Dividends Are Dumb

Dividends Are Dumb

By Anand Chokkavelu, CFA 
February 26, 201

Question everything.

It's a good motto if you ever find yourself in a government-conspiracy movie. And it'll also serve you well any time money's involved.

The folks who question seemingly self-evident principles can make an absolute killing.

• Ask the Super Bowl bettors who took the so-called suckers' bet of the Giants over an 18-0 Patriots team.
• Ask hedge fund manager John Paulson, who made more than $10 million a day in 2007 ($3.7 billion total) because he figured out housing prices could actually fall.  
• Or ask some guy named Craig who questioned the virtual monopoly that newspapers had on classifieds (yes, that's a craigslist reference).

So when I heard the argument recently that dividends are actually a bad thing, I was willing to listen.

In fact, it's a more compelling argument than you may think.

These dividends are just dumb
Why do we invest money in a company? Ultimately, it's because we think that company can grow our money by using that money to invest in its growth.

When a company turns around and gives us that money right back (creating a taxable event in the process), it defeats the purpose. If we want out, we can simply sell our shares. And do so on our own timetables.

Hence, anti-dividend people maintain that even the modest dividends that companies likeHalliburton (NYSE: HAL), General Electric (NYSE: GE), and Microsoft (Nasdaq: MSFT)pay out are just plain dumb.

But hear them out. The case against dividends gets stronger given the reason folks buy dividend stocks in the first place.

Frequently, investors who buy shares of companies that pay large dividends are seeking safety and stability. Why? Because a company that commits to a regular dividend payment is signaling exactly that -- safety and stability.

So it's ironic that a dividend can act like debt -- an obligation that makes the bad times worse. Although paying dividends is optional (while missing debt payments leads to bankruptcy), a company that chooses to cut its dividend signals weakness, often leading to a further weakening of its stock price. That's a double whammy no investor wants to face.

Yet I still heart dividends
So why am I still bullish on dividend payers?

I'll leave aside the empirical evidence that dividend payers have handily outperformed non-payers historically. Instead, let's look at a company's life cycle.

Early in a company's history, it feeds on cash like a baby sucks down formula. Investors don't care, though, because the company needs that capital to fuel its growth. Soon enough, that company either fails or becomes bigger and stronger.

At some point, it starts producing more cash than it's consuming. It can then build a war chest to ensure its survival through good times and bad.

But then what? If there aren't any compelling internal opportunities, a company has four choices:  

• Sit on the cash.
• Buy back shares.
• Make acquisitions.
• Pay dividends.

When you look at all four options carefully, dividends make a heck of a lot of sense.

Dividends stand alone
Sitting on cash is safe, but it’s a drag on a company's return on capital -- especially when interest rates are hugging 0%. Apple's (Nasdaq: AAPL) chosen this path, hoarding more than $20 billion. But few companies have the amazing innovation-driven growth that can hide this drag.

Buying back shares is almost like a dividend with no tax consequences. In fact, if a company can buy back its stock at low points, it can really juice returns to current shareholders. Unfortunately, most managements don't do a good job of timing. Even Goldman Sachs(NYSE: GS), the reputed master of the markets, made massive repurchases of its stock throughout the heady bubble years only to have to sell new stock to raise cash when its stock price was hammered. Classic "buy high, sell low" behavior.

Acquisitions are the scariest of all. You see, management is often judged on its ability to grow the business, specifically earnings per share. That's why they’ll buy back shares at inopportune times. And that's why they'll pursue ill-advised acquisitions and poorly conceived internal projects with such gusto. This growth at an unreasonable price helps management but hurts shareholders.   

Which leads to the reason I love dividends. The issuance of a regular dividend instills management discipline by removing some capital from consideration. You can't waste what you can't touch.

Meanwhile, as shareholders, we get a nice income stream ... the classic stock play that yields like a bond.

With 10-year Treasury bonds currently yielding just 3.6%, dividend stocks are that much more attractive. Because of this, let me share three dividend plays that the dividend hounds at ourMotley Fool Income Investor newsletter have identified and recommended.

