Saturday, May 28, 2011

The Aggressive Conservative Investor: Chapter 15

Martin Whitman founded Third Avenue Value Fund some twenty years ago. Over that time period, the fund has beaten the returns of the S&P 500 by several points annually. In The Aggressive Conservative Investor, Whitman collaborates with Martin Shubik to discuss a concept that they call "safe and cheap" investing.

The topic of this chapter is dividend policy. The authors make it clear that they believe an appropriate dividend policy is based on the needs of the business rather than the needs of the investor. There is a prevailing mindset that companies should pay out based on how shareholders view the shares; if the stock trades at a low (high) P/E, the company should have a high (low) payout ratio. The authors take issue with this, as they argue that there is no empirical evidence to suggest investors accurately gauge the growth prospects of a business. Instead, companies should invest where they see opportunities for above-average returns, and return the rest to shareholders.

A discussion of stock dividends and in-kind dividends is also presented. Stock dividends are mostly considered useless, except for the few companies that need to constantly raise capital. For them, the increase in share price that results from a consistent dividend (even if paid in stock) is valuable to the firm. In-kind dividends (for example, dividends have at times been paid in whiskey or chocolate) are unpopular because they trigger a taxable event, and yet no cash is provided to help pay that tax.

The authors also discuss share repurchases, which they view as similar to cash dividends with a few advantages and disadvantages. A benefit of repurchases is that shareholders are taxed as if the income was attained through capital gains. A further benefit is that investors get to choose when the cash is withdrawn, and therefore when the tax is paid. Finally, the value of shares can be enhanced if the shares were repurchased from weak hands at favourable prices.

On the other hand, share repurchases do have their downsides. They are legally more difficult to effect, they can reduce the liquidity of shares outstanding, and they are subject to manipulation activities by management. For example, an insider looking to sell his holdings can do so with the company's money. Or, a manager looking to take the company private can first reduce the share count at the expense of selling shareholders.

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