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Part I set out the definitions and premises which are ubiquitously (but almost always implicitly) used to justify the contention – which appears to be unquestioned in America and developing in Australia – that in order to maximise “growth” companies should retain as much of their earnings as possible and pay the smallest possible dividend. A related contention is that in order to maximise the returns from their investments shareholders should seek “capital gains” from “growth companies” rather than dividends from “defensive investments.” Part II showed that the definitions underlying this argument can be criticised. It now transpires that at least one of its premises does not emerge unscathed from critical scrutiny.
Retained Earnings and Earnings Growth: A Myth Ripe for Exposure
Consider Premise 1: if a company invests its retained earnings productively, then its earnings in future periods will increase. Let us accept this premise on the basis that to invest is to acquire assets, and to invest successfully is to increase the stream of income generated by those assets over time (for details, see the circulars entitled Reasoned Scepticism Versus Irrational Exuberance and The Robinson Crusoe Ethic Versus the Distemper of Our Times). At the same time, however, let us also ask a critical question which investors seem seldom to ask: to what extent do companies invest their retained earnings successfully? Evidence bearing upon this question, alas, is less than reassuring. In the words of Jonathan Clements (The Wall Street Journal, 30 October 2001) “if you are a stock market investor, you’d better pray that the suits in the corner offices know what they are doing.”
Clements cites a recent study by Clifford Asness (managing principal of AQR Capital Management in New York) and Robert Arnott (managing partner of First Quadrant in Pasadena, CA). They observed companies’ dividend payouts during the period 1950-91, the growth of earnings during the subsequent 10-year period and the correlation between the payout ratio and growth of earnings. Their findings, from a mainstream point of view, are paradoxical and counter-intuitive: the higher the dividend payout ratio at a given point in time, the stronger the subsequent rate of growth of earnings. When payments are modest, in other words (and note that payouts in America are presently at unprecedented lows), growth of earnings during the following ten years tends to be weakest.
More generally, during the lowest quartile of payment periods (i.e., those 25% of periods when dividend payouts were lowest) earnings net of inflation fell by an average 0.7% a year during the next ten years. How to explain this counter-intuitive result? Mr Arnott’s “favourite theory is that cash burns a hole in management’s pocket and [that] they over-invest in a series of less-attractive projects …
The poster child for this is the massive investment in telecommunications equipment in the late 1990s. [Conversely], when they are paying out a lot as dividends, companies are forced to run lean and think very hard about every project.” Mr Clements concludes: “more than ever, stock returns hinge on management making smart decisions with shareholders’ capital. Worried about your portfolio’s performance? You better hope the corner-office crowd doesn’t gorge itself on stock options or waste your cash on foolish empire building.”
Another Myth
Let us now turn our attention to Premise 2, i.e., the contention that whether they do so via increases in working capital, acquisitions of other companies or the purchase of their own shares, companies can invest their retained earnings more productively than shareholders can reinvest the dividends paid to them by the company. With respect to mergers and acquisitions, the main results of recent research and the outcomes of recent mergers and acquisitions in Australasia (summarised in Corporate Mergers and Acquisitions: A Contrarian Case for Caution) do not, to put it mildly, substantiate this contention. Nor do the results of research reported by Jarred Harford (The Journal of Finance December 1999). Harford found that cash-rich firms destroy approximately $0.07 for every $1.00 of cash they retain. Considered as a group, in other words, the investment returns of the cash-rich firms studied do not exceed the results available to any schoolboy by simply depositing cash in a passbook savings account; indeed, these firms’ investments tend to lose rather than make money. Harford proposes a novel explanation for this disturbing result. Compare two hypothetical firms that are considering a project or acquisition of marginal value. The first firm is cash-poor and must therefore obtain the capital required to undertake the project/acquisition either from a commercial bank (through a loan) or an investment bank (through the issue of stock or bonds). To rely upon external finance, as this first firm does, is to submit to external scrutiny of the project by risk-averse lenders. The second firm is cash-rich, can finance the project with retained earnings and thus requires no outside scrutiny. Harford finds that the cash-rich company is much more likely to make this potentially unprofitable investment. In so doing, “large cash balances remove an important monitoring component from the investment process.” In short, to retain earnings is to provide acquisitive executives with a honey pot and an irresistible temptation to raid it – all without external scrutiny. Rather counter-intuitively, then, in these hands excess cash is a Bad Thing.
