Ever since 1934 we have argued in our writings for a more intelligent and energetic attitude by shareholders toward their managements. We have asked them to take a generous attitude toward those who are demonstrably doing a good job. We have asked them also to demand clear and satisfying explanations when the results appear to be worse than they should be, and to support movements to improve or remove clearly unproductive managements. Shareholders are justified in raising questions as to the competence of the management when the results (1) are unsatisfactory in themselves, (2) are poorer than those obtained by other companies that appear similarly situated, and (3) have resulted in an unsatisfactory market price of long duration.

In the last 36 years practically nothing has actually been accomplished through intelligent action by the great body of shareholders. A sensible crusader—if there are any such—would take this as a sign that he has been wasting his time, and that he had better give up the fight. As it happens our cause has not been lost; it has been rescued by an extraneous development—known as takeovers, or take-over bids.^* We said in Chapter 8 that poor managements produce poor market prices. The low market prices, in turn, attract the attention of companies interested in diversifying their operations—and these are now legion. Innumerable such acquisitions have been accomplished by agreement with the existing managements, or else by accumulation of shares in the market and by offers made over the head of those in control. The price bid has usually been within the range of the value of the enterprise under reasonably competent management. Hence, in many cases, the inert public shareholder has been bailed out by the actions of “outsiders”—who at times may be enterprising individuals or groups acting on their own.

It can be stated as a rule with very few exceptions that poor managements are not changed by action of the “public stockholders,” but only by the assertion of control by an individual or compact group. This is happening often enough these days to put the management, including the board of directors, of a typical publicly controlled company on notice that if its operating results and the resulting market price are highly unsatisfactory, it may become the target of a successful take-over move. As a consequence, boards of directors have probably become more alive than previously to their fundamental duty to see that their company has a satisfactory top management. Many more changes of presidents have been seen in recent years than formerly.

Not all companies in the unsatisfactory class have benefited from such developments. Also, the change has often occurred after a long period of bad results without remedial action, and has depended on enough disappointed shareholders selling out at low prices to permit the energetic outsiders to acquire a controlling position in the shares. But the idea that public shareholders could really help themselves by supporting moves for improving management and management policies has proved too quixotic to warrant further space in this book. Those individual shareholders who have enough gumption to make their presence felt at annual meetings—generally a completely futile performance—will not need our counsel on what points to raise with the managements. For others the advice would probably be wasted. Nevertheless, let us close this section with the plea that shareholders consider with an open mind and with careful attention any proxy material sent them by fellow-shareholders who want to remedy an obviously unsatisfactory management situation in the company.

Shareholders and Dividend Policy

In the past the dividend policy was a fairly frequent subject of argument between public, or “minority,” shareholders and managements. In general these shareholders wanted more liberal dividends, while the managements preferred to keep the earnings in the business “to strengthen the company.” They asked the shareholders to sacrifice their present interests for the good of the enterprise and for their own future long-term benefit. But in recent years the attitude of investors toward dividends has been undergoing a gradual but significant change. The basic argument now for paying small rather than liberal dividends is not that the company “needs” the money, but rather that it can use it to the shareholders’ direct and immediate advantage by retaining the funds for profitable expansion. Years ago it was typically the weak company that was more or less forced to hold on to its profits, instead of paying out the usual 60% to 75% of them in dividends. The effect was almost always adverse to the market price of the shares. Nowadays it is quite likely to be a strong and growing enterprise that deliberately keeps down its dividend payments, with the approval of investors and speculators alike.^*

There was always a strong theoretical case for reinvesting profits in the business where such retention could be counted on to produce a goodly increase in earnings. But there were several strong counter-arguments, such as: The profits “belong” to the shareholders, and they are entitled to have them paid out within the limits of prudent management; many of the shareholders need their dividend income to live on; the earnings they receive in dividends are “real money,” while those retained in the company may or may not show up later as tangible values for the shareholders. These counter-arguments were so compelling, in fact, that the stock market showed a persistent bias in favor of the liberal dividend payers as against the companies that paid no dividends or relatively small ones.¹

In the last 20 years the “profitable reinvestment” theory has been gaining ground. The better the past record of growth, the readier investors and speculators have become to accept a lowpay-out policy. So much is this true that in many cases of growth favorites the dividend rate—or even the absence of any dividend—has seemed to have virtually no effect on the market price.^*

A striking example of this development is found in the history of Texas Instruments, Incorporated. The price of its common stock rose from 5 in 1953 to 256 in 1960, while earnings were advancing from 43 cents to $3.91 per share and while no dividend of any kind was paid. (In 1962 cash dividends were initiated, but by that year the earnings had fallen to $2.14 and the price had shown a spectacular drop to a low of 49.)

