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The crux of Part III can be briefly summarised. According to The Wall Street Journal (3 March 2002), “today, companies are gunning for faster growth, by eschewing dividends and instead plowing a much higher percentage of profits back into their business. But will this strategy pay off? [Richard Arnott, managing partner of First Quadrant in Pasadena, California and hedge-fund manager Cliff Asness] took a look at the issue. Their finding: historically, profit growth has been surprisingly sluggish when management hangs on to a big chunk of earnings. ‘We wanted some basis for optimism,’ Mr Arnott says. ‘We didn’t find it. The argument that higher retained earnings leads to higher growth doesn’t hold up to historical scrutiny.’” Accordingly, and in the words of William Bernstein (quoted in The Wall Street Journal 11 July 2000), “the evidence is overwhelming that, on average, a dollar of earnings reinvested in the company benefits the investor a good deal less than a dollar of earnings distributed as dividends... Investors should [therefore] prefer the cash in their hands than in a company’s hands. A bird in the hand is worth two in the bush.” Similarly, and as Robert Shiller wrote in Irrational Exuberance (Paperback ed., 2001, Broadway Books; ISBN: 0767907183), “the reliable return attributable to dividends, not the less predictable portion arising from capital gains, is the main reason why stocks have on average been such good investments historically.” Dividends paid to shareholders oblige executives to evaluate spending proposals more carefully, and thereby provide a useful brake on corporate spending.
Once Upon a Time
This appreciation of dividends flies in the face of today’s orthodoxy. In America today it is nearly universally accepted, and in Australia it is becoming accepted, 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.”
It is instructive to contrast this contemporary orthodoxy with that which preceded it. Jeremy Siegel (The Wall Street Journal 13 February 2002) notes that “history provides us with important lessons about the sources of shareholder value. In the 19th century there was no Securities and Exchange Commission, [Financial Accounting Standards Board] or any of the other numerous agencies that oversee our securities markets today. A firm released whatever information it liked whenever it wanted and management didn’t fret it would be taken to task for reporting a dubious number …Given the total lack of standards back then, how did a firm signal that its earnings were real? The old-fashioned way, by paying dividends, an action that gave tangible evidence of the firm’s profitability and proof that the firm’s earnings were authentic.” The crash of 1929 and the Great Depression of the 1930s grafted government intervention (in the form of the SEC, FASB, Glass-Steagall, etc.) to this orthodoxy. It also moulded and in some respects hardened it. Investors in that chastened era lived in the constant fear that more companies would become bankrupt and that the prices of stocks would plunge further. As a compensation for this risk, and as a confirmation of the veracity of corporate communications and accounts, they therefore demanded – and over time received – ever-more generous dividend payouts.
This mindset permeated influential finance textbooks of the day. They tended to define “investment” in terms of the purchase and retention of dividend-paying stocks. Stocks that did not meet this and other conservative financial criteria were denigrated as “speculative issues.” A company that paid a dividend, the texts contended, was less likely to liquidate and its stocks were less likely to decline should another crash occur. Many academic studies were predicated upon this concept, and two generations of finance students and practitioners learnt to value companies in terms of their expected dividends. This approach, utterly alien to the viewers of CNBC and the readers of the popular press, continues to resonate among at least one influential academic. According to Jeremy Siegel (The Wall Street Journal 13 February 2002), “dividends are crucial for pricing a firm since finance theory states emphatically that the price of a stock is not the discounted value of future earnings, but the discounted value of future dividends and other cash distributions. Earnings are only a means to an end, and that end is to maximise future cash returns received by investors.” Benjamin Graham was and value investing remains very much a product of this Depression-era mindset. Traditional Grahamites’ approach to the valuation of a company invariably emphasises a company’s ability to generate earnings and to return them to its owners. For Graham and the academics and practitioners who followed in his footsteps, time preferences are high: that is, a cash dividend in the hand is worth more than the promise of capital gain in the bush. Given the risks that inhere in investing, it is better to receive money from the company now than have to depend on its ability to generate future profits on shareholders’ behalf. Graham wrote in the 1934 edition of Security Analysis that
Until recent years the dividend factor was the overshadowing factor in common-stock investment. This point of view was based on simple logic. The prime purpose of a business corporation was to pay dividends to its owners. A successful company is one which can pay dividends regularly and presumably increase the rate as time goes on. Since the idea of investing is closely bound up with that of dependable income, it follows that investment in common stocks would ordinarily be confined to those with a well-established dividend. It would also follow that the price paid for an investment in common stocks would be determined chiefly by the amount of the dividend.
