And the winner is ... dividends!

In Chapter 29 of Security Analysis, Graham and Dodd make the comment “Until recent years the dividend return was the overshadowing factor in common-stock investment”. (These words come from the 1940 edition of the book.)

To illustrate this they present two tables, one for American Sugar Refining Company (ASR) and one for Atchison Topeka and Santa Fe Railway Company (ATSR). Each table shows for a number of years, the price range of the stock, the earnings per share and the dividends per share.

ASR had quite volatile earnings, for example going from $18.92 per share in 1911 to $5.31 per share in 1912, but maintained a constant dividend of $7 per share over the period of the table (1907 – 1913). According to Graham and Dodd, the volatility of its share price was low, suggesting that it was the dividends driving the price rather than earnings.

The table for ATSR covers the years 1916 to 1925. The dividend paid was $6 per share each year except for the last when it rose to $7 per share. Earnings per share, while exhibiting some volatility, had a general upward trend. The price range again was relatively steady and level, but jumped in the final year when dividends were raised. So again, dividends seem to be driving the price.

I decided to undertake a similar exercise on a current ASX listed company. I chose National Australia Bank Limited (NAB) because I thought a long established bank would have steady dividends but volatile earnings and because, due to accidents of history, I own some (a very little some) NAB shares.

Instead of replicating the tables, I created two graphs: one plotting earnings per share against closing price on the day the full year results were announced and one plotting dividends per share for the year against closing price on the day the full year results were announced.

Here’s the graph of earnings against closing price for the years 2003 to 2007 inclusive. Closing prices were taken from Yahoo’s finance site, which only goes back to 2003. The R-square figure of 0.163 is a measure of how well the movement of earnings per share affects the closing price. A R-squared of 1 would mean that a change in the earnings per share would result in the exact same change in the closing price. A R-squared of 0 would mean that a change in the earnings per share would result in absolutely no change in the closing price. A R-squared of 0.163 is very low suggesting earnings per share has little influence on price.





What I see when I look at the graph is a squiggle – it folds back on itself. In this case I think the R-squared is meaningless and earnings do not directly affect the share price.

In contrast, when I look at the graph of closing price against dividends per share for the same period, things are a bit clearer. Each rise in dividends paid has lead to a rise in the share price. The R-squared of 0.664 suggests a reasonable correlation. So although there are not many data points here and no doubt a statistician would draw no conclusions from this, it would appear dividends directly affect share prices and earnings do not.




The impact of dividends could also be seen in the market reaction to Qantas’s decision to cut its interim dividend for the FY2010 half year despite the profit result being in line with company guidance. Its share price fell 8% in one day.

You may be wondering why I only took the graphs out to 2007. It’s because 2008 is when the global financial crisis hit and things went awry. When I extend the graphs out to 2009, it all goes horribly wrong.





Now both graphs are squiggles. So from this I conclude when it all goes wrong, it all goes wrong and hopefully when it happens again, I will have already switched my portfolio into cash.

What is a share?

Typically the answer to the question "what is a share?" runs along the lines of "a share is part ownership in a company". This definition is almost entirely unhelpful because it does not explain what ownership means.

If you own an ipod you can download music to it, you can listen to it, you can put a cover on it, you can stick it in a blender and turn it into dust like in that YouTube video, but you can do none of these things to a share.

The best definition of ownership that I have come across is that ownership is a bundle of rights. The rights associated with a share are quite limited. From what I can tell these are the rights available to shareholders:

- you can sell your shares
- you are entitled to dividends in proportion to the number of shares you own, that is, the cents per share paid as dividends will be the same for your shares as for everybody elses (unless there are different classes of shares with different rights, in which case, all shares in a class will receive the same dividends)
- you have the right to attend and vote at the annual general meeting (which, if you work full-time, you will be unlikely to be able to attend)

This does not look like ownership of a company to me. This looks like ownership of a financial instrument and the point of a financial instrument is to move money around from where it is not needed to where it is needed so that everyone benefits.

Why is this important?

It is important because it has a bearing on how you value a company and if you don't value a company you can't tell whether you are paying too much for the shares or not.

If you take the view that a share is part ownership of a company then you would value the company by forecasting its earnings, discounting them to present value (see note below) and dividing by the number of shares. If you take the view that a share gives you the right to receive dividends, you would deduct the proportion of earnings that will be retained by the company from the earnings to determine the dividends then discount the dividends to present value. This adds an extra element of risk, which means you would use a higher discount rate, which would give a lower value.

Why am I thinking about this now?

I am thinking about this now because Graham and Dodd point out the existence of the conflict between ownership of a financial instrument vs part ownership of a company in Chapter 29 of Security Analysis. They only mention it in passing before going on to look at dividends in detail, but I needed to get my thoughts straight.


