Value, dividends and liquidity – what are my thoughts?
Another viewer question I would like to share…
Roger,
A few questions (assume for all questions below that I am referring to stocks with low debt and high return on equity):
1) If you see the market as overvalued and most stocks you look at above their intrinsic value, do you just stay in cash until they become cheaper, even if you could be waiting years (like the 2003-2007 period)?
RM – I look at individual companies rather than the market. If there are no individual companies that are cheap, the answer is yes.
2) I know you like stocks that pay no dividends, but what happens if management does something stupid and the stock price plummets? At least you have got something from your investment if you have received dividends.
RM – You have misunderstood my stance on dividends, which is quite a common misunderstanding. My position is that all things being equal, a company with a high ROE that can retain its profits and compound them at a high rate is worth more than a company with the same ROE but paying some proportion of its earnings out as a dividend.
I am quite happy to buy companies that pay dividends – I bought Fleetwood earlier this year on a dividend yield of more than 20% – but the price I must pay for them is lower.
On the second part of your question, you are right. The assumption is that if management is going to retain profits they must generate high returns on those retained earnings. The track record of management doing stupid things however is long so I can understand shareholder reticence towards management hanging onto the cash.
3) Do you have any concerns about buying a stock that has low liquidity (as it could be difficult to sell if something goes wrong)
RM – Even when managing more than $100 million I bought shares with low liquidity, but I was right in those cases and their superior performance eventually attracted increased liquidity. Had I been wrong then yes, the illiquidity would have been a problem. They key is to worry more about being right, then you don’t have to worry about the liquidity.
Posted by Roger Montgomery, 3 December 2009
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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John
:
Apologies – I neglected to mention above that it is from an SMSF perspective.
John
:
Excellent clarification on dividends. Might I also add that it is important to also adjust for franking credits and account for the lower CGT discount when assessing share return? Though, I can understand that such tax considerations are a mere distraction if one has the diligence and emotional steadfastness to pick out ten baggers.
Richard
:
Roger,
You mentioned that you bought FWD. I notice that FWD maintained its ROE above 20% in its latest results. Did you assume a ROE over 20% in your valuation? How did you know that it would be able to maintain its ROE when 2008 was a difficult year? Wasn’t there a risk that its ROE could suffer a big drop? Did you wait for the results in Feb before you invested? I ask because I was watching NOD, and I noticed that its ROE dropped to 16% in its latest results.
http://money.ninemsn.com.au/shares-and-funds/research-a-company/results.aspx?inforeq=historical&code=NOD
rogermontgomeryinsights
:
Hi Richard,
My apologies for taking so long to reply to your very good question. There are three or four things you can do. The first is to meet with the company, model the balance sheet, p&l and cash flow of the business and arrive at an estimate of earning and thus ROE, the second, is adopt an average of the analysts forecasts for EPS and DPS and arrive at an ROE estimate that way. The third is to use the recent past and the fourth is to use some average of the past. I do all of them where possible and always at least three.
Roger
Nathan Baker
:
Roger, there is an interesting point to be made concerning investor psychology and the payment of dividends. In recent studies in the area of behaviour finance it has been shown that companies that pay a dividend plus go up in value are perceived more favourably than a company that doesn’t pay a dividend (even if the final result is the same). Conversely if a dividend is paid but capital is lost, the feelings toward the company are less negative. One of the reasons put forward is that the dividend paying company has given us two positives, or one negative and one positive respectively. So it always ‘out points’ the company with no dividend. Perhaps what we need to ask ourselves is whether we’re investing because we need the dividend, or because we simply like the fact that we get one. An important point given that our tax system actually penalises us for receiving the income, so our desire to receive a dividend is counter intuitive.
rogermontgomeryinsights
:
You raise some interesting points Nathan as does John in his post below. WHile tax is paid on income in the year it is earned and gains can be compounded (an interest free loan from the tax office), there is the small matter of the value of franking credits having no value when they are retained. But you are also right where you intimate that tax can drive poor capital allocation decisions. If management make poor decisions with the cash they keep ( a very real and justified perception held by AUstralian investors) – stupid acquisitions, excessive salaries etc, then there’s a real benefit in taking the cash. But this would show up in a low or declining ROE. On the other hand, Berkshire has never paid a dividend (with the exception of 1967) and the perception towards this company has been sufficient to promote the price to far above the book value -why? because of sustained high rates of ROE. Buffett hasn’t made a huge number of mistakes in the capital allocation dept.
Roger
Richard
:
Thanks for the reply Roger, much appreciated.