Company	Description	Dividend Yield
Paychex (Nasdaq: PAYX)	America's largest payroll processor for small and medium-sized businesses	4.1%
Clorox (NYSE: CLX)	Maker of Clorox bleach, Glad trash bags, Kingsford charcoal, and Pine-Sol	3.3%
Philippine Long Distance Telephone	The Philippines' leading fixed and mobile telecom provider	4.9%

One of the companies above is a "buy first" recommendation -- and only six companies get that nod from the Income Investor analysts.

http://www.fool.com/investing/dividends-income/2010/02/26/dividends-are-dumb.aspx?source=ihpdspmra0000001&lidx=3

Buffett Overpaid, and It Made Sense

By Morgan Housel 
March 1, 2010 | 

"Buffett overpaid for Burlington Northern Santa Fe Corp. and ... should have instead returned the company's excess cash to investors."

That quote, pulled from a news article, is a common attitude when it comes toBerkshire Hathaway's (NYSE: BRK-A)(NYSE: BRK-B) November purchase of railroad giant Burlington Northern.

The $100-per-share buyout represented a 30% premium on Burlington's stock price -- a stock that had already gained 50% over the previous eight months. By any valuation metric, Buffett was coughing up top dollar for Burlington. Coming from the guy who coined the phrase, "price is what you pay, value is what you get," and who built his reputation buying companies like Coca-Cola (NYSE:KO) and American Express (NYSE: AXP) at fire-sale prices, this was a puzzle. Berkshire suddenly looked more like Blackstone (NYSE: BX).

Buffett also partially financed the deal with Berkshire's common stock, a rare move for him, and one he often later regretted. And since he was willing to use Berkshire's stock as currency, he was sending a clear signal to the market: Either Berkshire shares were fully valued (if not overvalued), or he was using an undervalued stock to buy Burlington, making the deal even more expensive than it looked.

Please don't tell me he's lost his marbles
On Saturday, Berkshire released its 2009 letter to shareholders. Within, Buffett went into detail on the mechanics and valuation of the Burlington acquisition. In short, yes, Berkshire paid a full price. Yes, Berkshire shares were probably undervalued at the time. And yes, that means the full price could turn into a dear price.

But the decision nonetheless made sense. Here's exactly what Buffett had to say:

In our [Burlington] acquisition, the selling shareholders quite properly evaluated our offer at $100 per share. The cost to us, however, was somewhat higher since 40% of the $100 was delivered in our shares, which Charlie and I believed to be worth more than their market value ...

In the end, Charlie [Munger] and I decided that the disadvantage of paying 30% of the price through stock was offset by the opportunity the acquisition gave us to deploy $22 billion of cash in a business we understood and liked for the long term. It has the additional virtue of being run by Matt Rose, whom we trust and admire. We also like the prospect of investing additional billions over the years at reasonable rates of return. But the final decision was a close one. If we had needed to use more stock to make the acquisition, it would in fact have made no sense. We would have then been giving up more than we were getting.

The price of being huge
One of the unfortunate rules of finance is that returns wither with size. As individual investors, we can meaningfully buy any stock in the market universe, since the few thousand bucks we'll invest probably won't contort the company's stock price. Our tiny investments mean nothing to the market, but they can mean big bucks for our humble portfolios. The world is our oyster.

Not so for big investors like Berkshire. Heck, Berkshire makes more than $1,000 a minute in dividends on its stakes in General Electric (NYSE: GE) and Goldman Sachs (NYSE: GS) -- and that's a fairly small portion of the overall portfolio. When cash piles up that fast, you have to be able to deploy it in massive chunks -- billions at a time -- to make a dent in the portfolio. That purges most small investment opportunities, forcing investors like Berkshire to settle for lower returns.

That's exactly what happened with Burlington. Paying an overvalued price made sense because it provided the opportunity to deploy tens of billions of cash at reasonable, but not great, returns.

For decades, Buffett has repeated a similar line in Berkshire's annual letters: "[O]ur performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue ... huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge."

