Value Investing Forum

Graeme, you might take a look into truthisntstupid from fool.com CAPS. He's a fan of dividends and has claimed in his blogs that he has used the dividends to pay expenses when needed.

And a while back I think it was you who was looking for brokerages. If you haven't decided yet there's one more reason you might choose TD Ameritrade:

100+ Commission Free ETF's

Of particular interest is VIG which is a dividend acheivers fund (companies that have paid/increased dividends for at least 10 consecutive years).It has a low expense ratio. And as long as you meet holding requirements (at least 30 days I think) you can buy them 1 share at a time whenever you have the desire without worrying about transaction costs.

On that note, I've started glancing at dividend challengers (companies that have increased dividends for 5-9 consecutive years) since they may get some recognition once they hit 10 years. I'm hoping I can find one or two opportunities there.

And if you aren't too concerned with upside, covered call strategies can be a good way to increase cash returns. The trade-off is that you'll miss out on any huge unexpected jumps (perhaps due to some unknown value emerging).

jalleninvest said:

If that is all it takes, you're doing something wrong.

Looking at cash flows is only part of a "thorough analysis [which] promises safety of principal and an adequate return."  Even more important is a thorough understanding of the balance sheet.  One of the aspects of Graham's Net Net Current Asset metric is that a company that can pay ALL debt from current assets, and is selling for less than 2/3rds of what's left of current assets, forgetting about fixed assets,  is in pretty decent shape, not likely to be heading off to bankruptcy court anytime soon.

Debt levels on many balance sheets are at levels that Graham would not have been comfortable with.  It is the debt level, compared to assets and earning power, that constitute a significant risk.  A company with zero debt can make a lot of mistakes and survive, even prosper, while it sorts itself out.

---

 

None of that is sufficient to take care of a black swan event. Think of things like BP's oil problem. While it didn't tank them, there was significant uncertainty over whether it would. The liabilities can add up very fast and equity holders can either be wiped or at least deluted in a restructured company.

Or imagine a scenario in which a manufacturer has a defect in the product which causes serious harm (death, disease, etc). The liabilities on this can add up very fast. In addition, there can be damage to brand name which will harm future revenues. Even with a solid balance sheet, the harm can be permanent.

While I do agree examining the balance sheet can help mitigate those risks they aren't sufficient to eliminate them. Those potential liabilities aren't likely to show up on a balance sheet anywhere. If you're lucky it will get mentioned in a note or in the risks section and there may not be adequate information at all. (And many of such scenarios, the worst case scenario can't be estimated because they are genuine unknowns involved.)

A rational dividend policy calls for retaining earnings if the company can invest the cash at a higher return than the shareholders, after taxes, of course. If not, pay 'em out.

While I'm entirely sympathetic to the idea that retaining earnings is and can be beneficial there are significant trade-offs. And there are pros and cons to both. This is where the old proverb of "a bird in the hand is worth two in the bush" comes into the play. The future benefits are unknown and uncertain. This isn't to say that, statistically speaking, you can figure out which ones are more likely to succeed than others. But you can't protect yourself entirely from black swan events. And the reinvestments aren't guaranteed. It's certainly not cut and dry.

But a dividend paid to me today is quite certain. I know I've received it. There's no question about it. So that's the trade-off.

And that's why I think gtrockefellar has suggested that non-dividend paying stocks are more speculative. There's an added uncertainty there that you don't get with a dividend paying stock. This of course doesn't mean the trade-off isn't worth it; it most certainly can be.

That is one of the fascinating things about Berkshire Hathaway. Had I invested a year's pay back when Buffett asumed control in 1965, I would have owned about 1,000 shares of "A" stock. Now those shares would be worth $116 million. I would be rich, but wouldn't have any money. 46 years later, I would have yet to see a dime.

…which is entirely dependent upon the market's estimation of Berkshire's value, is it not?

No doubt Buffett and Munger have done an excellent job reinvesting those cash earnings and have had a great record. But until you see a dime of that cash you just own a piece of paper with some voting rights (which if your position isn't that large, is pretty neglible). As I mentioned before, I like the "owning stock is like owning a business" metaphor. I just think it has clear limitations.

Post edited 3:50 am – January 3, 2012 by jalleninvest

---

 somrh said:

For that reason, I've become skeptical at even looking at the cash flows of a business because, in reality, if they never pay out those in dividends, I won't see anything. And it only takes one bad year, one bad trade, one stupid move, for a business to go into bankruptcy.

If that is all it takes, you're doing something wrong.

