Bernstein also gives an unfair example -- unfair because, to make a rational argument, he uses an extreme and emotional example.
In 1974 Consolidated Edison voted to suspend paying dividends, because they were faced with a financial crisis. Many investors were upset, and Bernstein quotes a woman as saying that since her husband died Con Ed had to be her husband and support her.
Now, Bernstein is correct that in this extreme situation the board of Con Ed did the correct thing. A bankrupt company can't pay dividends. I'm not saying that a company should pay dividends that it needs to survive.
But that's not the normal situation. The textbook argument is not that a company pay dividends and go bankrupt or stay in business . . . it's that a company should not pay dividends to expand the business or invest in other, more productive businesses.
Shareholders are co-owners of the business. They should see some return (and I mean REAL, spendable return -- not the kind of "returns" that most financial writers refer to when they call capital gains a 'return' even though NOTHING has been returned to the shareholder by the rise in stock price) on their investment -- or else they'd be better off in bonds.
Let's say you bought a McDonald's franchise. When it's new you'd have to buy equipment, the building, and so on. Once it's established, it should reinvest some profits in maintaining or replacing needed equipment, interior decorating, advertising, and so on -- if the current number of fryers and grills and satisfying the customer demand, it doesn't need to buy new ones in the hope that if it does, more customers will walk into the restaurant.
Given that reality, who would blame the franchise owner for taking some of the profits out of the business? Nobody, except Bernstein.
Given these many issues, I think it's quite rational for investors to think that $1 in their pocket is worth $2 in the retained earnings of a company whose stock they own.
stock dividends
stock dividends
Wednesday, June 27, 2007
Dividends versus Capital Gains Part 3
And what about investors? Bernstein argues that if they need money, they'd be just as well off selling their shares of the company, which in theory are worth that much more, because the company didn't pay dividends.
He writes that it's irrational for an investor to spend $600 in dividends to buy a TV but not to be willing to sell $600 worth of stock (that didn't pay out dividends) to buy the same TV.
But as I've argued above, the share price in the long run is only a little influenced by retained earnings.
If stock prices always reflected a rational evaluation of the company's balance sheet, and balance sheet improvement (or decline) were always 100% reflected in the stock's price rise (or fall), then this would make sense.
But in the real world, stock prices rise and fall every day purely on the give and take of supply and demand, between the bulls and the bears, mostly due to factors beyond the individual companies.
Today's $600 capital gain could easily become tomorrow's $600 -- or more -- loss.
Stock price rises are not permanent.
A dividend check cannot be taken back. The shareholder may waste it, but at least it was theirs to spend, reinvest or lose.
A capital gain is here today, gone next year.
Maybe for a lot of years.
As Bernstein well knows, dividends were the only reason to own stock from the October 1929 crash to 1954, and from 1966 to 1981. Is he saying that if companies had only refused to pay dividends that their stock prices would have gone up despite the Great Depression and World War 2. Despite the social turmoil of the 1960s, the Vietnam War, Watergate, the 1973 oil embargo and the tremendous rise in commodity prices during the 1970s, and the tremendous spike in interest rates?
Does he really want to say that companies could have raised their stock prices during all those problem periods, if only they'd refused to pay out dividends but reinvested the dividends instead?
Given the uncertain and fluctuating nature of capital gains, it's hardly a surprise that investors want to hang on to the shares of stock they own and collect the dividends. When they keep the shares, they can continue to collect the dividends, or even collect capital gains in the future if they so choose.
stock dividends
stock dividends
He writes that it's irrational for an investor to spend $600 in dividends to buy a TV but not to be willing to sell $600 worth of stock (that didn't pay out dividends) to buy the same TV.
But as I've argued above, the share price in the long run is only a little influenced by retained earnings.
If stock prices always reflected a rational evaluation of the company's balance sheet, and balance sheet improvement (or decline) were always 100% reflected in the stock's price rise (or fall), then this would make sense.