After the Burlington deal, it's clear he isn't kidding.

http://www.fool.com/investing/general/2010/03/01/buffett-overpaid-and-it-made-sense.aspx?source=irysithln0000001

Buffet's view on Derivative contracts

Derivative contracts

Finally, you should expect large swings in the carrying value of these contracts, items that can affect our reported quarterly earnings in a huge way but that do not affect our cash or investment holdings. That thought certainly fit 2009’s circumstances. Here are the pre-tax quarterly gains and losses from derivatives valuations that were part of our reported earnings last year:

Quarter    $ Gain (Loss) in Billions
1    (1.517)
2    2.357
3    1.732
4    1.052

As we’ve explained, these wild swings neither cheer nor bother Charlie and me. When we report to
you, we will continue to separate out these figures (as we do realized investment gains and losses) so that you can more clearly view the earnings of our operating businesses. We are delighted that we hold the derivatives contracts that we do. To date we have significantly profited from the float they provide. We expect also to earn further investment income over the life of our contracts.

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to
invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998.

The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead

• to leverage and/or 
• counterparty risk that is extreme. 

At Berkshire nothing like that has occurred – nor will it.

It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault.  It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.


http://www.berkshirehathaway.com/letters/2009ltr.pdf



Comment:

For those tracking their portfolio, the large swings in their portfolio values should be expected and should not excite them unduly.  For the long term investor, focusing on the operations of the businesses of the stocks in the portfolio is more important.  As was mentioned, the large swings do not affect his cash position or his investment holdings.

Berkshire's common stock investments

Investments

Below we show our common stock investments that at year end had a market value of more than $1 billion.

12/31/09

Shares
Company
Percentage of Company Owned
Cost *
Market
(in millions)

151,610,700
American Express Company . . . . . . . . . . . . . . . . . . . . . . . .
12.7
$ 1,287
$ 6,143

225,000,000
BYD Company, Ltd. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.9
232
1,986

200,000,000
The Coca-Cola Company . . . . . . . . . . . . . . . . . . . . . . . . . .
8.6
1,299
11,400

37,711,330
ConocoPhillips . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.5
2,741
1,926

28,530,467
Johnson & Johnson . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.0
1,724
1,838

130,272,500
Kraft Foods Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.8
4,330
3,541

3,947,554
POSCO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2
768
2,092

83,128,411
The Procter & Gamble Company . . . . . . . . . . . . . . . . . . . .
2.9
533
5,040

25,108,967
Sanofi-Aventis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.9
2,027
1,979

234,247,373
Tesco plc . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.0
1,367
1,620

76,633,426
U.S. Bancorp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.0
2,371
1,725

39,037,142
Wal-Mart Stores, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.0
1,893
2,087

334,235,585
Wells Fargo & Company . . . . . . . . . . . . . . . . . . . . . . . . . .
6.5
7,394
9,021

Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6,680
8,636

Total Common Stocks Carried at Market . . . . . . . . . . . . . .
$34,646
$59,034

*This is our actual purchase price and also our tax basis; GAAP “cost” differs in a few cases because of write-ups or write-downs that have been required.

In addition, we own positions in non-traded securities of Dow Chemical, General Electric, Goldman Sachs, Swiss Re and Wrigley with an aggregate cost of $21.1 billion and a carrying value of $26.0 billion. We purchased these five positions in the last 18 months. Setting aside the significant equity potential they provide us, these holdings deliver us an aggregate of $2.1 billion annually in dividends and interest. Finally, we owned 76,777,029 shares (22.5%) of BNSF at year end, which we then carried at $85.78 per share, but which have subsequently been melded into our purchase of the entire company.

In 2009, our largest sales were in ConocoPhillips, Moody’s, Procter & Gamble and Johnson & Johnson(sales of the latter occurring after we had built our position earlier in the year). Charlie and I believe that all of these stocks will likely trade higher in the future. We made some sales early in 2009 to raise cash for our Dow and Swiss Re purchases and late in the year made other sales in anticipation of our BNSF purchase.

We told you last year that very unusual conditions then existed in the corporate and municipal bond markets and that these securities were ridiculously cheap relative to U.S. Treasuries. We backed this view with some purchases, but I should have done far more. Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.

We entered 2008 with $44.3 billion of cash-equivalents, and we have since retained operating earnings of $17 billion. Nevertheless, at year end 2009, our cash was down to $30.6 billion (with $8 billion earmarked for the BNSF acquisition). We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.

http://www.berkshirehathaway.com/letters/2009ltr.pdf

Why Buffett bought Burlington Northern Santa Fe Corp

In earlier days, Charlie and I shunned capital-intensive businesses such as public utilities. Indeed, the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. We are fortunate to own a number of such businesses, and we would love to buy more. Anticipating, however, that Berkshire will generate ever-increasing amounts of cash, we are today quite willing to enter businesses that regularly require large capital expenditures. We expect only that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest. If our expectations are met – and we believe that they will be – Berkshire’s ever-growing collection of good to great businesses should produce above-average, though certainly not spectacular, returns in the decades ahead.


Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities.

• In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. 
• Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. 
• Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. 
• Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant.

We see a “social compact” existing between the public and our railroad business, just as is the case with our utilities. If either side shirks its obligations, both sides will inevitably suffer. Therefore, both parties to the compact should – and we believe will – understand the benefit of behaving in a way that encourages good
behavior by the other. It is inconceivable that our country will realize anything close to its full economic potential without its possessing first-class electricity and railroad systems. We will do our part to see that they exist.

In the future, BNSF results will be included in this “regulated utility” section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not* guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.

http://www.berkshirehathaway.com/letters/2009ltr.pdf

Comment:

-  The best business are those that generate high return on capital with need for little incremental re-investments to grow, that is, those that generate large FCF.  It is increasingly difficult to find such companies to invest into due to the size of Berkshire generating ever increasing amounts of cash.

-  Berkshire is willing to invest into companies that require large capital expenditure to grow provided that these businesses have reasonable expectations of earning decent returns on the incremental sums they invest.  These businesses are expected to produce above-average, though certainly not spectacular, returns in the decades ahead.


-  *The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged.


NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.


Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.

The Way The Stock Market Works.

The Way The Stock Market Works.

I have come to the conclusion that the market is (dare I say) generally being manipulated/influenced by firstly the large institutions, Secondly by full time professional traders and day traders.

The general public and the “Mum and Dad” investors are the last to know what is actually happening and invariably the ones that lose out in the long run.

The advantage the Institutions have is the “Millions” of dollars that they have available to use at any given time. This is usually obtained from the public in the first place, in the form of Insurance, Superannuation and Managed Funds etc.Which we (the general public) all contribute to on a daily basis.

The large advantage they have is the enormous amount of shares they are able to purchase at any given time.

What occurs is that even a small movement in share price means big profits for them, because of the volume/turnover of shares which occurs whenever a share transaction takes place.

Now Volume is the “Fuel” driving the market. An uptrend in share price to survive and to continue must be nourished by new buyers who are being fed by cautious, seemingly reluctant sellers.

Consistent volume is very important, if there is to be any change in the existing trend. There must be a surge of buyers or sellers capable of changing the current share price.

Remember for every “Seller” there has to be a “Buyer” and vice versa.

The seller thinks or knows the share price is going down and the buyer thinks the opposite.

Now too much selling will invariably force the price downwards as will too much buying forces the share price upwards. This is the law of “supply and demand”.

This “Law” is taken advantage of by the large Institutions who are well aware of what happens when they buy or sell huge volumes.


Some Reasons Why Share Prices Go Upwards.

It’s always a good idea to look at stocks that have jumped in price to see what clues where there beforehand. By gaining a greater understanding of what happened before stocks jump in price, it can give you a better chance of being on board some of the next ones.

When the share price increases, it means that the buyers (on average) want to buy larger parcels of shares. When people buy large parcels of shares it generally means that they are very confident in the stock and its future prospects.

A large increase in Smart Money (Traders in the know) and Buyer Demand can occur before a large jump in price happens. This information lets you know that other people are very interested in this stock and are prepared to spend big money on it. This can be another good clue.

When you see large spikes in Buyer Demand when the price is starting to rise upwards it often indicates that the stock is set for a much longer bull run. The rushes for stock are caused from either news or rumors and (as long as there is no bad news) this activity will then start attracting attention from other traders.

Another great clue is to be found when Directors are buying there own stock. It means that they must have confidence in their own company to invest money in it. You can find out when Directors are buying and selling by checking the ASX company announcements on a daily basis.

Companies are on strict instructions to notify the ASX when ever a Director buys or sell shares in his company. Directors buying are usually based on a profit motive.

Christopher Strudwick is a keen amateur share trader on the Australian Stock Market Visit his weblog for more free articles and useful information at http://www.asxnewbie.com


Read more about • The Way the Stock Market Works | My Stocks by mystocks.netai.net

http://mystocks.netai.net/5105/the-way-the-stock-market-works/