Looking at cash flows is only part of a "thorough analysis [which] promises safety of principal and an adequate return."  Even more important is a thorough understanding of the balance sheet.  One of the aspects of Graham's Net Net Current Asset metric is that a company that can pay ALL debt from current assets, and is selling for less than 2/3rds of what's left of current assets, forgetting about fixed assets,  is in pretty decent shape, not likely to be heading off to bankruptcy court anytime soon.

Debt levels on many balance sheets are at levels that Graham would not have been comfortable with.  It is the debt level, compared to assets and earning power, that constitute a significant risk.  A company with zero debt can make a lot of mistakes and survive, even prosper, while it sorts itself out.

Cash flow is the raison d'etre of being in business.  You have to invest your capital, produce your product, sell it, collect the sales price, pay the expenses and have more cash than you did at the start of the cycle, the more the merrier.  It is important because while it is relatively easy to play games with earnings, and management has gotten very good at it, it is hard to fool with cash…. not impossible, just harder.

An investor thinks of himself as part owner of the business, not merely a paper holder who hopes to sell the paper soon at a higher price.  The end result of investment analysis is NOT to guess which prices will be higher a year from now but to figure out when Mr. Market is in one of his moods, to take advantage of.

A rational dividend policy calls for retaining earnings if the company can invest the cash at a higher return than the shareholders, after taxes, of course.  If not, pay 'em out.

That is one of the fascinating things about Berkshire Hathaway.  Had I invested a year's pay back when Buffett asumed control in 1965, I would have owned about 1,000 shares of "A" stock.  Now those shares would be worth $116 million.  I would be rich, but wouldn't have any money.  46 years later, I would have yet to see a dime.

 

gtrockefellar said:

The assumption is that Stocks are a claim on earnings of a company but if you are not getting dividends, you are only getting a representation of a claim on earnings, which really means nothing.  Stocks which have never paid a dividend in my book are speculative issues because you are taking on all the risk without any of the actual benefits.  I would never invest in anything, be it stocks or real estate, that didn't pay me anything except for a potential appreciation of value unless it was trading at less than the true "liquidation value".  

 

That is an interesting take on it. But what about companies that are capable of reinvesting their earnings at above average rates of return? If I own a company that is capable of this I don't want them paying me a dividend which I then get taxed on. I would rather have them reinvest it (my opinion).

If guess my feeling is that dividends or lack of dividends is only one of many factors to be weighted when determining if an issue or investment in an issue is speculative. Capital allocation abilities and track records for capital allocation provide some insight into what may happen with earnings that are not paid out and allow you to compare two companies with similar cashflows that don't pay dividends and determine which one is likely to increase in intrinsic value and at what rate. 

That being said I respect your opinion and thank you for discussing it. Good thread!

 

gtrockefellar said:

To answer your question here.  Berkshire Hathaway is worth whatever the next person is willing to pay for it.  That in my mind is speculation.  The way I would value Berkshire would be a combination of on a book value basis as well as a historical value based on a discounted cash flow with a MOS but I'd also use a much larger discount rate based on what I assume to be dividend risk.  Now there is a difference between investing and speculation but there is also a difference between stupid speculation and smart speculation.
 

There are a lot of questions as to where the stock price of Berkshire Hathaway is going to go once Warren Buffett dies.  Buffett has the ethics to keep the company honest but if he is no longer CEO of Berkshire, who is to say that the next CEO won't use Berkshire money in a way that you don't want to see.  

---

Fair enough. I have to wonder if Berkshire will start paying dividends soon. With its size, opportunities are becoming harder to find.

I am kind of curious if any one else here will take this as far as you do. I'm actually quite sympathetic to what you're saying. I've ventured off into call options for partly that reason. I see call options to be, in some respects, preferable to non-dividend paying stocks. The downside is there's a time limit. But typically one can risk less capital and leverage returns with a call option. So there's a trade-off but I figure if I'm going to be speculating (as you suggest) I might as well make it worth my while.

I still like dividends though.

Graeme wrote:

So instead of "investor vs speculator" I think it really comes down to
smart risk takers and stupid risk takers. Or playing the game you have a
the best chance of winning. Buffet is correct in saying that he'd focus
on one-foot hurdles; that doesn't mean there is no risk, speculation or
even forecasting, but it is of a different quality.

To some extent I think this is in line with Graham's second quote from my original post.

Of course what fascinates me about financial markets (using your metaphor) is that, unlike baseball, the betters infuence the game (I suppose if you include the folks who pick the players that holds as well). Horrible companies can thrive for years due to the fact that the markets put a high price tag on their stock which enabled them to raise capital (think Allied Capital) while others may fail due to low stock price so they are unable to raise capital to meet their objectives.