But in the real world, stock prices rise and fall every day purely on the give and take of supply and demand, between the bulls and the bears, mostly due to factors beyond the individual companies.
Today's $600 capital gain could easily become tomorrow's $600 -- or more -- loss.
Stock price rises are not permanent.
A dividend check cannot be taken back. The shareholder may waste it, but at least it was theirs to spend, reinvest or lose.
A capital gain is here today, gone next year.
Maybe for a lot of years.
As Bernstein well knows, dividends were the only reason to own stock from the October 1929 crash to 1954, and from 1966 to 1981. Is he saying that if companies had only refused to pay dividends that their stock prices would have gone up despite the Great Depression and World War 2. Despite the social turmoil of the 1960s, the Vietnam War, Watergate, the 1973 oil embargo and the tremendous rise in commodity prices during the 1970s, and the tremendous spike in interest rates?
Does he really want to say that companies could have raised their stock prices during all those problem periods, if only they'd refused to pay out dividends but reinvested the dividends instead?
Given the uncertain and fluctuating nature of capital gains, it's hardly a surprise that investors want to hang on to the shares of stock they own and collect the dividends. When they keep the shares, they can continue to collect the dividends, or even collect capital gains in the future if they so choose.
stock dividends
stock dividends
Dividends versus Capital Gains Part 2
Granted, many companies just can't afford to pay dividends. New companies that still must make a lot of investments to secure their businesses. Capital intensive companies that have to spend a lot just to keep up with the competition, and so on. Still, I would advocate that most investors stay away from such companies.
The companies that do traditionally pay dividends tend to be older and more established. They can afford to pay them.
One good example is Coca-Cola. It's paid only probably billions and billions of dollars in dividends to shareholders over the course of its long history. If it'd kept all that money, would it be even more successful? Would it have smashed all competition from Pepsi to Vess? Would Coke be sold in every single country in the world, even North Korea? Would every person in the world be buying a 6 pack or more a day? Or that the executives who introduced New Coke would have figured out they were making a mistake?
I don't think so. I could be wrong, but I think Coke has obtained as much brand saturation up to this point as it could have. It will keep expanding in the future, of course, and branching out into different kinds of drinks, but I don't think that there'd be a Coca-Cola bottling plant on every corner of the world if only Coca-Cola had refused to pay its shareholders dividends. I think many people in the world had to wait for various political and technical barriers that had nothing to do with Coke itself to fall. Plus, there're cultural and financial reasons why many people don't buy a drink they're not used to and can't afford. And of course Coke can't buy entry into North Korea or Iran.
I doubt its stock price would be so much higher that its investors would be glad it didn't pay any dividends.
It's Bernstein himself in an earlier section of this book that stresses the action of "return to the mean," or that trees don't grow to the sky, and businesses don't take over entire stock exchanges. At some point, the useful of that cash to the business would have to diminish. Some businesses have a natural limit to their growth, bounded on consumer tastes and other demand for their goods and services.
stock dividends
stock dividends
The companies that do traditionally pay dividends tend to be older and more established. They can afford to pay them.
One good example is Coca-Cola. It's paid only probably billions and billions of dollars in dividends to shareholders over the course of its long history. If it'd kept all that money, would it be even more successful? Would it have smashed all competition from Pepsi to Vess? Would Coke be sold in every single country in the world, even North Korea? Would every person in the world be buying a 6 pack or more a day? Or that the executives who introduced New Coke would have figured out they were making a mistake?
I don't think so. I could be wrong, but I think Coke has obtained as much brand saturation up to this point as it could have. It will keep expanding in the future, of course, and branching out into different kinds of drinks, but I don't think that there'd be a Coca-Cola bottling plant on every corner of the world if only Coca-Cola had refused to pay its shareholders dividends. I think many people in the world had to wait for various political and technical barriers that had nothing to do with Coke itself to fall. Plus, there're cultural and financial reasons why many people don't buy a drink they're not used to and can't afford. And of course Coke can't buy entry into North Korea or Iran.
