Wednesday, November 03, 2010

A Girl in the Convertible

There were some academic studies done on capital structure some years ago by two professors. I only remember the study as the M&M theory. M&M being the initials of the two professors. Both professors subsequently won Nobel Prizes! The same theory also talks about dividends, and I thought that the conclusions are worth sharing here.

According to the study, in a perfect world where there are no taxes, no legal or accounting fees and stocks are infinitely divisible, then it doesn’t matter whether stocks pay dividends or not. Bcos investors can just sell part of their holdings whenever they feel like paying themselves some money.

In the bigger scheme of things, it also doesn’t matter what the capital structure of the company looks like. The firm’s capital can be 100% debt or 100% equity or any other makeup, it doesn’t really matter. What matters is that the firm will only be able to generate enough profits to keep it from going bankrupt, and the market price of the firm is always the right price, ie its intrinsic value. And this is the basis of the Efficient Market Hypothesis.

Luckily the world is not like that and dividend matters. A bird in hand is worth two in the bush. Or as Warren Buffett puts it, a girl in the convertible is worth five in the phonebook. So as investors, we want some dividends to come to us, regardless of what Nobel Prize winners theorize.

Hence, I personally like to find good dividend stocks, and hopefully the firm also enjoys a bit of growth over time. The Dividend Aristocrats of the S&P500 is really a good hunting ground for high quality global names. As for Singapore, I have generated some dividend stock lists in the past couple of years. The most popular one is at the right column of the blog.

Some would question why this huge emphasis on dividends? If a high quality firm can compound its growth much faster, it would be wise to let the firm keep the money and use it to grow. This is the excuse most growth co.s don’t give dividends. Even after they become ex-growth, and they happily squander the cash in stupid ventures or M&As.

Perhaps the best positive example is actually Berkshire Hathaway. Since Buffett can compound growth much better than most people, it doesn’t make sense to pay dividends to his other shareholders. However it is difficult to find managers who can efficiently use capital to compound growth better in the first place. So returning excess cash to shareholders or doing share buyback when the stock is cheap is what a good CEO would do.

Paying an ok dividend also signals that the management have shareholders in mind. (This is also called the signalling theory). Ok being like 2-3% dividend yield, which is whatmost of the Dividend Aristocrat stocks are paying currently. The thinking on this would be something like: Well we don’t need ALL the money to grow, bcos we are in such a fabulous business, we can still grow with limited capex and can generate good cashflow too. And so we would pay our shareholders some dividends, while we continue to grow. Just as we did in the last 25 years.

The long and short of this all is that a stock has a good track record of growing its dividend payment is probably one of the best deals out there (if you can grab it at a reasonable price). Which is probably why Warren Buffett holds quite a number of Dividend Aristocrats like J&J, P&G and Becton Dickinson.
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