Another extreme illustration is provided by Superior Oil. In 1948 the company reported earnings of $35.26 per share, paid $3 in dividends, and sold as high as 235. In 1953 the dividend was reduced to $1, but the high price was 660. In 1957 it paid no dividend at all, and sold at 2,000! This unusual issue later declined to 795 in 1962, when it earned $49.50 and paid $7.50.^*

Investment sentiment is far from crystallized in this matter of dividend policy of growth companies. The conflicting views are well illustrated by the cases of two of our very largest corporations—American Telephone & Telegraph and International Business Machines. American Tel. & Tel. came to be regarded as an issue with good growth possibilities, as shown by the fact that in 1961 it sold at 25 times that year’s earnings. Nevertheless, the company’s cash dividend policy has remained an investment and speculative consideration of first importance, its quotation making an active response to even rumors of an impending increase in the dividend rate. On the other hand, comparatively little attention appears to have been paid to the cash dividend on IBM, which in 1960 yielded only 0.5% at the high price of the year and 1.5% at the close of 1970. (But in both cases stock splits have operated as a potent stock-market influence.)

The market’s appraisal of cash-dividend policy appears to be developing in the following direction: Where prime emphasis is not placed on growth the stock is rated as an “income issue,” and the dividend rate retains its long-held importance as the prime determinant of market price. At the other extreme, stocks clearly recognized to be in the rapid-growth category are valued primarily in terms of the expected growth rate over, say, the next decade, and the cash-dividend rate is more or less left out of the reckoning.

While the above statement may properly describe present tendencies, it is by no means a clear-cut guide to the situation in all common stocks, and perhaps not in the majority of them. For one thing, many companies occupy an intermediate position between growth and nongrowth enterprises. It is hard to say how much importance should be ascribed to the growth factor in such cases, and the market’s view thereof may change radically from year to year. Secondly, there seems to be something paradoxical about requiring the companies showing slower growth to be more liberal with their cash dividends. For these are generally the less prosperous concerns, and in the past the more prosperous the company the greater was the expectation of both liberal and increasing payments.

It is our belief that shareholders should demand of their managements either a normal payout of earnings—on the order, say, of two-thirds—or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings. Such a demonstration could ordinarily be made in the case of a recognized growth company. But in many other cases a low payout is clearly the cause of an average market price that is below fair value, and here the shareholders have every right to inquire and probably to complain.

A niggardly policy has often been imposed on a company because its financial position is relatively weak, and it has needed all or most of its earnings (plus depreciation charges) to pay debts and bolster its working-capital position. When this is so there is not much the shareholders can say about it—except perhaps to criticize the management for permitting the company to fall into such an unsatisfactory financial position. However, dividends are sometimes held down by relatively unprosperous companies for the declared purpose of expanding the business. We feel that such a policy is illogical on its face, and should require both a complete explanation and a convincing defense before the shareholders should accept it. In terms of the past record there is no reason a priori to believe that the owners will benefit from expansion moves undertaken with their money by a business showing mediocre results and continuing its old management.

Stock Dividends and Stock Splits

It is important that investors understand the essential difference between a stock dividend (properly so-called) and a stock split. The latter represents a restatement of the common-stock structure—in a typical case by issuing two or three shares for one. The new shares are not related to specific earnings reinvested in a specific past period. Its purpose is to establish a lower market price for the single shares, presumably because such lower price range would be more acceptable to old and new shareholders. A stock split may be carried out by what technically may be called a stock dividend, which involves a transfer of sums from earned surplus to capital account; or else by a change in par value, which does not affect the surplus account.^*

What we should call a proper stock dividend is one that is paid to shareholders to give them a tangible evidence or representation of specific earnings which have been reinvested in the business for their account over some relatively short period in the recent past—say, not more than the two preceding years. It is now approved practice to value such a stock dividend at the approximate value at the time of declaration, and to transfer an amount equal to such value from earned surplus to capital accounts. Thus the amount of a typical stock dividend is relatively small—in most cases not more than 5%. In essence a stock dividend of this sort has the same overall effect as the payment of an equivalent amount of cash out of earnings when accompanied by the sale of additional shares of like total value to the shareholders. However, a straight stock dividend has an important tax advantage over the otherwise equivalent combination of cash dividends with stock subscription rights, which is the almost standard practice for public-utility companies.

The New York Stock Exchange has set the figure of 25% as a practical dividing line between stock splits and stock dividends. Those of 25% or more need not be accompanied by the transfer of their market value from earned surplus to capital, and so forth.^† Some companies, especially banks, still follow the old practice of declaring any kind of stock dividend they please—e.g., one of 10%, not related to recent earnings—and these instances maintain an undesirable confusion in the financial world.

