Saturday, December 21, 2013

Dividends Aren't Evil

Matt Yglesias has a post called "Dividends Are Evil", he is right in some ways, but mostly wrong. Let's count the ways:

1. Yglesias begins by saying that dividends are a "triumph of short term thinking"; I could not disagree more. Dividend investing requires long term thinking. No one cares about a 3% current yield, but if you can grow it into a double digit yield on cost you have a pretty interesting investment. This will take ten years, so you are automatically oriented to a) quality and b) long term. Thinking a decade plus out is vastly longer term than 99.9% of Wall St, and that's a good thing.

2. Yglesias leads off the piece criticizing GE and AT&T for raising their dividends. He is singularly unimpressed by AT&T's track record of 30 straight years of dividend increases. Please re-read above point #1. A 1984 investor in AT&T got paid $0.11/share dividend and today the yield is $1.76. I doubt long term holders are complaining too much. If anything AT&T shareholder might wish for better growth, the 25 year annualized dividend growth rate is 5.9%. Did all these payments hurt shareholder returns as Yglesias is concerned about?

If you bought $1,000 in AT&T in December 1984, today you would have $22,866, an annualized return of 11.4%. I don't see that AT&T shareholders have been hard done by with regard to AT&T's dividend policy.

3. Yglesias: "When a firm such as GE flushes cash out in this way (dividends), the good news for shareholders is that they get money...The advantage, of course, is that you can use money in the bank to buy a car or make a down payment on a house."

Yes, that is an advantage! Far from being a negative, its simple, relatively efficient way to return cash to shareholders. As Morningstar's Josh Peters says, "dividends are always a positive." This is worth keeping in mind, because Yglesias goes on to state that buybacks are a better way to return cash to shareholders. That can be true, but not always.

4. Yglesias goes on to make the case for buybacks. A lot of income investors eschew buy backs, preferring say Shell's 5% dividend yield versus Exxon's 3% yield plus buybacks. I think there's plenty of reasons to like buybacks in some circumstances. Some of the great capital allocation track records in history, like John Malone's, have been built up through judicious buybacks.

Aye, but there's the rub. There are not many John Malones out there! Michael Jordan played by the "Jordan Rules", what is good strategy for the best of the best is often a recipe for disaster for the average, i.e most management teams. If you have a John Malone at the helm, then buybacks are a wonderful way to return cash to shareholders, and Yglesias is right to say that they are more tax efficient than dividends. But this is only the case when you have a master capital allocator at the helm with talent and integrity. Otherwise, buybacks can absolutely destroy shareholder value. Look no further than HP where various managers bought back 1/3 of shares outstanding in last decade at prices well above today's, and at the same time earnings per share went way down and debt went way up. So whereas dividends are always a positive, buybacks can be good or they can be a way to light money on fire.

5. Skills. Yglesias says "the only real disadvantage is that buybacks look unattractive when stock market prices are relatively high", CEO skills are around operating their business. Making airplanes or jet engines or running restaurants or mobile networks, is it reasonable to expect a CEO that can do all the things necessary to operate effectively and on top of that be a great judge of when is a good time to buy? Given that mutual fund managers as a group underperform the S&P 500 when that is their only job, its unreasonable to think any CEO can do this as a second job in addition to running their company.

Let's say you are CEO of Caterpillar. Every day you have find a way to widen your moat, compete with Komatsu, watch for new upstarts from China, deeply understand the global infrastructure cycle, and ensure the business operates at maximum efficiency. If you do all of this you are in the top 10% of CEOs. Now on top of that is it fair  to think you are also a clear thinker about investment value, objective, unemotional and rational about your own business, and can allocate capital like Buffett, Singleton or Malone? Doubtful.

6. Incentives. Dividends align shareholder and management incentives. Everyone gets paid. Buybacks can be a good or a bad thing here with regard to incentives. Many companies use buy backs as a fig leaf to cover up the fact they are also issuing shares to enrich management.

7. James Montier's August 2010 paper "A Man from a Different Time"
    Dividends still matter
    To those who charge around in markets trying to guess
    the next quarter’s make-believe earnings number, the
    concept of dividends seems wholly irrelevant. However,
    to those with an attention span measured in longer than
    milliseconds – who are few and far between, to judge
    from today’s markets – dividends are a vital element
    of return. Exhibit 2 illustrates this point graphically.
    Looking at the U.S. market since 1871, on a 1-year time
    horizon, nearly 80% of the return has been generated by
    fl uctuations in valuation. However, as the time horizon
    is extended, “fundamentals” play an increasing role in
    return generation. For example, at a 5-year time horizon,
    dividend yield and dividend growth account for almost
    80% of the return.