I doubt its stock price would be so much higher that its investors would be glad it didn't pay any dividends.
It's Bernstein himself in an earlier section of this book that stresses the action of "return to the mean," or that trees don't grow to the sky, and businesses don't take over entire stock exchanges. At some point, the useful of that cash to the business would have to diminish. Some businesses have a natural limit to their growth, bounded on consumer tastes and other demand for their goods and services.
stock dividends
stock dividends
Dividends versus Capital Gains Part 1
I was reading Against the Gods by Peter Bernstein again last night, and near the end there's a section about the misperceptions and departures from pure rationality that investors make. I was shocked when I started reading a section that began by saying that there's no rational reason for corporations to pay dividends, or for shareholders to want them to.
As much as I've enjoyed his books up until then, I now have to think that when he wrote that he purely had his head up his rear end. That's a rational academic argument, but it's got no relation to the real world.
The academic argument is that when a corporation pays out dividends, it is losing cash that could be better spent in other ways, such as paying down debt or being invested in some way to make a better return. By being used to improve the company's balance sheet or to make a better business investment, the company's financial position is improved.
This means that the company's stock in theory will be worth more, because the company will be in a better financial situation.
At the time this book was written, capital gains got preferential tax treatment, so an investor receiving dividends paid full tax on them but an investor raising the same money by selling stock paid less in taxes. That's been changed in recent years, but the Democrats plan to go back to socking it to the owners of dividend-paying stocks (anybody who owns dividend-paying stock is obviously rich and evil and needs to have their money taken away from them ((according to class-warfare Democrats)) . . . by I digress.)
(Bernstein didn't mention transaction charges, which favor the dividend receiver over the stock seller who must pay brokerage commissions, but I admit that's minor compared to the tax difference.)
That's a great theory, and a company's stock price does get adjusted for payout of dividends, but that's hardly a major factor in a company's stock price determination. As Bernstein has written about himself, per modern financial theories a company's stock price is mostly determined by the overall market.
How many investors say to themselves, I liked company X at $50 a share but since it just paid out a dividend of 50 cents per share I'm not going to pay over $49.50? Stock buyers that really like that company will buy at market.
Furthermore, it's not real world to say that all cash a company keeps in retained earnings is invested well. Companies can and do waste it. It may just go to give company officers more stock options, which is not a benefit to shareholders. It may go to acquire another company which is a waste of time and effort. Many things can happen to that cash, many of them of no value to shareholders.
The 50 stocks in this Mergent index are not doing poorly in the market place even though they pay dividends.
Not to mention, Enron, Global Crossing and obvious frauds. Most companies and executives are not frauds, but that doesn't mean they're building shareholder value the best way with retained earnings.
stock dividends
stock dividends
As much as I've enjoyed his books up until then, I now have to think that when he wrote that he purely had his head up his rear end. That's a rational academic argument, but it's got no relation to the real world.
The academic argument is that when a corporation pays out dividends, it is losing cash that could be better spent in other ways, such as paying down debt or being invested in some way to make a better return. By being used to improve the company's balance sheet or to make a better business investment, the company's financial position is improved.
This means that the company's stock in theory will be worth more, because the company will be in a better financial situation.
At the time this book was written, capital gains got preferential tax treatment, so an investor receiving dividends paid full tax on them but an investor raising the same money by selling stock paid less in taxes. That's been changed in recent years, but the Democrats plan to go back to socking it to the owners of dividend-paying stocks (anybody who owns dividend-paying stock is obviously rich and evil and needs to have their money taken away from them ((according to class-warfare Democrats)) . . . by I digress.)
(Bernstein didn't mention transaction charges, which favor the dividend receiver over the stock seller who must pay brokerage commissions, but I admit that's minor compared to the tax difference.)
