Earnings reinvested at high rates of return
When investing I am on the lookout for businesses with a sound competitive position, good growth prospects and excellent people running the show. I try to develop a sound long-term view of the potential for per share business compounding. Compounding is the magic sauce.
Today’s post is about how dividends fit into that equation. We need to dig into the uses that are made by management of company retained earnings.
Different uses of retained earnings
The title of this post is taken from a chapter in Philip Fisher’s book Common Stocks and Uncommon Profits originally published in 1958 and republished by Wiley & Sons in 2003 (Fisher, 2003). Warren Buffett read the book avidly (and even wrote about it) and credits Fisher with being one of the major influences on his approach to investing.
Fisher tells us that shareholders sometimes get no benefit from a company’s retained earnings: “This occurs when substandard managements can get only a sub-normal return on the capital already in the business, yet use the retained earnings merely to enlarge the inefficient operation rather than to make it better.”(Fisher, 2003) p115. (Emphasis added)
Another situation where shareholders get no benefit from retained earnings is where management is forced to use capital to stay competitive. That would be a situation where a failure to spend the money would cause a loss of business if the expenditure had not been made. He also points to the situations where companies constantly have to use retained earnings to replace outmoded assets.
Fisher notes that the best companies, the kind we want to invest in, are able to invest retained earnings in attractive growth opportunities. It is in this context that one needs to evaluate the proper role of dividends.
The proper role of dividends.
Fisher writes: “If [investors] are saving any part of their income rather than spending it and if they have their funds invested in the right sort of common stocks, they are better off when the management of such companies reinvest increased earnings than they would be if these increased earnings were passed on to them as larger dividends which they would have to reinvest themselves.” (Fisher, 2003) p.118. (Emphasis added)
He adds: “Therefor, [the investor] is usually running less risk in having this good management make the additional investment of these retained extra earnings than he would be running if he had to again risk serious error in finding some new and equally attractive investment for himself. The more outstanding the company considering whether to retain or pass on increased earnings, the more important this factor can become.” (Fisher, 2003) p.119.
Ultimately Fisher tells us that most really great companies will generate enough excess capital to be able to invest in maintaining the business, invest in growth opportunities and also pay a reasonable dividend. So, for these kinds of companies the role of dividends is to distribute to shareholders excess capital that is not needed for maintenance and growth.
Earnings reinvested at marginal rates of return
There is a good discussion by Warren Buffett in the 1984 Berkshire Hathaway Chairman’s Letter about corporate dividend policies. As with Fisher’s discussion, Buffett first refers to companies that have to spend all their earnings just to stay in the same place. He points out that some companies with asset-heavy business models have what he calls ‘ersatz’ reported earnings. Just to maintain unit volume, their competitive position and their financial strength they have to plow all their earning back into their business. Lawrence A. Cunningham, The Essays of Warren Buffett: Lessons for Corporate America. (Buffett, 1998) p123.
He puts automobile manufacturers in this camp. In 1980 Buffett correctly anticipated the 2009 G.M. bailout by the U.S. taxpayer. Train, J., The Money Masters – Nine Great Investors: Their Winning Strategies and How You Can Apply Them. (1980).
Naturally, these spend all the company earnings and yet spin their wheels. These companies cannot safely pay a dividend. Many, like GM always do. And they raise fresh capital from shareholders to keep the Ponzi scheme going.
Earnings reinvested at high rates of return
In a second camp Buffett puts companies whose “earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business.” (Buffett, 1998) p124.
And what makes sense for shareholders? “…you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.” (Buffett, 1998) p125. (Emphasis added)
So where does all of this leave us? Over the years I have made no distinction in my portfolio between dividends and capital gains. All I am concerned about is total return. John Templeton taught: “For all long-term investors, there is only one objective-“maximum total real return after taxes.”” (Proctor & Phillips, 1983, 2012)p.153.
I am not a dividend investor. Everyone has their own approach. Some investors are focused on ‘dividend growth stocks’. I think what they mean is a track record over many years of companies increasing their dividends, so called ‘dividend aristocrats’. My approach is different. I look for companies generating substantial owner earnings that have the ability to reinvest excess capital at high rates of return. Some of the companies I invest in pay modest dividends of between 1% and 2%. Some pay no dividend at all. And I’m ok with that.
Ultimately, it comes down to the question of whether the directors and executive officers of each company can be trusted with shareholders’ capital, whether they are coinvested with shareholders thereby aligning our interests, whether I can be satisfied that they’ve been successful in the past, and do I have a high degree of confidence that they can execute going forward.
Dividend investing is quite different from total return investing. To learn more about this distinction see my post A steely eyed look at dividend investing
If you want to read more about how to choose common stocks take a look at Chapter 31. General approach to choosing common stocks
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