Benjamin Graham confessed he’s disappointed that a recommendation he had been making for nearly 40 years had been mostly overlooked. That's why, in chapter 19 of “The Intelligent Investor”, he turned his attention to shareholders and management.
Making management more accountable
He argues shareholders should ask questions about management’s competence when one of three red flags are raised:
- The results are “unsatisfactory in themselves.”
- Poorer results than those of comparable companies.
- Unsatisfactory share prices over a long period.
While shareholders have not rallied to the cause, Graham noted an external development--takeovers or takeover bids—have come to the rescue.
“It can be stated as a rule with very few exceptions that poor managements are not changed by action of the 'public stockholders,' but only by the assertion of control by an individual or compact group. This is happening often enough these days to put the management, including the board of directors, of a typical publicly controlled company on notice…”
Because of this threat from outside, Graham saw boards of directors becoming more attuned to their responsibility of having “satisfactory” top management. As a result, he had seen many presidents changed in the years before publication of “The Intelligent Investor” in 1973.
He then wound up the section by pleading with shareholders that they consider, “with an open mind and with careful attention” any proxy materials sent to them by fellow shareholders.
What Graham was witnessing, of course, was just the opening round of a partially transformed relationship between management and shareholders. In the years that followed 1973, we witnessed the emergence of shareholder activists (both sophisticated and unsophisticated), proxy voting firms such as Institutional Shareholder Services, pressure from shortsellers and alliances between activist investors and institutional investors.
Dividends
When writing or rewriting this edition, Graham said investors were witnessing a meaningful evolution in dividend policy. Traditionally, shareholders wanted more cash from earnings, while management wanted to hold as much as possible to “strengthen the company.” That position was becoming less feasible, he said:
“In recent years the attitude of investors toward dividends has been undergoing a gradual but significant change. The basic argument now for paying small rather than liberal dividends is not that the company “needs” the money, but rather that it can use it to the shareholders’ direct and immediate advantage by retaining the funds for profitable expansion.”
In other words, there had been a shift; management traditionally held on to cash for unspecified needs, while in the new model, management held cash to grow the company. In the past, from Graham’s perspective, only weak companies held on to earnings because they needed the funds to survive. That, in turn, dampened share prices.
In modern times (the early 1970s), it was more widely recognized that strong and growing companies should reinvest rather than pay dividends. Not that there were not objections from some quarters: profits belong to shareholders, “many” shareholders need dividend income to live on, and so on. Nevertheless,
“In the last 20 years the 'profitable reinvestment' theory has been gaining ground. The better the past record of growth, the readier investors and speculators have become to accept a low-pay-out policy.”
As evidence, Graham named a couple of fast-growing companies that paid low dividends or no dividends—and their market prices were not unduly affected. And while there were clearly growth companies and income companies, the majority are somewhere in the middle. The essential question, then, became how well management could use reinvested funds. Graham said:
“It is our belief that shareholders should demand of their managements either a normal payout of earnings— on the order, say, of two-thirds—or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings.”
Stock dividends and stock splits
The objective here was to delineate the differences between stock dividends and stock splits. The stock dividend is a payment in kind to shareholders; for example, a 5% stock dividend would give shareholders an extra five shares for each 100 shares held.
A stock split, on the other hand, “represents a restatement of the common-stock structure” and is usually done to lower the price range of shares. That, in turn, can lead to greater demand for shares and upward pressure on the share price.
Graham had this recommendation for a dividend policy:
“We have long been a strong advocate of a systematic and clearly enunciated policy with respect to the payment of cash and stock dividends. Under such a policy, stock dividends are paid periodically to capitalize all or a stated portion of the earnings reinvested in the business.”
He added he found it useful to compare a stock dividend policy such as this with the practice of public utility companies, which pay liberal cash dividends, but then take back much of that by selling shareholders additional shares through subscriptions.
And, finally:
“Efficient corporations continuously modernize their facilities, their products, their bookkeeping, their management-training programs, their employee relations. It is high time they thought about modernizing their major financial practices, not the least important of which is their dividend policy.”
Other thoughts
In his commentary to chapter 19, Jason Zweig asked why Graham changed this chapter so much from the original published in 1949. He said the original also dealt with shareholder voting rights, judging the quality of management and techniques for identifying conflicts between the interests of insiders and external shareholders.
Zweig believes Graham gave up hope that shareholders would ever get sufficiently interested to monitor management’s behavior. Or that they would begin to think like business owners, rather than speculators. Theoretically, investors should be concerned, but in practice, “the shareholders are a complete washout.”
He also channeled Graham’s two basic questions for stockholders:
- Is management reasonably efficient?
- Does management give proper recognition to the interests of the average outside shareholder?
In answer to the first question, shareholders should assess management’s effectiveness by comparing their profitability, size and competitiveness with similar companies in the same industry.
Responding to the second question, Zweig wrote there was a “Daddy knows best” attitude among many companies, but that amounted to “bunk." He continued:
“In short, most managers are wrong when they say that they can put your cash to better use than you can. Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the managers’ hands before they can either squander it or squirrel it away.”
Finally, Zweig addresses the belief that companies should buy back shares rather than pay dividends. In theory, that works if management buys when shares are cheap, but in practice that does not always happen. Instead, buybacks are used, or manipulated, to drive executive compensation.
Conclusion
Once again, we are reminded that issues in finance and investment don't get permanently solved. Today, we need to be concerned as Graham was about holding management accountable, dividend policies, stock dividend policies and stock splits. Graham remains as relevant today as ever.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with chapter-by-chapter commentary by Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)