Graham acknowledged circumstances under which companies legitimately do not and should not pay dividends. If executives can marshal a strong argument and hard evidence that the retention of earnings will strengthen cash flow increase productive capacity or “eliminate an overcapitalisation” (i.e., repurchase shares), then their retention is justified. More generally, when a company can make demonstrably better use of its cash internally than investors can externally, then both prudence and the necessity to serve shareholders demands that the company retain its earnings and suppress its dividends. But this is the exception rather than the rule; and the onus is upon executives to demonstrate that they can allocate retained earnings more effectively than can shareholders. Although he made no presumption that it could or would do so, Graham acknowledged that if a company successfully reinvests its earnings then it will be in a better position to resume the payment of dividends (or pay higher dividends) in the future. By sacrificing $1 of dividends now, in other words, investors may benefit more if the company can reinvest the money and generate more than $1. If so, then sooner or later that $1 will return to shareholders in the form of a dividend. Again, however, it must be emphasised this is an exception rather than the rule; and the point bristles with ifs, ands and maybes.
In Praise of Dividends
Unlike most other investors, Leithner & Co. appreciates dividends and emphasises the decisive role they play in the valuation of companies. In this context is it instructive to note that significant numbers of solid companies with talented executives have ignored the retained earnings and capital gains mantras of the 1980s and 1990s, and have resisted the temptation to slash their dividends. Indeed, during the past ten years a small number of quality Australian companies have generated higher earnings and increased their dividends over time. These executives may understand something about the creation of real, long-term wealth that most executives, consultants, advisors and brokers have forgotten. According to a recent study by Michael Goldstein (Babson College) and Kathleen Fuller (University of Georgia), over the past three decades an investment in the average dividend-paying company has benefited its shareholders more than an investment in a non-dividend paying company.
Sound companies typically generate more cash than they can remuneratively reinvest. And talented executives recognise that one can only re-invest so much each year and earn a superior return on the money. It follows, then, that most sound companies should return a significant percentage of their earnings to their owners. To do so is preferable to the placement of too much money into reasonable lines of business, and to the “investment” of any amount in a questionable line of business. Both are undisciplined uses of capital, and both lower the overall return on the company’s equity. Gail Dudack, in a report published in February 2002, summarises the defence of dividends in these terms: “only companies with real cash flow and real earnings will consistently pay dividends to investors. Dividends are a financial commitment from a company. They cannot be paid with smoke and mirrors. And companies that increase their dividend payments are steadily and consistently rewarding shareholders for their loyalty. Equally important, companies with a track record of paying dividends and increasing dividend payments are making a clear statement about the confidence they have in their earnings potential, real cash flow and the viability of their long-term business plan. It is action instead of words.”
The Last Word
We conclude, then, that the average Australian company (let us call it X Ltd) is no Berkshire Hathaway Inc., Wesfarmers Ltd or Westfield Holdings Ltd. Accordingly, because superior results are unlikely to be obtained year after year by augmenting X Ltd’s working capital, financing its acquisitions of other companies or repurchasing its own shares, it follows that X Ltd should, as a rule, remit the bulk of its earnings to its shareholders. Moreover, companies with high dividend payout ratios will tend to achieve the best operating results; shareholders’ best returns will derive disproportionately from such companies (and only incidentally from companies that retain a large percentage of their earnings); and therefore dividends provide the foundation of an investor’s accumulation of wealth over the long term.
The last word, appropriately, goes to Benjamin Graham: “basically price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”
 
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