“Twisted thinking,”“confusion” and “half truths” are just a few of the words Philip Fisher uses to launch into chapter seven of “Common Stocks and Uncommon Profits and Other Writings,” the classic investing book published in 1958.
In using these words, the author is referring to “a number of aspects of common stock investments.” The aspect in question in this chapter was dividends and dividend action. He references a hypothetical company that begins paying dividends based on the premise that it is “doing something for shareholders”. Such thinking has been going on in recent times as well: For example, the demands from some investors for dividends or higher dividends from FAANG companies Facebook (FB, Financial), Apple (AAPL, Financial), Amazon (AMZN, Financial), Netflix (NFLX, Financial) and Alphabet's Google (GOOG, Financial)(GOOGL, Financial).
That view misses the point that the money going into dividends might have been reinvested, perhaps in a plant or some other part of the business, to improve future earnings. Fisher complained that starting dividend payments or increasing payments is often referred to as “favorable” dividend action, while reducing or eliminating dividends is considered “unfavorable” dividend action.
Fisher attributes this confusion to the amount of benefit that shareholders receive from retained earnings. Sometimes the shareholder benefits a great deal, as in the contemporary case of Amazon, and sometimes the benefits are negative, as in the many bad acquisitions that have taken place.
He follows that up by going into detail about the negative and positive benefits shareholders experience. Starting with the negative, he pointed to the stockpiling of cash, beyond current or future business needs. This reflects a lack of confidence and security among management and/or the board of directors.
Another negative case is that in which “substandard” management cannot get average or above-average returns out of the capital they have already committed. Retained earnings expand inefficient operations, rather than making them better. Shareholders enjoy no benefits from this retention of capital.
“How can it happen that earnings retained in the business can be vitally needed yet have no possibility of increasing the value of the stockholder shares?” asked Fisher. This can happen in two ways, he said: (1) a change in demand forces competitive companies to invest in assets that do not improve the business, but could lead to a loss if not taken and (2) a failure in accepted accounting methods, forcing the idea that a dollar is a fixed unit, regardless of the depreciation it experienced.
Regarding the second, think of a truck used to haul a company’s products; over the course of several years, the value of it obviously declines, but that may not necessarily be fully reflected on the balance sheet. Many would respond by referring to the depreciation allowance, but Fisher said that is not enough because in an environment of rising costs, the total accumulated depreciation will not add up to full replacement value. As a result, some funds must be taken from retained earnings to make up the difference. Note that this point was made in 1958 and may not be applicable today.
Interestingly, Fisher then added that growth companies were less affected by depreciation than all other classes of assets. He explained, “This is because the rate of acquiring new capital assets (as against merely replacing existing and about-to-be-retired assets) is usually so fast that more of the depreciation is on recently acquired assets installed at somewhere near today's values. A smaller percentage of it is for assets installed years ago at a fraction of today's costs.”
Getting back to a bird’s-eye view, Fisher noted that a good understanding of such situations offers an “easy key” to evaluating the real significance of dividends. He used the example of a company that has been using 50% of its earnings to pay its dividends. However, it has increased its earnings power to the point it is now able to pay the same dividend using just 25% of its earnings. Directors are split on what to do next: Some want to increase the dividend while others note the company has never had so many attractive investment opportunities.
After discussing the many ways in which individual shareholders might be affected by the payment of dividends (including taxation), Fisher said companies should set a dividend policy and not change it. The amount of the dividend then may change, but the policy itself remains the same. If this dividend policy is known, then investors can self-select. Those who would benefit from the company’s policy might invest in it, while those who would not benefit could buy other companies’ stocks.
That policy would start with a specific proportion of earnings that will be retained for maximum growth. Younger and rapidly growing companies could ignore dividends in their early years, but as they mature to the point where depreciation flowback increases to a certain level, then 25% to 40% of profits could be paid as dividends. Older companies would have a specific percentage established to allow shareholders to do their own long-term planning.
Of course, the board must be confident the company can pay out this percentage for at least several years in the future. According to Fisher, these companies win the widest approval among investors, who know their dividends will not be frozen or reduced except in the case of extreme emergencies.
In essence, individual companies can develop their own investor following, based on the preferences of shareholders. Some companies will pay high dividends and attract investors who want income or companies that are confident in their future. Other investors might follow companies that reinvest all or most of their earnings, so they can look forward to higher capital appreciation. And, most will likely be somewhere in the middle.
Then there is the case of Warren Buffett (Trades, Portfolio). His perspective was nicely captured by a Motley Fool headline: “Why Warren Buffett Loves Dividends, but Doesn't Pay Any.” The guru loves dividend stocks that pay consistent dividends and loves even more those that increase their payouts consistently. The reason? Consistent cash flow that Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) can invest in yet more dividend-paying companies (as an aside, Buffett is investing Berkshire's money, and personally has most of his capital invested in Berkshire). Berkshire does not pay dividends, again, because it sees so many investing opportunities.
Finally, Fisher argued dividend considerations should receive the least attention of investors looking for outstanding stocks. Over five to 10 years, the best dividends will come from companies with a currently low dividend yield. The companies behind these outstanding stocks should be purchased while the companies are still in growth mode; if held for five to 10 years, they will mature and the dividends will be much higher than they will be for investors who wait for the company to begin paying high dividends.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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