We have long been a strong advocate of a systematic and clearly enunciated policy with respect to the payment of cash and stock dividends. Under such a policy, stock dividends are paid periodically to capitalize all or a stated portion of the earnings reinvested in the business. Such a policy—covering 100% of the reinvested earnings—has been followed by Purex, Government Employees Insurance, and perhaps a few others.^*

Stock dividends of all types seem to be disapproved of by most academic writers on the subject. They insist that they are nothing but pieces of paper, that they give the shareholders nothing they did not have before, and that they entail needless expense and inconvenience.^† On our side we consider this a completely doctrinaire view, which fails to take into account the practical and psychological realities of investment. True, a periodic stock dividend—say of 5%—changes only the “form” of the owners’ investment. He has 105 shares in place of 100; but without the stock dividend the original 100 shares would have represented the same ownership interest now embodied in his 105 shares. Nonetheless, the change of form is actually one of real importance and value to him. If he wishes to cash in his share of the reinvested profits he can do so by selling the new certificate sent him, instead of having to break up his original certificate. He can count on receiving the same cash-dividend rate on 105 shares as formerly on his 100 shares; a 5% rise in the cash-dividend rate without the stock dividend would not be nearly as probable.^*

The advantages of a periodic stock-dividend policy are most evident when it is compared with the usual practice of the public-utility companies of paying liberal cash dividends and then taking back a good part of this money from the shareholders by selling them additional stock (through subscription rights).^† As we mentioned above, the shareholders would find themselves in exactly the same position if they received stock dividends in lieu of the popular combination of cash dividends followed by stock subscriptions—except that they would save the income tax otherwise paid on the cash dividends. Those who need or wish the maximum annual cash income, with no additional stock, can get this result by selling their stock dividends, in the same way as they sell their subscription rights under present practice.

The aggregate amount of income tax that could be saved by substituting stock dividends for the present stock-dividends-plus-subscription-rights combination is enormous. We urge that this change be made by the public utilities, despite its adverse effect on the U.S. Treasury, because we are convinced that it is completely inequitable to impose a second (personal) income tax on earnings which are not really received by the shareholders, since the companies take the same money back through sales of stock.^*

Efficient corporations continuously modernize their facilities, their products, their bookkeeping, their management-training programs, their employee relations. It is high time they thought about modernizing their major financial practices, not the least important of which is their dividend policy.

Why Did Graham Throw in the Towel?

Perhaps no other part of The Intelligent Investor was more drastically changed by Graham than this. In the first edition, this chapter was one of a pair that together ran nearly 34 pages. That original section (“The Investor as Business Owner”) dealt with shareholders’ voting rights, ways of judging the quality of corporate management, and techniques for detecting conflicts of interest between insiders and outside investors. By his last revised edition, however, Graham had pared the whole discussion back to less than eight terse pages about dividends.

Why did Graham cut away more than three-quarters of his original argument? After decades of exhortation, he evidently had given up hope that investors would ever take any interest in monitoring the behavior of corporate managers.

But the latest epidemic of scandal—allegations of managerial misbehavior, shady accounting, or tax maneuvers at major firms like AOL, Enron, Global Crossing, Sprint, Tyco, and WorldCom—is a stark reminder that Graham’s earlier warnings about the need for eternal vigilance are more vital than ever. Let’s bring them back and discuss them in light of today’s events.

Theory Versus Practice

Graham begins his original (1949) discussion of “The Investor as Business Owner” by pointing out that, in theory, “the stockholders as a class are king. Acting as a majority they can hire and fire managements and bend them completely to their will.” But, in practice, says Graham,

Graham wants you to realize something basic but incredibly profound: When you buy a stock, you become an owner of the company. Its managers, all the way up to the CEO, work for you. Its board of directors must answer to you. Its cash belongs to you. Its businesses are your property. If you don’t like how your company is being managed, you have the right to demand that the managers be fired, the directors be changed, or the property be sold. “Stockholders,” declares Graham, “should wake up.”²

The Intelligent Owner

Today’s investors have forgotten Graham’s message. They put most of their effort into buying a stock, a little into selling it—but none into owning it. “Certainly,” Graham reminds us, “there is just as much reason to exercise care and judgment in being as in becoming a stockholder.”³

So how should you, as an intelligent investor, go about being an intelligent owner? Graham starts by telling us that “there are just two basic questions to which stockholders should turn their attention:

