The Aggressive Conservative Investor: Chapter 14
Martin Whitman founded Third Avenue Value Fund some twenty years ago. Over that time period, the fund has beaten the returns of the S&P 500 by several points annually. In The Aggressive Conservative Investor, Whitman collaborates with Martin Shubik to discuss a concept that they call "safe and cheap" investing.
The authors now discuss the role of dividends in security analysis. Firm dividend policies are difficult to determine because they assume all shareholders are of a single mind, whereas various shareholder groups will have different preferences. For example, some shareholders no doubt rely on their portfolios for income, and thus high payout ratios would be their preference. On the other hand, other shareholders may prefer tax-sheltered earnings, where the company re-invests its profits and grows its worth over time.
The authors take issue with how dividends are often used to value a firm. The Dividend Discount Model (DDM), as it has come to be known, postulates that a firm is worth the present value of its future dividend payments. While useful in theory, however, the authors argue that a much more practical model would include all cash that may be received as a result of the investment, including proceeds from the sale of the stock to increased borrowing capacity. An example is discussed where a dividend stock is purchased on margin, but where the dividend is safe, and enough to pay the interest charges on the borrowed money.
Graham and Dodd argued that stocks with higher payout ratios tend to trade at higher relative prices. Whitman argues that this does not demonstrate the superiority of dividend stocks, as once again the investment preference depends on the investor's circumstances. To an investor relatively indifferent to the dividend, this would make low dividend stocks attractive (due to the lower prices) as in the future the price may rise from a change in payout ratio, or the company may have higher earnings (as a result of re-investment) from which to pay out.
Though Graham and Dodd rightly point out that all too often, firms with low payout ratios often squander the earnings in investments that don't generate adequate returns on capital, Whitman points out a few examples where firms kept their payout ratios too high whereas they should have been investing in their businesses.
Dividends also play an important role when a public company is majority-owned by another entity. Minority shareholders can profit from either mop-up transactions where the parent pays a premium price to take the company private, or from situations where the parent company needs the cash and therefore dividends must be paid from the subsidiary to all shareholders.
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