Benjamin Graham lesson 5 Quantitative analysis and dividends

Quantitative Analysis, dividends

Graham divides quantitative analysis for three parts:

1. Dividend ratio and record
   
2. Earning power
   
3. Balance sheet factors
   

Dividends

Investors have two sources of income: dividends and capitalized appreciation. The former is measured by the difference between the price used for selling and buying. Shareholders make decisions about the dividends in the annual general meeting. The board of directors gives a suggestion about the dividend and the shareholders either approve or they don´t by voting about it. Shareholder´s interest is not always the same as the interest of the company. Long term investor should always ask himself:

”Can the company invest the money paid as a dividend to the business better than the investor himself can earn by reinvesting it, when you take taxes into consideration?”

Big dividend is a good thing, when the answer to the question is no. The answer to this question isn´t simple. Different businesses have different needs for capital. When you make an analysis, you have to evaluate how good is the dividend policy compared to the capital needed. Companies with lots of net debt cannot pay so much dividends as the companies with no net debt. Good businesses pay dividends and can increase the rate in the long-term. The other possibility is to buy own stocks under the real value of future cash flows.

Companies have three reasons not to hand out the current earnings for the shareholders:

1. Strengthening the financial position of the company
   
2. Increasing productive capacity
   
3. Eliminating overcapitalization
   

First reason is for accumulating cash. When the management are not willing to hand out current earnings and increases its cash position, it delivers a message to the shareholders. This message is telling the shareholders that management can increase the dividends in the future. You have to analyse whether this cash could be invested in something else. You also have to check the track record of the previous cash accumulations of the management. Their signals may be completely wrong. In this case, there is always a possibility that the future earning power of the company doesn´t proportionately expand with the increasing surplus of cash.

Giving a small dividends starts from the assumption that the owner and the company have the same benefits. Capital surplus can be a benefit for the company, but for the owners´ benefits can be different. Sometimes, part of the capital surplus cannot be used to increase future earnings enough. Then, the owners lose a possibility to invest this cash to some other places. Future earnings potential is not completely correlated on the capital surplus. When the company retains a dollar into its capital, it has to create at least a dollar of added value in the future. When this doesn´t happen, all the extra dollars should be given to owners.

Directors can be the biggest obstacles in a rational dividends policy. Owners have to protect their rights. Usually, the board of directors make a proposal about the dividend for the general meeting. Mostly, owners are lambs who easily succumb to the proposal. This can cause wrong incentives to the directors to use the surplus in any way they want. For example, getting generous options programs. Many directors have also tendencies to expand their own sand boxes by using the surplus in acquisitions or some other ways that are too expensive for the owners. On average, Graham thought that dividends were the better option for the owners than accumulating surplus in cash. He thought that a company must use sufficient part from the profits to increase its earnings potential and dividends. If the dividends is small, owner has to demand an exceptional skill of reinvesting the retained surplus from the directors.

Some owners may benefit from the smaller dividend rate than others. Owners have different kind of incentives like different tax rates for dividends. Smaller dividend rate can keep stock price lower, because markets may not understand the benefits of smaller rates compared to other similar type of companies. Owners can also suffer from the rate that is too high, because reinvested profits are not creating new profits or the profits are obligatory reserves left to the company. Sometimes investors are confuse the real profits and these reserves, because they invest only to get dividends.

Owners should make wise decisions about dividends and not leave the profit sharing proposal for the directors. Sometimes there is a demand for special decisions. Sometimes it is wise to leave the profits for the company and other times it is not the smartest choice. Every decision is made in special circumstances. Every owner should consider profit sharing proposals from his/her own perspective and make a decision how to vote in the general meeting.

I hope you will check the dividend policy of the companies you are interested in investing. Think about how reasonable it is for the owners.

Have a nice week!

-Tommi T

Benjamin Graham Lesson 4 Qualitative factors in analysis

Graham´s expertise was not in a qualitative analysis. For example, he missed a durability of competitive advantage concept. Graham examined a company´s market share, its physical, geographical and functional features, the quality of the company´s directors, and finally a company´s, industry´s and common financial expectations. An analyst has to examine qualitative features from many different sources. He has to go through all the company´s press releases and annual reports. He has to check some expert opinions, trade magazines, competitors´ annual reports, etc. Sometimes, sources are opinions. An industry expert may give his opinion about the company or its directors. Different people can have different opinions about quality. Using individual sources can produce wrong conclusions. Graham thought qualitative analysis was less useful, because it was hard to him.