The chart above shows the opposite of Yglesias' assertion. Dividends only matter for long term (5 year), and share price movement matters on a short term (one year) basis.

8. Buybacks rely on management being focused on the stock market and share prices, but this approach is pretty limited. Benjamin Graham: "Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies."

Yglesias raises some good points in his piece and its always good to hear contrary points of view. Most of his points around buybacks are fine so long as your CEO is an all time great investor, but that's a shaky assumption. There are way more Chuck Princes than there are Tom Gayners. Buybacks are fine if your CEO is John Malone, for everyone else there's dividends.

Friday, December 20, 2013

Innophos - Can Phosphates Deliver Dividend Growth?

Innophos is in a range of pretty boring businesses, the cover the phosphate waterfront - Specialty Ingredients, Asphalt Modifiers, Fire Suppressants, Water Treatment, Bakery Leavening, Deli Meats (hungry yet?), Toothpaste Abrasives, and more. I have followed the company for awhile, Todd Wenning wrote it up in his search for dividend growers, and Barron's profiled the company this week and there is a lot of interesting pieces to this puzzle.

The Barron's article highlights some recent issues and a potential catalyst:

The company's manufacturing facility in Mexico has been the source of recurring equipment failures, which has hurt productivity and resulted in high maintenance costs. As recently as the September quarter, a planned maintenance outage took longer to complete than expected, due to the extensive repairs required.

For the past few years, management has been upgrading the facility, and on its Oct. 29 conference call, CFO Mark Feuerbach said that he believes the plant "has turned the corner." Indeed, the plant generated higher production yields in the quarter.

Overall, the key dividend growth qualities looks to be in place.
  • Forward yield 3.3%. 
  • 1 Year Dividend Growth: 24%
  • 5 Year Dividend Growth: 13% 

The balance sheet is not subject to much leverage with a 0.3 Debt/Equity ratio.

The company's price is not that cheap. The P/E is 22 on trailing basis and the P/CF is 14.

Last month, I looked Clorox and it appeared to be quality company at a reasonable price. Innophos stacks up pretty well alongside Clorox.

CompanyFwd Yield1 Yr Div Growth5 Yr Div GrowthP/CF

(Source: Morningstar)

Innophos beats Clorox across the boards, and whereas Clorox debt to equity ratio is a stratospheric 26, Innophos operates much, much more conservatively (0.3 Debt/Equity). Clorox has excellent brands and great long term track record, but on the metrics that matter for dividend growth investors, Innophos looks to be a better buy today.

Thursday, December 5, 2013

Samuel Lee on Quality at a Reasonable Price

Samuel Lee's recent article discusses Warren Buffett and the Time Horizon Arbitrage. In it, he describes the implications of Buffett's conversion from a Graham-style deep value, bargain hunter to a Munger-style quality oriented approach. Since Graham pioneered value investing, this distinction is not trivial and some of the implications challenge the basic tenets that people associate with value investing, focusing on quality over price. This is distilled down to Munger's Three Great Lessons of Investing:

Focusing on business quality is something that is not that hard to understand, but the knock on effect here is that outside a global financial crisis, you are never going to get Coca Cola at a bargain basement price. That's where time horizon matters, in order for this strategy to work the investor has to think long term.

Overall, its got a lot overlap with dividend growth investing. After all, what do Buffett and Munger's largest holdings IBM, Coca Cola, Wells Fargo, and Exxon have in common? Excellent dividend growth track records:

Company Fwd Yield 1 Yr Div Growth 3 Yr Div Growth 5 Yr Div Growth
Coca Cola 2.8% 8.5% 7.6% 8.5%
Exxon Mobil 2.7% 17.8% 9.5% 9.7%
IBM 2.1% 13.8% 15.4% 17.1%
Wells Fargo 2.7% 90.2% 16.7% -7.9%
(Source: Morningstar)

Samuel Lee gets to the heart of the quality at a reasonable price and why its so hard for institutional managers to follow this simple approach:

Both Buffett and Munger declare their favorite holding period is forever. This seems to contradict the fact that at a high enough price, even the most wonderful business in the world will produce less-than-wonderful returns. No doubt part of their hesitance to sell wonderful businesses at any price reflects a philosophical aversion to "gin rummy" investing. I think, though, the main reason they hold on is because they truly believe wonderful businesses are persistently undervalued by the market, even when common valuation metrics suggest otherwise.

This suggests to me that much of Buffett and Munger's edge rests in the ability to engage in time-horizon arbitrage: buying assets with long-term value underappreciated by the market.