That's a great theory, and a company's stock price does get adjusted for payout of dividends, but that's hardly a major factor in a company's stock price determination. As Bernstein has written about himself, per modern financial theories a company's stock price is mostly determined by the overall market.
How many investors say to themselves, I liked company X at $50 a share but since it just paid out a dividend of 50 cents per share I'm not going to pay over $49.50? Stock buyers that really like that company will buy at market.
Furthermore, it's not real world to say that all cash a company keeps in retained earnings is invested well. Companies can and do waste it. It may just go to give company officers more stock options, which is not a benefit to shareholders. It may go to acquire another company which is a waste of time and effort. Many things can happen to that cash, many of them of no value to shareholders.
The 50 stocks in this Mergent index are not doing poorly in the market place even though they pay dividends.
Not to mention, Enron, Global Crossing and obvious frauds. Most companies and executives are not frauds, but that doesn't mean they're building shareholder value the best way with retained earnings.
stock dividends
stock dividends
Sunday, June 24, 2007
Don't sell stock and you don't have to worry about volatility
Later in Against the Gods, Peter Bernstein comes close to what I'll be writing about in my own book on income investing.
He points out that the volatility Harry Markowitz posits as equal to stock market risk does not matter to "For true long-term investors -- that small group of people like Warren Buffett who can shut their eyes to short-term fluctuations and who have no doubt that what goes down will come back up -- volatility represents opportunity rather than risk, at least to the extent that volatile securitites tend to provide higher returns than more placid securities."
In that sentence he cannot get away from a concern with market price. But he does mention his wife's late aunt who used to boast that she was his only in-law who never asked him what he thought the market was going to do.
"I didn't buy in order to sell," Bernstein quotes his aunt-in-law.
Most people don't understand this attitude -- but it's perfectly logical if you are buying to receive dividends for the rest of your life.
Then you don't need to care about the market price, as long as you continue to receive ever-incresing dividend checks every quarter.
Your only risk is the danger that the company will decrease, suspend or end its quarterly dividend payments.
dividends overcome volatility
dividends overcome volatility
He points out that the volatility Harry Markowitz posits as equal to stock market risk does not matter to "For true long-term investors -- that small group of people like Warren Buffett who can shut their eyes to short-term fluctuations and who have no doubt that what goes down will come back up -- volatility represents opportunity rather than risk, at least to the extent that volatile securitites tend to provide higher returns than more placid securities."
In that sentence he cannot get away from a concern with market price. But he does mention his wife's late aunt who used to boast that she was his only in-law who never asked him what he thought the market was going to do.
"I didn't buy in order to sell," Bernstein quotes his aunt-in-law.
Most people don't understand this attitude -- but it's perfectly logical if you are buying to receive dividends for the rest of your life.
Then you don't need to care about the market price, as long as you continue to receive ever-incresing dividend checks every quarter.
Your only risk is the danger that the company will decrease, suspend or end its quarterly dividend payments.
dividends overcome volatility
dividends overcome volatility
Volatility is a good proxy for risk only if you are a short-term investor
Against the Gods by Peter Bernstein is subtitled "The Remarkable Story of Risk" though this is somewhat clipped. Obviously, risk as danger is not something that has a story. The book is about the attitudes and techniques people take in facing risk.
We have always faced danger. But we couldn't always buy insurance.
When it comes to stock market investing, Bernstein does finally discuss the nature of risk, when writing about Harry Markowitz's famous paper Portfolio Selection.
Because Markowitz uses volatility as a "proxy" for risk, Bernstein writes. The vast majority of financial writing do not even realize that volatility is not risk per se.
So he does discuss whether or not volatility is a good proxy for risk, or whether there's a better way to deal with it. If you don't look upon volatility as itself dangerous to your money, then stock market investing is less risky than putting your money into
a certificate of deposite that is risky because of its low yield.
volatility does not equal risk
volatility does not equal risk
We have always faced danger. But we couldn't always buy insurance.
When it comes to stock market investing, Bernstein does finally discuss the nature of risk, when writing about Harry Markowitz's famous paper Portfolio Selection.