1. Is the management reasonably efficient?
2. Are the interests of the average outside shareholder receiving proper recognition?”⁴

You should judge the efficiency of management by comparing each company’s profitability, size, and competitiveness against similar firms in its industry. What if you conclude that the managers are no good? Then, urges Graham,

What is “proxy material” and why does Graham insist that you read it? In its proxy statement, which it sends to every shareholder, a company announces the agenda for its annual meeting and discloses details about the compensation and stock ownership of managers and directors, along with transactions between insiders and the company. Shareholders are asked to vote on which accounting firm should audit the books and who should serve on the board of directors. If you use your common sense while reading the proxy, this document can be like a canary in a coal mine—an early warning system signaling that something is wrong. (See the Enron sidebar above.)

Yet, on average, between a third and a half of all individual investors cannot be bothered to vote their proxies.⁶ Do they even read them?

Understanding and voting your proxy is as every bit as fundamental to being an intelligent investor as following the news and voting your conscience is to being a good citizen. It doesn’t matter whether you own 10% of a company or, with your piddling 100 shares, just 1/10.000 of 1%. If you’ve never read the proxy of a stock you own, and the company goes bust, the only person you should blame is yourself. If you do read the proxy and see things that disturb you, then:

• vote against every director to let them know you disapprove
• attend the annual meeting and speak up for your rights
• find an online message board devoted to the stock (like those at http://finance.yahoo.com) and rally other investors to join your cause.

Graham had another idea that could benefit today’s investors:

One can only imagine the consternation that Graham’s proposal would cause among the corporate cronies and golfing buddies who constitute so many of today’s “independent” directors. (Let’s not suggest that it might send a shudder of fear down their spines, since most independent directors do not appear to have a backbone.)

Whose Money Is It, Anyway?

Now let’s look at Graham’s second criterion—whether management acts in the best interests of outside investors. Managers have always told shareholders that they—the managers—know best what to do with the company’s cash. Graham saw right through this managerial malarkey:

In the late 1990s and into the early 2000s, the managements of leading technology companies took this “Daddy-Knows-Best” attitude to new extremes. The argument went like this: Why should you demand a dividend when we can invest that cash for you and turn it into a rising share price? Just look at the way our stock has been going up—doesn’t that prove that we can turn your pennies into dollars better than you can?

Incredibly, investors fell for it hook, line, and sinker. Daddy Knows Best became such gospel that, by 1999, only 3.7% of the companies that first sold their stock to the public that year paid a dividend—down from an average of 72.1% of all IPOs in the 1960s.⁹ Just look at how the percentage of companies paying dividends (shown in the dark area) has withered away:

FIGURE 19-1

Who Pays Dividends?

Source: Eugene Fama and Kenneth French, “Disappearing Dividends,” Journal of Financial Economics, April 2001.

But Daddy Knows Best was nothing but bunk. While some companies put their cash to good use, many more fell into two other categories: those that simply wasted it, and those that piled it up far faster than they could possibly spend it.

In the first group, Priceline.com wrote off $67 million in losses in 2000 after launching goofy ventures into groceries and gasoline, while Amazon.com destroyed at least $233 million of its shareholders’ wealth by “investing” in dot-bombs like Webvan and Ashford.com.¹⁰ And the two biggest losses so far on record—JDS Uniphase’s $56 billion in 2001 and AOL Time Warner’s $99 billion in 2002—occurred after companies chose not to pay dividends but to merge with other firms at a time when their shares were obscenely overvalued.¹¹

In the second group, consider that by late 2001, Oracle Corp. had piled up $5 billion in cash. Cisco Systems had hoarded at least $7.5 billion. Microsoft had amassed a mountain of cash $38.2 billion high—and rising by an average of more than $2 million per hour. ¹² Just how rainy a day was Bill Gates expecting, anyway?

So the anecdotal evidence clearly shows that many companies don’t know how to turn excess cash into extra returns. What does the statistical evidence tell us?

• Research by money managers Robert Arnott and Clifford Asness found that when current dividends are low, future corporate earnings also turn out to be low. And when current dividends are high, so are future earnings. Over 10-year periods, the average rate of earnings growth was 3.9 points greater when dividends were high than when they were low.¹³
• Columbia accounting professors Doron Nissim and Amir Ziv found that companies that raise their dividend not only have better stock returns but that “dividend increases are associated with [higher] future profitability for at least four years after the dividend change.”¹⁴

In short, most managers are wrong when they say that they can put your cash to better use than you can. Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the managers’ hands before they can either squander it or squirrel it away.