Of course, many managers claim they take the long view, shunning Wall Street's quarterly earnings game. It sounds great in theory, but the nature of the investment-management industry makes time-horizon arbitrage nearly impossible. Few managers can live through more than a few years of massive underperformance, but beyond 10 years? Forget it. You've long since been fired.

This is a critical flaw of the investment-management industry, because the real value of most firms is not in their next 10 years of earnings, but the 20 years after that. The real time arbitrage is beyond what most investors can stomach.

In dividend growth investing we see the same dynamic play out. Who cares about a 2.9% current yield? its a rounding error. But compound it at double digit rate over a decade plus and watch the yield on cost rise. Its practically impossible for Wall St firms to think in decades. Of course, what's impossible for institutions and funds creates a major opportunity for individual investors for high total returns at relatively low risk.

Monday, December 2, 2013

Manual of Ideas Book Review

Manual of Ideas is a great title and the book delivers on that promise. This is a different kind of investing book. Its not wedded to one approach, rather its a survey of many different techniques across the value investing spectrum.

Its very useful to practitioners because the author John Mihaljevic covers a lot of different value investing techniques. In this sense its kind of a cookbook. There are not many books like it, one that comes to mind is Joel Greenblatt's You can be a Stock market Genius, which does an excellent job of showing how special situations result in mispricings.

The Manual of Ideas is a very good cookbook but it adds two things that make it even more helpful for investors. First, the author shows not just how a specific technique works, but also describes when and how a technique may fail. For example, there's extensive coverage on screening, but this approach has its limitations and Mihaljevic goes into lots of detail as to what things the screens will miss. The chapter on Deep Value gives a good description on Graham's approach but shows its limitations for an investor looking for long term and low turnover.This shows "time in cockpit" and more importantly can help investors avoid mistakes.

The second thing, the Manual of Ideas does beyond a cookbook is that it puts each technique into a context of where and how the analytical tools may be useful. In this way, it helps to highlight the right tool for the right job.

The Deep Value chapter is one of the best, its at the intersection of quantitative and qualitative analysis. A good example - is finding a Net Net in a non-capital intensive business an oxymoron or an opportunity?

There are second and third level questions to push Graham "bargains" through to a more in depth understanding. Once your Deep Value screen uncovers "bargains" - is their value growing, staying flat or shrinking? As to the famed liquidation value, the text rightly observes that "In reality, a liquidation scenario would most likely play out in conditions of industry distress, in which it might be exceedingly difficult to find buyers." That's an important model flaw to account for. What you paid for your seat on the ship doesn't matter to buyers if the ship is sinking.

The book is a good source of ideas from many investors. I particularly enjoyed this one from Josh Tarasoff of Greenlea Capital, "One of the most powerful ideas I have ever encountered is the one-decision stock: a company you can simply hold for a decade or two and receive an outstanding outcome. My ideal investment would be to purchase a company like this at a significant discount to intrinsic value, and then hold it for a very long time. This approach is a combination of letting the economics of a great business play out, while opportunistically  taking advantage of market inefficiencies." Great idea, easier said than done of course, but the book goes on to connect the dots as to how an investor may achieve this - look for businesses with pricing power, specifically those that can raise prices higher than the rate of inflation.

The chapter on Small Caps illustrates the importance of bottom up research. Eric Khrom reflects on lessons learned from Patient Safety Technologies 8-K, "There is a lot of time pressure in the operating room, and there are 32 million procedures done annually...there are about 4,000 retained sponges (at a cost to the industry of $1.7 billion)...the hospitals that have used their system have had zero retained sponges...Reading the 8-K was very interesting because they pretty much announced in one sentence that they signed  on the second largest hospital operator in the United States. They went from having about 80 hospitals to immediately having 255 hospitals."

One criticism is the chapter on International Investing. The author lists some sources for global investing such as the FT's global equity screener, and includes a long list of investors to follow by country. So if you are interested in Japan or New Zealand or the Czech Republic to name a few, there are names to check into. But would be maybe more helpful to talk about these markets and investors in greater detail to give a fuller picture. That may be too much to ask or it may be book in itself. Beyond that quibble, the International Investing chapter is worthwhile and talks about key questions for certain reqions (Europe: how global is the business?) and advocates for excluding countries from analysis based on downside risk.

The Manual of Ideas brings together in one place many valuable insights found elsewhere, some unique analysis, and delivers the context that shows how the ideas hang together. Most practically, the book gives sober guidance on where the ideas may not work and this alone separates its from 90% of the books on the investing bookshelf. Worth your time.