InvestorsFriend Newsletter June 6, 2015
The Essense of Stock Investing
The essence of stock investing is to choose stocks of companies that are reasonably profitable and are growing their profits and that are available at reasonable prices and to then simply ride along and benefit from the increased profits.
The first criteria (profits) is often more important than the criteria of paying a reasonable price. You can’t get blood from a stone and buying the stone at a bargain price does not change that fact. In order to profit from stock investments it makes sense to focus on companies that are making good (or excellent) profits. In this case the rising profits will often cover up the “sin” of having paid a rich price for the stock.
The Intelligent Use of Profits by Corporations
The ultimate financial goal of companies on the stock exchange is (or should be) to earn attractive returns for their share owners.
Profitable companies typically generate cash which they can then use in three ways:
1. To pay out cash to owners as dividends or by buying back shares, or
2. To reinvest in the company for future growth, or
3. To pay down debt (This one is rare for growing companies)
Often, companies choose some combination of the three.
To illustrate, imagine that a certain company has $100 million in owner’s equity and that it earns an attractive return of 10% on equity. Imagine also that the company has 10 million shares outstanding which therefore have a book value of $10 each.
For the sake of simplicity, let’s assume that the earnings are realized in cash. Free cash flow after accounting for any cash that needs to be expended to maintain the current size of the company is therefore also 10%. This company then has $10 million at the end of the year which it can distribute as dividends, use to buy back shares or use to invest in growing the size of the business or use to pay down debt.
What should the company do with the $10 million?
Some investors would argue that all of the money should be paid out as dividends. Others would argue that the best use of the cash would be to buy back shares in order to push up the value of the shares on the market. Still others might argue that the company should retain the $10 million and invest it for growth. The company could aslo use the cash to pay down debt. In the face of these competing uses for cash, companies often decide to do a little of each, (with the exception of paying down debt which is unusual for growing companies).
In reality the best course of action depends on the circumstances of each company.
If the above company that is making 10% on its $100 million of book value has no ability or opportunity to expand its existing business then it may not have any valid reason to retain any of of the $10 million.
If, on the other hand, the company has the ability and opportunity to invest in and expand its operations in a manner such that it will earn an attractive return on the incremental investment then it may be most logical for the company to retain all the earnings for reinvestments and not pay out any cash to owners at this time.
Debt should generally be paid down only if it is excessive.
If a company determines that it should pay out cash to owners then it can choose between dividends and stock buybacks. The two are not equivalent.
Dividends pay out cash to all owners proportionately.
Stock buybacks pay out cash only to departing owners who sell all or some of their shares. The continuing share owners have, in effect, collectively bought out the shares of the departing owners using the companies money (which they collectively own) to do so. Each continuing share now represents a slightly larger percentage of ownership of the company. However the company no longer possesses the cash that it used to buy back the shares.
From the perspective of the continuing share owners, a share buyback is a wise use of the company’s cash if and only if the shares are trading at something of a bargain price. A company that wishes to pay out cash should consider buying back shares if they are trading at what it considers to be a bargain price and should instead pay the cash as a dividend if its shares are not trading at a bargain price.
It is also the case that that “the market” expects dividends to be maintained or increased over the years. Therefore a company that pays a dividend should generally be prepared to maintain or increase its dividend. If a company wishes to pay out a dividend that it does not expect to be able to maintain it should consider declaring that as a special (one time) dividend.
How a company chooses to use or allocate its cash profits as between dividends, stock buybacks and reinvestment in the company can have a huge impact on the long-term returns enjoyed by its share owners. This decision is sometimes called the capital allocation decision.
Warren Buffett has sometimes been criticised because Berkshire Hathaway does not pay a dividend. But the record shows that Buffett had the ability and the opportunity to reinvest Berkshire’s cash profits on behalf of its owners at very attractive rates of return. The payment of dividends would have sharply reduced the long term returns for Berkshire’s owners.
On the other hand, there are companies like Bombardier which has historically used much of its cash profits to make acquisitions that have turned out to provide mediocre or negative returns. Nortel, in its hey-day used cash to make many dubious acquisitions. Had Nortel used cash to pay down debt it might still be in business.
Warren Buffett has pointed out that if a company is making a 10% ROE and if it retains all earnings and continues to make a 10% ROE then its book value of equity will double in less than eight years. How a company chooses to use its profits has a major impact on the long-term returns generated for its owners. If annual returns on equity of 10% can be reinvested in growing the business in a manner which maintains the 10% ROE, then the profits of the business will double in less than eight years. However, if the reinvestments are poured into investments that do not add to profits then profits will be unchanged after eight years despite the retention of years of profits. In that case it might have been far better to have paid ot the profits as dividends or perhaps through share buybacks.
Successful companies generate attractive returns for their owners through a combination of dividends, share buybacks or reasonably profitable reinvestments into the company.
Some companies simply do not have the opportunity and ability to reinvest profits at attractive returns. It is imperative that those companies pay out cash to owners. On the other hand, those companies that have the ability and the opportunity to reinvest profits at attractive returns should do rather than pay out money to owners.
When evaluating the track record of companies, investors should consider whether the company has been intelligent in regard to its policies around dividends, share buybacks and the retention of earnings for growth.
Stocks versus Bonds
There are many claims made about the performance of stocks versisu bonds and the wisdom of holding stocks versu bonds or some balanced combination of the two.
I have updated two reference articles that look at the returns from stocks versus bonds over various periods of time going back to 1926. Click the links to see these update articles:
Historic returns from stocks, bonds, treasury bills and gold.
Are Stocks Really Riskier than Bonds?
Is This A Good Time to Invest in Stocks?
Stock markets have historically risen more years than they have fallen and they have provided attractive returns over the long term. Given record-low interest rates, I believe the evidence is that stocks are not necessarily over-valued on average at this time. And, there are clearly some stocks which are at attractive valuations.
The following link shows our stock ratings at the start of 2014 and how they performed.
Our current stock ratings are available on a subscription basis. Click this link for more information.
To see older editions of this newsletter, click here.
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