Saturday, May 1, 2010

New Era Value Investing: Chapter 2

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Tengler takes the reader through the history of fundamental analysis in the stock market. While many value investors know the history as far back as Benjamin Graham and David Dodd's Security Analysis, Tengler goes further back to give credit to two New Yorkers who laid the groundwork that allowed Graham and Dodd to do their thing.

In the late 1800's, the stock market was akin to a casino, as fraudulent activities reigned throughout. Louis Guenther started a magazine in 1902 that reported on and exposed securities fraud, while Alfred Best published a service focused on reporting accurate information on insurance company financials, originally to allow customers to buy fire insurance from reputable companies that weren't going to go under. It was Best that first noted the concept of intrinsic value, whereby investors were encouraged to purchase stocks if they traded below the estimate of their intrinsic values.

In the 1930s came the groundbreaking work from Graham and Dodd, but even in subsequent editions of Graham's books did his methods evolve, though based on the same principles. This is because the market continued to evolve, as the methods that worked the best during the Great Depression were not the same as those that worked the best during WWII.

Over time, the dividend has also become less relevant. At one time, it was a mark of a great company that could continually reward its shareholders, but more recently it has become a sign that a corporation does not have profitable uses for its earnings. Dividend-focused value investors would be forced to change.


Ankit Gupta said...

The issue I have with dividends is the added taxation. First, the corporation pays a tax on earnings, and then the shareholders pays a second tax on the dividend issued.

I would rather see management spend that on buying back stock if it is fairly priced. If you have to pay 25% in tax on dividends, that represents 25% neither you nor the stock price will see. If you buy back stock, you avoid that 25% layer and can provide increased value to the shareholders on an intrinsic basis.

There is an issue with this though, because retail investors will often flock to a company touting high dividends. (See O Realty Income as an example) The stock price will increase and offer a premium because of the dividend. If the dividend is steady, investors see it as maybe a 5% return annually for holding the stock even when they might just be having a bad quarter or two.

Management of publicly traded companies need to be careful of this though, because being publicly traded already adds a lot of pressure and overhead to a business. By doing things to attract potentially less-knowledgeable investors, you might face additional trouble when they don't understand why you're doing something a certain way. The investors who prefer share buybacks and have a longer-term outlook would rather see that tax cost be used to further help the stock price and will probably be a little more sophisticated than others and less of a "hassle" for management to deal with.

There are some assumptions with this though - if you're conducting fraud, it might be easier to deal with retail investors who won't go digging around. All you have to do is look to Allied Capital's history and David Einhorn's experience in dealing with them.

The decision of a dividend or share buyback is one that I think will tell me a lot about management and their goals. It's like a report card that I can use to get an idea of how good they are at allocating capital, because share buybacks at an inflated price can be disastrous while dividends when the stock price is cheap also send a signal. I believe this is a good indicator of their performance because the board and management will have a much better outlook on the future of the business than anyone else and will also understand why the stock trades the way it does. They should make use of this extensive industry/business knowledge and make good decisions on how to use excess cash.

Chroma said...

I know stock buy backs are popular with Buffett too. But My problem with them in actuality is that management often buys back stock at the top of the market and not when their price is beaten down and it would increase shareholder value. Taxation aside, overpaying for a stock is no better if management is doing it than if I am.