As a side note to dividends and whatnot. When I first decided to (naively) venture on my own and pick some stocks in 2008 (I figured with everyone selling, it would be a good time to buy), I first looked at Google thinking it was a good company. (In hindsight, I would have been better off to stick with Google.) But I immediately looked at earnings and did an earnings yield calculation before I ever even heard of a P/E ratio. I compared it to Microsoft and thought Microsoft was the better bargain. (In hindsight, buying Microsoft would have been better than what I ended up doing.)

But I didn't really care about the earnings per se. I wanted some cash. I figured, "who cares what the stock price is so long as the company pays me a good amount of cash". So "cleverly" I started looking at dividend yields. And I made some of my first purchases. There was at least one REIT and a few financial institutions selling with very high dividend yields. Not surprisingly, the dividends were cut and the stocks tanked with it.

So I think you're absolutely right to think that the balance sheet, the business, the cash flows, etc aren't entirely irrelevant. Maybe if I learned a bit more about those I would have bought MSFT instead of ACAS.

gtrockefellar said:

The assumption is that Stocks are a claim on earnings of a company but if you are not getting dividends, you are only getting a representation of a claim on earnings, which really means nothing.  Stocks which have never paid a dividend in my book are speculative issues because you are taking on all the risk without any of the actual benefits.  I would never invest in anything, be it stocks or real estate, that didn't pay me anything except for a potential appreciation of value unless it was trading at less than the true "liquidation value".  

So just out of curiosity, what's Berkshire Hathaway worth?

In the Graham days, stocks actually paid healthy dividends unlike the 2-5% (or whatever it is) that they pay today. I was really wondering why this was and I did a lot of research on it. A lot of it has to do with the move from the capital gains tax which was much higher back then to the all time low capital gains tax of today. Stock investors are taxed much less today on capital gains than they were back in the Graham days, which is why it makes more sense in theory for companies to retain earnings if they are growing at a faster pace with the retained capital.

I definitely agree with that. Personally I think we should change our tax structure there but that's a whole different discussion. (In case you want to know, I think capital gains/dividends should be taxed at income tax rates, corporate tax rates should be lowered to be line with the rest of the world and dividends, like interest, should be tax deductible.)

I also have to wonder what role incentive pay (stock options in particular) play here. If a manager holds onto the cash then the stock price will reflect that cash that's retained by the business which makes his options potentially more valuable.

I do recall though Keynes making an interesting comment on this:

These considerations should not lie beyond the purview of the economist. But they must be relegated to their right perspective. If I may be allowed to appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life, it is by no means always the case that speculation predominates over enterprise. As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the above sense) is enormous. Even outside the field of finance, Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be; and this national weakness finds its nemesis in the stock market. It is rare, one is told, for an American to invest, as many Englishmen still do, “for income”; and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that, when he purchases an investment, the American is attaching his hopes, not so much to its prospective yield, as to a favourable change in the conventional basis of valuation, i.e. that he is, in the above sense, a speculator. Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism — which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

-J.M. Keynes, The General Theory of Employment, Interest and Money, CH 12

I'm also quite sympathetic to how Keynes here disguinshes between "speculation" and "enterprise". If you haven't read his Ch 12, it's well worth the read, even if only for the "prettiest face contest".

Lots of good material here. I'll just add a few comments as I'm feeling under the weather atm…

Jae wrote:
Looking at the big picture, the stock market really is just a game of poker, where you get to control your own odds. You need luck and skill to play this game, but there is much more to it than that.

I guess I want to comment more on Lynch's metaphor here. I like exploring how far metaphors work and where they break down. There's a crucial point here where this metaphor breaks down.

Poker is a zero-sum game (you may have to include the house that takes a portion of the ante). As a result, the average poker player will tend to lose money (assuming money is being taken from the pot by the house). The only way to profit in poker is if the game is inefficient. In such a case, players who are better able to acquire and exploit information can do quite well. If poker playing were efficient, the only one who would win, on average, would be the house. (FWIW, I used to play Texas Holdem online for fun when it was still legal. I made some money from it but I was always too nervous about risking too much capital on it.)

Contrast that with the stock market. In theory, even if you're in an efficient market, the average player should get returns equivalent (on average) to market returns. So it's not a zero sum game. I would think that if markets were actually efficient, then a person who bought the market was "investing". In that sense, I would disagree with Peter Lynch's definition in that respect.

ankitgu wrote:
B) Things are worth different amounts to each investor – I may be buying
a stock as a standalone investment, but to a business, they could buy
the entire company and realize synergies. If they can operate with 10%
less employees because of redundant functions between companies, the
profit they'll earn by being combined is greater than if I buy the
stock.