A note on discounting

Discounting can be thought of as the opposite of earning interest. If you have $1,000 and you put it in a term deposit at 5% interest, in a year's time it will be worth $1,050. So the present value is $1,000 and the future value is $1,050. If you were saving for something that costs $1,050 and you wanted to buy it in a years time, you would 'discount' the $1,050 by 5% to find out how much you had to put in the term deposit now to have $1,050 in a years time.

In the case of a bank account, it is fairly straight forward because you know the interest rate. In the case of shares you have to work out for yourself what dividends you think you will recieve in future and what level of return you want to compensate you for investing in the shares and taking the risk of not recieving those dividends either at that level or at all. This amount should be higher than what you can recieve by putting money in the bank because you can be fairly confident that you will be paid the interest by the bank and be able to get your principal back.

Starting Over

State of Play: Way back in August, when I wrote my last post, I was looking at Nomad Building Solution as a potential investment. Or more correctly, I was concluding that they were not a potential investment due to their lack of transparancy on an issue that was never fully explained.

My position on this might seem a bit over the top to some people, but it is based on my training as a banker. The first question a banker is supposed to ask themselves before considering anyone for a loan is "does this borrower have integrity?". Nomad's lack of info about the issue, plus their trumpeting of double-digit revenue growth and leaving the fact this was due to the aquisition of two businesses for inclusion in the fine print, leads me to question their integrity. Banks take mortgages and charges so they can force repayment of loans, share investors are at the mercy of the market when it comes to getting their money back. This is why I'm passing over Nomad.

I also said, in my last post, that I would look at their next set of results, just out of interest to see where the story went. However, my laptop has been stolen with all my blogs and workings, so I'm not going to go back and recreate excel files just for the sake of curisoity. I did take a look at how their share prices has moved over the last year however. They reached a high of $1.23 per share on 9 Sep 2009 and closed at 26c on 3 Feb 2010. My guess is they rode the market up but reality hit them in the end.

Nomad originally came to my attention as a result of judging every listed company against a set of critera. I developed the criteria after reading a couple of books on investing (see previous posts). This was done in January 2010. You will note that a year has passed since then. [You may also note that my postings in this blog can best be described as intermittant. My only defence is that I have had a baby in November and being pregnant and then looking after a new born are not condusive to blogging or investing.]

Anyway, to recap what has happened since my last post in August 2009, I re-ran the criteria on the 30 June 2009 financial statements. Only one company made it to the shortlist - ALE (they own pubs which they rent out to others to operate). Unfortunately, about that time I attended a conflicts of interest course at work and learned that I am not allowed to trade any shares in my industry sector (property) regardless of whether they are clients or not. So, ALE are disqualified.

At that point I decided its was time for a new approach, which means a new book. The Snowball, the biography of Warren Buffet, details how he read Graham & Dodd's book Security Ananlysis, then went to Columbia University to study with them and later joined Graham's investment firm. Has ever a book come so highly recommended on any topic?

So I headed to Readers Feast in Melbourne, which always has a good selection of books on finance and investment and indeed found a copy of Security Analysis (6th edition). My first impression is that it is a very big book at 2.5 inches thick with an accompanying CD containing additional chapters and appendices. It covers both bonds and shares, so fortunately I don't have to read the whole thing (but being a Virgo I probably will).

Anyway, back to the content. The issue I am currently grappling with (which I admit might not appear entirely obvious) is how do I select companies to invest in? The short answer to this is provided in Chapter 28 - Newer Cannons of Common Stock Investment.

I have to admit, that I did not find this chapter an entirely easy read, but this is what I believe it is saying:

• there are four approaches to share investing
• first approach - create a portfolio of "carefully selected, diversified group of common stock purchased at reasonable prices". This approach is discounted on the basis that investors cannot count on a general market wide increase in earnings or profit. I would have thought this would be taken care of by the careful selection, but maybe they are just saying there's no guarantee the market will go up.
• second approach - select growth stocks. This approach is discounted on the basis that by the time you can be certain a stock is a growth stock it may have matured and will not grow further or, even if it is a growth stock the price will contain a premium taking this into account.
• third approach - exploit market swings through buying when the market is low and selling whent he market is high. This approach is discounted on the basis that it is too difficult to pick the market turning points.
• fourth approach - buy undervalued shares. Graham and Dodd contend that although it is rare for a good stock to sell at a low price, it is common to find stock that have average prospects for the future and appear cheap on quantitative measures. This is because most investors focus on companies with unusually good prospects. "Because of this emphasis on the growth factor, quite a number of enterprises that are long established, well financed, important in their industries and presumable destined to stay in business make profits indefinitely in the future, but have no speculative or growth appeal, tend to be discriminated against by the stock market - especially in years of subnormal profits - and to sell for considerably less than the business would be worth to a private owner."

This fourth approach is the margin of safety principal and is considered the best by Graham and Dodd. Unfortunately, it appears I cannot just set a few criteria and bingo - there's a portfolio. It appears I must do a fair bit of analysis to form a view on the value and discover whether a certain share is trading at a discount to value. So from this point I think all I can do is plow on with the book and see where it takes me.