The qualitative functional features are the dependency of capital, competitive environment, regulations, the raw materials need, the need for research and development investments, etc. All these factors have an effect on the earnings prospects for the future. These factors change along industry´s and common financial cycles. You need to analyse these factors partly through the numbers. Graham thought that it was hard to find any useful information by analysing the industry. Every industry have many details to analyse. Analyst need to decide which pieces of information are the most important ones. Most of the industry´s numbers are known by everyone. Graham thought that the best informational advantages were found from the industries, which were going through changes. Bigger changes equal bigger risks and opportunities. If you didn´t understand these changes, Graham would recommend you to analyse other industries.

Graham believed that high profit margins in all the industries were going to be diminished in the long run into normal levels. This was going to happen because eventually these markets would get more competitors. They would bring lower profit margins. He thought there were no durable competitive advantages. Products like Coca Cola, have kept their competitive advantages for decades. There are no changes in the horizon. Graham also believed that all the biggest market shares would diminish through years.

He believed that the stability of the business was the most important qualitative factor. It means resistance to change and makes evaluating the future earnings prospects easier. Stability of the business doesn´t mean that future profits will stay the same as in the past in most of the earnings units. For example, the turnovers and the profit margins of the individual companies can have lots of variations. Companies with bigger market shares are more stable than companies with smaller ones. Increasing earnings are good signs. You can only make assumptions about the future from the earnings history.

All the businesses have their natural turnover and profit cycles. Without understanding them, analyst gets less accurate predictions about the future and the quality of the business. All the businesses need to be evaluated through their natural business cycles. A trend in earnings prospects can be over before the analyst notices it. Analysis cannot be based solely on the assumptions about the trends business is going through. But it can be a baseline in evaluating the future of the business. Graham thought that an investor should take into consideration changes in the future. But instead of trying to take advantage of them, he should protect himself from the changes.

Financial strength and capital structure have an effect on the quality of the business. Having a significant amount of cash or its equivalents and a reasonable amount of debt are factors of quality. A reasonable amount of debt gives leverage to the company. Too much debt, especially debt that has to be paid soon can become lethal to the company. Worst kind of debt comes from the banks. Big debts from them are the worst kind of debts for companies.

The abilities of the directors are hard to measure. Some of your ideas about directors are based on rumors and presumptions. Most outsiders cannot really know the directors without working with them. The best proof of the quality of the directors is found by comparing the success of the company with other companies in the same industry. This comparison should be made for the longer time period, like many years. It takes time to make changes for the companies. The best conclusions can be made, when the directors of different companies have managed to stay in their positions many years. You shouldn´t make any conclusions without having a possibility to see the track records of the directors.

Graham thought that members of the board of directors belonged to the five groups:

1. Directors who are mainly interested in their own good.
2. Investment bankers, whose first objective is to make money for their bank.
3. Normal bankers, whose aim is to keep their loans running
4. Persons, who are doing business with the company
5. Some people who are actually interested in owner´s assets

He also thought that most of the people in the fifth group have created friendships with other board members to get their position in the board. One of the most important qualitative factors is how the directors treat shareholders. All the profits from the business belongs to the owners. Directors should maximize the earnings of the owners in the long run. Graham believed that one factor of quality is how many consecutive years has the company paid dividends. Directors shouldn´t maximize the amount of cash in the business without finding profitable investment possibilities. They shouldn´t pay too much dividends either. Directors shouldn´t also pay themselves too much.

The owners shouldn´t suffer, when the business is growing. Acquisitions should happen only, when it maximizes the earnings of the owners in the long run. One factor of the quality of the directors is the way they pay for the acquisitions. Most of the times, it is not smart to use company´s stocks as a payment method. Graham also thought that most of the acquisitions should be paid with cash. Using your own stocks should happen seldom, and as a smaller part of the payment. You can also use quantitative analysis to see how the owners are treated. Most of these qualitative factors should be confirmed by the numbers in the income statements and balance sheets.

I hope you will find time to think about some company and its qualitative factors and compare them to its competitors. It will be beneficial to you.

©Tommi Taavila 2018