Because Markowitz uses volatility as a "proxy" for risk, Bernstein writes. The vast majority of financial writing do not even realize that volatility is not risk per se.
So he does discuss whether or not volatility is a good proxy for risk, or whether there's a better way to deal with it. If you don't look upon volatility as itself dangerous to your money, then stock market investing is less risky than putting your money into
a certificate of deposite that is risky because of its low yield.
volatility does not equal risk
volatility does not equal risk
Value investors exhibit Gambler's Fallacy
Peter Bernstein continues to raise interesting points in Against the Gods.
He writes about the concept of regression to the mean, and how this has worked as a system of investing for people such as Warren Buffett and other value investors. Although he doesn't mention it, it also explain the Dogs of the Dow technique (before it became well known.)
Not to mention the "magazine cover" effect. This is where people who make the covers of magazines in their fields for their accomplishments often go downhill afterward. SPORTS ILLUSTRATED has actually studied it, because there're numerous examples of players and teams who have never been so good as they were before making the cover of that magazine. One options guru I know of (you likely get mail order advertisements from him) uses magazine covers as a contrary indicator in his system. If a company or CEO makes the cover of a business magazine, it's time to dump the stock!
It also explain the Growth Trap as explained by Jeremy Siegel in his latest book The Future for Investors. When you pay a premium for a stock with great growth prospects, you don't do as well as you do when you put the same money into an investment that is not comparatively overpriced. He compares long term investments in IBM and Standard Oil, and in China and Brazil. (Yes, in the past Brazil has been the better long term investment despite all its political and economic problems and despite China's phenomenal growth -- keep that in mind the next time you get sales letters in the mail telling you that you're going to be poor if you don't invest in China and India.
However, keep in mind Bernstein's caution that it's not always easy to know where the mean is and when the regression will occur. People who invested in the stock market in 1930 because they thought the crash was over lost a lot of money.
In gambling circles, the belief that random results will soon revert to normal because they've been abnormal, is known as the Gambler's Fallacy.
A lot of people have lost a lot of money to casinos because they were sure the roulette's wheel long streak of red "had" to end on the next spin, or 7 had to come up, or the slot machine had to pay off . . .
regression to the mean
regression to the mean
He writes about the concept of regression to the mean, and how this has worked as a system of investing for people such as Warren Buffett and other value investors. Although he doesn't mention it, it also explain the Dogs of the Dow technique (before it became well known.)
Not to mention the "magazine cover" effect. This is where people who make the covers of magazines in their fields for their accomplishments often go downhill afterward. SPORTS ILLUSTRATED has actually studied it, because there're numerous examples of players and teams who have never been so good as they were before making the cover of that magazine. One options guru I know of (you likely get mail order advertisements from him) uses magazine covers as a contrary indicator in his system. If a company or CEO makes the cover of a business magazine, it's time to dump the stock!
It also explain the Growth Trap as explained by Jeremy Siegel in his latest book The Future for Investors. When you pay a premium for a stock with great growth prospects, you don't do as well as you do when you put the same money into an investment that is not comparatively overpriced. He compares long term investments in IBM and Standard Oil, and in China and Brazil. (Yes, in the past Brazil has been the better long term investment despite all its political and economic problems and despite China's phenomenal growth -- keep that in mind the next time you get sales letters in the mail telling you that you're going to be poor if you don't invest in China and India.
However, keep in mind Bernstein's caution that it's not always easy to know where the mean is and when the regression will occur. People who invested in the stock market in 1930 because they thought the crash was over lost a lot of money.
In gambling circles, the belief that random results will soon revert to normal because they've been abnormal, is known as the Gambler's Fallacy.
A lot of people have lost a lot of money to casinos because they were sure the roulette's wheel long streak of red "had" to end on the next spin, or 7 had to come up, or the slot machine had to pay off . . .
regression to the mean
regression to the mean
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