Thursday, July 31, 2008

Security Analysis: Chapters 29 and 30

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

These chapters cover the topic of dividends. The authors are critical of the way corporations handle dividend payments, as managers use criteria in determining the dividend rate which are not aligned with shareholder benefits. Investors appear to recognize this, as two identical companies except for their dividend rates will show a higher valuation for the company with the larger dividend. Unfortunately, investors do not hold managers up to a better standard of dividend policy.

Specifically, one reason corporations withhold dividends is to ensure its stability. If earnings gyrate, dividend payments would also gyrate, which is not in the interest of the stock owner. To an extent, the authors agree with this argument, however, they cite numerous examples where this line of reasoning is abused, where average earnings far outsize the stable but artificially low dividend.

Another reason corporations keep dividends low is to re-invest and thus grow the business. In some cases, this may be of advantage to shareholders. However, in the majority of cases, the increment in profit derived from the re-investment of profits does not justify the investment. This is a clear case of interest misalignment: managers benefit in wages and reputation as the size of the business increases, but in many cases shareholders would be better off had they received the dividend. In many examples, companies ended up going bankrupt (after hard times had hit) having not paid out dividends as they should have, as they had instead re-invested in capital equipment which is now worthless.

The authors finish the topic on dividends by discussing the benefits and drawbacks of various forms of stock dividends, where investors receive stock instead of cash.

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