This reminds me of another metaphor that, while I like, has its deficiencies. That's Graham's metaphor that stock is like owning a business. I think it is in many respects but isn't in some others. I think this brings up a good point here.

The other thing that I don't like is the fact that if I actually owned a business, then cash flows that business generated would be mine for me to use however I so chose. That is not the same with a stock. Only a portion of cash flows are mine to use (dividends). The rest are used at the discretion of the managers and board of directors (which unless I have a large position, I have little influence over).

For that reason, I've become skeptical at even looking at the cash flows of a business because, in reality, if they never pay out those in dividends, I won't see anything. And it only takes one bad year, one bad trade, one stupid move, for a business to go into bankruptcy.

So I have to wonder, are stocks which don't pay dividends (all else being equal) potentially more speculative, for that reason, than ones that pay dividends? Though I would put that question in context because I'm in agreement that the asset itself is not the sole indicator of investment/speculation. The process one comes to purchase an asset has to be factored in as well.

Graeme wrote: For me the way that I frame the "are you a speculator or a value investor" debate is to view the debate as no different than any other "adherance to a school" debate that you see throughout history.

I think that's a fair comparison (and partly why I like these discussions to begin with.) Of course, I have less interest in setting/adhering to the boundaries and more interest in blurring the lines. But I actually think the distinction is useful in some respects. I think there are a few things that I would definitely say is "not investing" but I doubt I could develop some demarcation of any sort (nor do I think there need be one).

Post edited 6:39 am – December 27, 2011 by Graeme

---

Somrh, you beat me to it. I had a "start a speculation vs investing thread on OSV" on my evernote to-do list for this week. 

 

For me the way that I frame the "are you a speculator or a value investor" debate is to view the debate as no different than any other "adherance to a school" debate that you see throughout history. My field is in literature and theology, so I wont bore you with comparisons between this and the "romantic vs classicist" debates of the 19th century or the ever fun "Calvinist vs Armenian" sillyness, but the dynamic of the argument is the same. The first thing to note is that we are arguing things that belong in the same family. Just as romantics and classicists have strong claims to the literary concepts of sublimity and fate, and just as Calvinist and Armenian stay close to a sola scriptura, the two positions of investor and speculator both have their roots in the buyer/seller, winner-of-the-trade/loser-of-the-trade mechanics (shoot. I said I wasn't goint to bore you with the similarities. Well, whatever.) So I think it is totally appropriate to talk about investors vs speculators; we aren't talking apples to oranges. They are in the same ecosystem. 

 

With any school of thought you have the masters–the guys who either invented the field or perfected it for their time. In value investing one of the masters is Graham, and as with all masters he establishes the tenets of his position (and, in so doing, establishes the tenets of what he sees as the opposite of his position. In this case, The Speculator.) For the most part his tenets are: hold for long periods of time, establish a strong margin of safety by being really strict about your buy price, and be in control of your emotions so that you can be methodical as opposed to reactionary. Therefore his description of The Speculator is the opposite of these: either no regard for holding time, or a short holding time. Momentum as opposed to margin of safety and more emphasis on emotional sensitivity because that is what is such a driving force in momentum. 

 

So the master sets the standards and the people who come after him try to place themselves on his spectrum. You have some people who are very strong adherants to Graham and who follow his tenets religiously. I came across one example in Brandes book Value Investing Today where he says that any holding period less than 3-5 years is speculation (Brandes pg. 13.) To him he sees Graham's first tenet and sets up his system around it. 

 

I think the best money managers are the ones who have read many of the masters, picked the style they resonate the most with and then apply it to their own particular abilities and contexts. The best theologians are the ones who are well read, generally pick a school (or at least an area of focus) and then add to it and bring their own observations and context to the discussion. Ditto for literary critics or writers. I think that the Value Investor vs Speculator then is a spectrum with a hard Graham investing style on one end and a pure speculation style on the other. It is up to you then to read a lot, know the intellectual landscape you're in and then apply it to your own contexts and abilities. 

 

One of the best parts about these forums is the constant refinement of our own investing styles that we undergo. And as we talk to eachother we get better. Iron sharpens iron. 

 

As for me and my investing strategy I think it starts in what I think is Graham's most important legacy in that famous first chapter:

(1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it

This emphasis on "know yourself and be honest about what you are doing and why you are doing it" is a pretty big cornerstone for me. 

 

I would say that you define investing and speculating for yourself. But lots of people think that that means a "whatever floats your boat" or a "no one idea is better than another." That's dumb. There is obvioulsy a heiarchy of ideas and implementations. Some do it better than others. The trick is to learn the basics and then apply it to your own context. You will be brutal at applying if you haven't mastered the masters.