Rajan, Servaes and Zingales (Journal of Finance, February 2000) extend and elaborate this result. They analyse the operations of large conglomerates and find – again, counter-intuitively from a contemporary mainstream point of view – that investment capital tends to flow most readily to the conglomerate’s least productive divisions. Moreover, the more highly diversified the company (i.e., the less related its component businesses) the more systematically perverse its misallocation of capital. Finally, Ang, Cole and Lin (Journal of Finance, February 2000) find that these perversities are most egregious when managers own little or no stock; when few of the managers are ordinary investors; and when there is little or no bank or other scrutiny of the company’s operations. It follows that the most successful business tends to be run by a sole owner or a small group who collectively own most shares, and by managers who are transparent, frank and think and act as if they were substantial shareholders. Mr Buffett, of course knew (or intuited) this fifty years ago.
An Australian Example
The Weekend Australian (25-26 August 2001) provided an example, as conspicuous as it was painful for shareholders, of the systematic nature of the corporate misallocation of capital. During that week the CEO of one of Australia’s most prominent mining companies announced that he was slashing the company’s dividend in order to pursue a policy of “capital growth.” In the same announcement he noted that the company had destroyed $289 million of shareholders’ funds (more than double its operating profit) during the preceding year. More generally, and as TWA noted, the investment record of most Australian mining companies from the late 1980s to the late 1990s was mediocre at best and disastrous at worst. “Despite being the most capital-intensive of industries, mining has a terrible record of capital management.” BHP’s disasters during the 1990s ranged from the Ok Tedi mine in Papua New Guinea to the Hartley Platinum project in Zimbabwe and the hot-briquetted iron works in Western Australia; Western Mining Corp.’s miscues included its Seabright Gold investment in Canada; and Pasminco’s purchase of the Century Zinc deposit in Queensland (or, more precisely, its hedging of zinc sales), touted as a company maker, turned out to be a company breaker.
The misallocation of capital in the mining industry is hardly a uniquely Australian phenomenon. An analysis conducted in 2001 by the London-based consulting firm Resource Strategies found that, of the world’s top 20 resources companies, only three – Alcoa, Rio Tinto and Phelps Dodge – had achieved a return on invested capital that was greater than their weighted average cost of capital over the past 10 years. The allocation of capital within the mining industry, as Some Reflections on the Philosophy of Mining emphasised, is particularly fraught with difficulty. Julian Simon noted that the prices of natural resources (including industrial metals) have declined erratically but relentlessly for as long as price records have existed. Prices fall to the point that higher-cost mines cannot meet their variable costs and are closed. Meanwhile, mining technology is erratically but relentlessly becoming more efficient. Accordingly, and despite the closures of inefficient mines, existing and new mines tend constantly to increase supply. Hence the bottom of each price cycle tends to be lower than that which preceded it.
In TWA’s (25-26 August 2001) words, “this vicious logic has kept all mining companies focussed on getting their projects into the lowest quartile of operating costs in the world. However, the obsession with operating costs and margins has not been matched by similar attention to the capital costs of such efficiency.” The analysis conducted by Resource Strategies shows there is almost no correlation between the cash margins of the top 20 miners and their returns to shareholders. It notes that mining companies will invariably subject any new project to tight financial scrutiny. At the same time, however, this analysis is typically based upon the technical details provided by the project team. Similarly, the project’s champion (not infrequently a senior executive or the board of directors) will tend to accentuate the project’s benefits and attenuate its drawbacks, and as a result its key assumptions are almost inevitably optimistic. Acquisitions are not necessarily less risky and may be more so. The typical problems relate to inadequate due diligence because the bidder is too eager. The technical problems of resource properties are underestimated; the reserve figures are taken at face value; the capital requirements to develop them are underestimated; and the price paid is too high.
A Startling and Sombre Conclusion
William J. Bernstein, upon whose article Of Earnings, Dividends, and Agency this circular has drawn heavily, concludes “so we are faced with a startling paradox. The enormous recent success of American corporations has left them with elephantine cash flows that free them from outside scrutiny, which is in turn likely to result in future capital inefficiencies. A nearly identical scenario played out when low dividend payouts led to the conglomerate mania of the 1960s, which in turn generated the industrial malaise of the 70s. Plus ça change.”
A case can be made, then, that the argument set out in Part I does not withstand scrutiny (or, at least, does not emerge unscathed from scrutiny). Its definitions have several weaknesses, two of its major premises are questionable and hence (at least in their current form) they do not unambiguously support their intended conclusions. Indeed, as Part IV shows, diametrically opposite conclusions (which were orthodox in America during the 1940s and 1950s but are derided today) may be closer to the truth. What Australian companies have done for decades, in other words, continues to serve shareholders well: companies should retain and re-invest only those earnings which (using suitably dour assumptions) are very likely to generate demonstrably better results than can reasonably be expected if invested elsewhere. If they cannot demonstrate a superior ability to re-invest excess capital, then they should return it to its owners.
…continued in Part IV
 
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