 million of tangible assets. Second, although annual earnings are now $64 million greater, the business requires only $40 million more in invested capital to operate than was the case then.

The dramatic growth in earning power of B, accompanied by their minor need for incremental nominal capital, illustrates clearly the power of the economic goodwill during an inflationary period (a phenomenon as detailed in the article before this). The financial characteristics of B have allowed A to use a very large portion of the earnings B generate elsewhere – acquiring C, D and so on. If an average business requires $8 million to generate an additional $1 million in pre-tax earnings, that business would, therefore, have needed over $550 million in additional capital from its owners in order to achieve an earnings performance commensurate to our fictitious business B.

When returns on capital are ordinary, an earn-more-by-putting-up-more strategy is no great managerial feat. You can get the same result personally while operating from your rocking chair – just triple your principle in a savings account and you tripled your earnings. If you know the facts, you would have held back praises for such actions. Yet, when CEOs retire, praises were often heaped for even those who quadrupled earnings in such companies during their reign – with no one examining whether this gain was attributable to many years of retained earnings and the working of compound interest.

If the company consistently earned a superior return on capital throughout the period, or if capital employed only doubled while earnings quadrupled during the CEO’s reign, the praise may be well deserved. But if return on capital was lackluster and capital employed increased in pace with earnings, applause should be restrained. A savings account in which interest at 8% would quadrupled in earnings in 18 years (of course, savings account isn’t 8% now).

The power of this simple math is often ignored by companies to the detrimental of their shareholders. Many corporate compensation plans reward managers handsomely for earnings increases produced sorely, or in large part, by retained earnings (earnings withheld from owners). For instance, 10-year, fixed-priced stock options are granted routinely, often by companies whose dividends are only a small percentage of earnings.

An illustration will show the inequities possible under such circumstances. Let’s suppose you had a $100,000 savings account earning 8% interest and “managed” by a trustee who could decide each year what portion of the interest you were to be paid in cash. Interest not paid would be “retained” and added to the savings account to compound. And let’s suppose that your trustee, in his superior wisdom, set the “pay-out ratio” at one quarter of the annual earnings.

Under these terms, your account would be worth $179,084 at the end of ten years. Additionally, your annual earnings would have increased about 70% from $8,000 to $13,515 under this “inspired” management. And, at last, your “dividends” would have increased commensurately, rising regularly from $2,000 in the first year to $3,378 in the tenth year. Each year, when your manager prepared his annual report to you, all of the charts would have had lines marching skyward.

Now to add more fun, let’s push the scenario one notch further and give your trustee-manager a ten-year fixed-priced option on part of your “business” (i.e. your savings account) based on its fair value in the first year. With such an option, your manager would reap a substantial profit at your expense – simply by withholding most of your earnings. If he was both a Machiavellian and a bit of a mathematician, he might just cut the payout ratio totally once he was firmly entrenched.

This scenario is not as far fetched as you might think. Many stock options in the corporate world simply have worked in the exact same way. They have gained in value simply by withholding earnings and not because it did well with the capital in its hands. If granting stock options as a way of compensation to its executives is a way of wresting shareholder’s funds, it will be even more unthinkable for those businesses where its managers grant options that was still regularly adding or obtaining additional capital for the business.

You would hardly see anywhere in the business world where ten-year options are granted to outsiders – ten-months are in fact very rare. The unwillingness of managers to do-unto-outsiders, however, is not matched by an unwillingness to do-unto-themselves. Any outsider wanting to secure such an option would be required to pay fully for capital added during the option period. Managers regularly engineer ten-year, fixed-priced options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value, and second, ignore the carrying cost of capital. As such, these managers end up profiting much as they would have had they had an option on that savings account that was automatically building up in value.

Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. Ironically, managers who are really exceptional to shareholders almost always get far less than they should. But when the result is equitable, it is accidental. Once granted, the option is blind to individual performance. Because it is irrevocable and unconditional (as long as the manager remains in the company), the sluggard receives rewards from his options precisely as does the star.

Ironically, the oratory about options frequently describes it to be desirable because they put managers and owners in the same financial situation. In reality, the situations are far apart. In terms of capital costs, owners have bore the burden of it whereas the holder of a fixed-priced option bears no capital costs at all. An option holder has no downside risk while the owners have to weigh the upside potential against the downside risk. In fact, the business project in which you would wish to have an option is frequently the project in which you would reject ownership – you’ll be happy to accept a TOTO ticket as a gift but you’ll never buy one.

Despite the shortcomings of options, it can be appropriate under certain circumstances. The earlier criticism on it relates to its indiscriminate use and, in this connection, there are a couple of points that need to be highlighted.

First, stock options are inevitably tied to the overall corporation performance. Thus, it should logically be awarded only to those managers with overall responsibility that causes the eventual result within their scope. The Michael Jordan of a team should expect, and also deserve, a big payoff for his performance – even if he plays for a mediocre team. While the side-kicks should get rewards that fit their performance even if he plays for a perennial winning team. Only those with overall responsibility for the team should have their rewards tied to its results.

Second, options must be structured carefully. There should be a carrying-cost factor built into it. Equally important, they should be priced realistically. Managers unfailingly point out how unrealistic market prices can be as an index of real value when they are faced with offers for their companies. But why, then, should these same depressed prices be the valuations at which managers sell portions of their businesses to themselves? Owners are generally not well served by the sale of part of their business at a bargain price – whether the sale is to outsiders or insiders. Thus, options should be priced at true business value.

In the whole wide world, only one corporation has never distributed any earnings to its owners except on one occasion. You would have guessed it – Berkshire Hathaway. Let’s turn to Berkshire and examine how these dividend principles apply to it. Historically, Berkshire has earned well over market rates on retained earnings, in other words, creating over a dollar of market value for each dollar retained – rarely (and I mean extremely rarely) has a corporation met this goal, not to mention that Berkshire is the only one for such a long time retain all its earnings and yet been able to do so. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.

In fact, if significant distributions were given in its early years, it would have been disastrous. Before the current mode of Berkshire Hathaway, it is operated under three entities: Berkshire Hathaway Inc, Diversified Retailing Company, and Blue Chip Stamps (all now merged). Blue Chip paid a small dividend, and the other two none. If, instead, the companies had paid out their entire earnings, it is most certain that there would be no earnings today, and perhaps running out of capital. The three companies each originally made their money from a single business: 1) Textiles at Berkshire, 2) department stores at DRC, 3) trading stamps at BCS. These cornerstone businesses then have, respectively, 1) survived but earned almost nothing, 2) shriveled in size while incurring large losses, and 3) shrunk in sales volume to about 5% its size at the time of their entry by 1984. Only by committing available funds to much better businesses were Berkshire able to overcome these origins.

The incentive-compensation system at Berkshire rewards key managers for meeting targets in their own turf. If, for example, See’s does well, that does not produce incentive compensation at the Buffalo News or vice versa. Neither does Berkshire looks at the price of Berkshire stock when they award bonus checks. It is in Berkshire that they believe good unit performance should be rewarded regardless of the overall performance of its parent – Berkshire in this case. If See’s makes $100 million in profit, See’s manager will be awarded based on the $100 million performance even if Berkshire makes a loss in that year. Similarly, average performance should earn no special rewards even if Berkshire share soar through the roof. Performance is therefore defined based on the underlying economic performance of the business – in cases where manager’s performance is due to any tailwinds not of their own making, applause should be withheld, or in other cases, if managers manage to arrest unavoidable headwinds, applause must be given.

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