Dividends do not make a good company – Part 2
With annual general meeting (AGM) season underway, what is becoming clear, yet again, is that great managers are good at two things. The first is running the business, the second is allocating capital. Some might be able to run a business, but many managers are incompetent at allocating capital.
Warren Buffett is famous for his ability to select good investments, but the way he runs his business interests is rarely discussed. It’s a shame really because there is much that could be learned from his approach.
When Buffett acquires a business for Berkshire Hathaway, he famously asks the vendor or their family to continue to run the business and retain a small stake. Most people are aware of that. What many don’t appreciate is why he asks that all the cash be sent to him for the purposes of allocation.
Running a business and allocating capital are two very different things, and it is common to find managers adept at one but incompetent at the other. The most obvious example of this is the frequency with which Australian company directors happily report their dividend payment policy but rarely explain why or how they have reached the decision.
You may hear something along the lines of, “We will maintain our stated policy of paying 50 per cent of earnings out to shareholders as a dividend”, but not a single word as to why this is the appropriate course for the company or the shareholders.
My previous article about dividends discussed the importance of retaining profits when returns on equity were high; and returning them in the form of dividends and buybacks when returns on equity were low, declining or had plateaued.
Overlay on this non-disclosure of dividend policy the habit of raising money from shareholders in the same year that dividends are paid and – the most galling event – the emergence of the unfranked dividend, and you have billions and billions of dollars being destroyed constantly.
There are exceptions to the rule, and good managers who generate modest returns on equity will elect to increase their payout ratios. This was evident when Mark McInnes joined David Jones in 2003 after the retailer had posted a prolonged period of single digit returns on equity. Of course, he promptly set about increasing returns significantly.
But executives able to manage both the business as well as capital allocation decisions are rare. Now delisted, Ten Network Holdings – the operator of TV Channel Ten – was an example of a company with a mixed track record on return on equity. Between 2000 and 2002, and again in 2006, 10 paid dividends that exceeded profits by running up increasing amounts of debt.
In 2009 dividends also exceeded profits, but strong cash flows enabled management to seize an opportunity and conduct a cash-boosting capital raising that reversed the legacy of previous debt binges. Not surprisingly, the ultimate outcome of all this capital-allocating activity was diluted shareholder wealth. And after falling from $4.36 to 16 cents over 11 years, the company was delisted.
There’s no course, seminar, or workshop in Australia for managers to attend specifically about capital allocation, and unfortunately, it is particularly evident in the business of takeovers.
You may have heard my views about many stock markets being full of toads that no amount of kissing will turn into princes. But poor decisions are also made on the other side of the bargaining table, where boards fail to negotiate the best possible prices for their businesses more often than you could imagine.
Australian corporate history is littered with the written-down shells of acquisitions and the fleeced bank accounts associated with poor investment decisions.
Capital allocation is about investing, about assessing alternate proposals: to pay dividends or to reinvest in oneself; to put the money in the bank; make an acquisition; or even to buy back shares and acquire oneself. But capital allocation is a field of expertise that business operations experience does not automatically qualify you for.
As an investor it is important to assess not only management operational expertise but their investing capability as well. The very best businesses can be undone by the poor investment decisions of those charged to be stewards of shareholders’ ownership stakes in the business.
If you haven’t yet, read Dividends do not make a good company – Part 1