Some Motley Fool readers have critiqued my QUALITY OF EARNINGS book having to do with the chapter on dividends and, “my own view, based upon empirical evidence, clearly is that, all things being equal, a corporation is better off in the long run paying minimal or no dividends.”Upon reflection, I would now agree that the above statement is too harsh regarding corporate dividend policy. However, the investor must be on guard if he has invested in a dividend-paying stock that has a very high debt level to shareholders' equity or is incurring additional debt in order to pay dividends. One classic example of a corporation that never paid a dividend was Teledyne, headed by Dr. Henry E. Singleton. Between 1972 and 1984, Singleton's stock repurchase policy, in lieu of paying common share dividends, resulted in the corporation's outstanding shares being reduced from 82 million to only 12 million. During this same time span, the price of Teledyne shares soared from a low of $6 to a high of $338. Another great illustration of a corporation reducing its dividend substantially and using excess cash flow to repurchase common shares is IBM. When Lou Gerstner came on board at IBM in 1993, the company was paying $1.21 a share in dividends per year. Within a few years, Gerstner slashed the dividend to only 40¢ annually. During Gerstner's reign at IBM between 1993 and 2002, the corporation's shares outstanding decreased to 1,695 million from 2,285 million. Even now, IBM's yearly dividend is only 78¢. Berkshire Hathaway has never paid a common share dividend. This is because Warren Buffett believes he can reinvest all of his excess cash flow more profitably than a shareholder could with the dividends he would receive from Berkshire. It should be noted that since 1973, Berkshire Hathaway has risen value from $35 a share to over $80,000 today. IT'S IMPORTANT TO NOTE THAT DIVIDENDS CONSTITUE A HIGH PERCENTAGE OF TOTAL STOCK MARKET RETURN. BETWEEN 1926 AND 2003, DIVIDENDS ACCOUNTED FOR OVER 30% OF AN INVESTING GAINS. Thornton Oglove
Upon reflection, I would now agree that the above statement is too harsh regarding corporate dividend policy. However, the investor must be on guard if he has invested in a dividend-paying stock that has a very high debt level to shareholders' equity or is incurring additional debt in order to pay dividends. I would be curious as to you view of companies with a very high debt level to shareholder's equity that incur debt to repurchase shares instead. It seems to have worked wonders with Autozone (AZO) and homebuilder NVR (NVR), less so with Ryan's Steakhouse (RYAN). To repeat my earlier note, "Quality of Earnings" is one of the five best investment books I've ever read - thanks!
- I typed that too quickly...NVR's inclusion is a poor example, as the BS isn't leveraged. The question still stands though, considering AZO's situation. thoughts?
I would be curious as to you view of companies with a very high debt level to shareholder's equity that incur debt to repurchase shares instead. It seems to have worked wonders with Autozone (AZO) and homebuilder NVR (NVR), less so with Ryan's Steakhouse (RYAN).My reply to this question is that the situation should be looked at on a case-by-case basis. From a purist standpoint, I would prefer that a soundly managed corporation with high cash flow refrain from paying common share dividends if the excess cash available, therein, is utilized to repurchase shares. In addition, this type of company could consider incurring added debt to purchase shares.By using excess cash flow and incurring some additional debt to repurchase shares, Homebuilder NVR is a textbook example of what enlightened management can do for the shareholder. Between 1996 and the year 2004, NVR reduced its common shares outstanding in half, from 13.6 Million to 6.3 Million. At year end December 31, 2004, NVR's common shares were selling for $769 versus an average price of $10, back in1996. It should be noted that even now, NVR's total debt is only 33% of the company's total capitalization. Another company you cited which is much more highly leveraged than NVR, is Autozone, Inc. Between 1998 and year end 2000, AZO's common shares declined to 79.6 Million from 152 Million. During this same time span, AZO's long-term debt soared to almost $1.9 Billion from $545 Million. The company's debt, which is entirely long-term, now totals 92% of AZO's capitalization. Within this timeline, AZO's share earnings more than quadrupled (from $1.48 to $6.56), and the stock has tripled in value.At this juncture, if an NVR and AZO investor asked me if they should still hold these stocks, my answer would be, yes. In closing, one interesting company with an exceedingly high debt level is Regal Entertainment (RGC-NYSE). In early 2003, when Regal was selling for $18, the company declared a special dividend totaling over $5 per share. The stock then immediately rose to $23. RGC borrowed $700 million in order to fund the dividend. Under the IRS tax code, if a corporation has no retained earnings and utilizes borrowed funds to pay a dividend, the pay out is considered to be a non-taxable distribution to shareholders. Incredibly, in the second quarter of 2004, RGC declared another extraordinary dividend of $5 per share. Again, RGC incurred mostly added debt to finance the distribution. Also, in 2004, RGC doubled the rate of its regular annual dividend from 60¢ to $1.20. For the year 2004, 87.5% of RGC's dividend, or about $5.80, was a non-taxable distribution. One key question would be, Should an investor purchase RGC at its current price of about $19? The answer has to be, no, because as of December 31, 2004, RGC's debt totaled 95% of capital and equity amounted to only 4% of capital. But an investor who purchased the stock at $23 in 2003, now has an adjusted price of only $11, after deducting all of the dividends they received during the past two years. So the punch line is, Such an investor is now receiving an annual return of almost l1%, mostly tax free. Therefore, on a yield basis, RGC is a good hold. An interesting side note concerning RGC was the attempt by the Louisiana State Pension Fund to legally block RGC from paying the $5 special dividend last year. The pension plan claimed that RGC was managing the company in a reckless fashion by incurring so much added debt to fund the pay out. A court ruled against the Fund on the grounds that it is within the purview of a corporation to decide its dividend policy. After the ruling, RGC told Louisiana State Pension plan that they should sell their RGC holdings if they disagree with RGC's dividend policy. Thornton Oglove
Dear Mr. Oglove,I've been reading some of your past posts and I'm very glad you participate in this forum. However, I must point out a fallacy with your recommendation on RGC in the previous post. It's a common mistake, but one many investors fail to realize.You wrote:"One key question would be, Should an investor purchase RGC at its current price of about $19? The answer has to be, no, because as of December 31, 2004, RGC's debt totaled 95% of capital and equity amounted to only 4% of capital. But an investor who purchased the stock at $23 in 2003, now has an adjusted price of only $11, after deducting all of the dividends they received during the past two years. So the punch line is, Such an investor is now receiving an annual return of almost l1%, mostly tax free. Therefore, on a yield basis, RGC is a good hold."Not really. I firmly believe that what is good for the goose is good for the gander; If a stock isn't a good buy at $19 for new investors, it's not a good buy for those who hold the stock either. What an investor has paid for a company is largely irrelevant when it comes to deciding whether a company should remain in the portfolio, with the sole exception of how this holding period is impacted upon by taxes. Although an investor who bought RGC at $23 and then received subsequent dividends can boast about what looks like an 11% perpetual return, that's only happening in his mind; in reality, he's holding a stock with only about a 5% yield that has appreciated about 80% from his purchase price. That's a very real gain and one that, if he doesn't feel comfortable holding RGC after he's adjusted its price for the loss from selling, should be realized. Even for an income investor, the prudent action would be to make the sale and reinvest the proceeds into a high-yielding stock with better financials or a better risk/reward ratio.
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