Selling Low, Buying High

What about the argument that companies can put spare cash to better use by buying back their own shares? When a company repurchases some of its stock, that reduces the number of its shares outstanding. Even if its net income stays flat, the company’s earnings per share will rise, since its total earnings will be spread across fewer shares. That, in turn, should lift the stock price. Better yet, unlike a dividend, a buyback is tax-free to investors who don’t sell their shares.¹⁵ Thus it increases the value of their stock without raising their tax bill. And if the shares are cheap, then spending spare cash to repurchase them is an excellent use of the company’s capital.¹⁶

All this is true in theory. Unfortunately, in the real world, stock buybacks have come to serve a purpose that can only be described as sinister. Now that grants of stock options have become such a large part of executive compensation, many companies—especially in high-tech industries—must issue hundreds of millions of shares to give to the managers who exercise those stock options.¹⁷ But that would jack up the number of shares outstanding and shrink earnings per share. To counteract that dilution, the companies must turn right back around and repurchase millions of shares in the open market. By 2000, companies were spending an astounding 41.8% of their total net income to repurchase their own shares—up from 4.8% in 1980.¹⁸

Let’s look at Oracle Corp., the software giant. Between June 1, 1999, and May 31, 2000, Oracle issued 101 million shares of common stock to its senior executives and another 26 million to employees at a cost of $484 million. Meanwhile, to keep the exercise of earlier stock options from diluting its earnings per share, Oracle spent $5.3 billion—or 52% of its total revenues that year—to buy back 290.7 million shares of stock. Oracle issued the stock to insiders at an average price of $3.53 per share and repurchased it at an average price of $18.26. Sell low, buy high: Is this any way to “enhance” shareholder value?¹⁹

By 2002, Oracle’s stock had fallen to less than half its peak in 2000. Now that its shares were cheaper, did Oracle hasten to buy back more stock? Between June 1, 2001, and May 31, 2002, Oracle cut its repurchases to $2.8 billion, apparently because its executives and employees exercised fewer options that year. The same sell-low, buy-high pattern is evident at dozens of other technology companies.

What’s going on here? Two surprising factors are at work:

• Companies get a tax break when executives and employees exercise stock options (which the IRS considers a “compensation expense” to the company).²⁰ In its fiscal years from 2000 through 2002, for example, Oracle reaped $1.69 billion in tax benefits as insiders cashed in on options. Sprint Corp. pocketed $678 million in tax benefits as its executives and employees locked in $1.9 billion in options profits in 1999 and 2000.
• A senior executive heavily compensated with stock options has a vested interest in favoring stock buybacks over dividends. Why? For technical reasons, options increase in value as the price fluctuations of a stock grow more extreme. But dividends dampen the volatility of a stock’s price. So, if the managers increased the dividend, they would lower the value of their own stock options.²¹

No wonder CEOs would much rather buy back stock than pay dividends—regardless of how overvalued the shares may be or how drastically that may waste the resources of the outside shareholders.

Keeping Their Options Open

Finally, drowsy investors have given their companies free rein to over-pay executives in ways that are simply unconscionable. In 1997, Steve Jobs, the cofounder of Apple Computer Inc., returned to the company as its “interim” chief executive officer. Already a wealthy man, Jobs insisted on taking a cash salary of $1 per year. At year-end 1999, to thank Jobs for serving as CEO “for the previous 2 1/2 years without compensation,” the board presented him with his very own Gulfstream jet, at a cost to the company of a mere $90 million. The next month Jobs agreed to drop “interim” from his job title, and the board rewarded him with options on 20 million shares. (Until then, Jobs had held a grand total of two shares of Apple stock.)

The principle behind such option grants is to align the interests of managers with outside investors. If you are an outside Apple shareholder, you want its managers to be rewarded only if Apple’s stock earns superior returns. Nothing else could possibly be fair to you and the other owners of the company. But, as John Bogle, former chairman of the Vanguard funds, points out, nearly all managers sell the stock they receive immediately after exercising their options. How could dumping millions of shares for an instant profit possibly align their interests with those of the company’s loyal long-term shareholders?

In Jobs’ case, if Apple stock rises by just 5% annually through the beginning of 2010, he will be able to cash in his options for $548.3 million. In other words, even if Apple’s stock earns no better than half the long-term average return of the overall stock market, Jobs will land a half-a-billion dollar windfall.²² Does that align his interests with those of Apple’s shareholders—or malign the trust that Apple’s shareholders have placed in the board of directors?

Reading proxy statements vigilantly, the intelligent owner will vote against any executive compensation plan that uses option grants to turn more than 3% of the company’s shares outstanding over to the managers. And you should veto any plan that does not make option grants contingent on a fair and enduring measure of superior results— say, outperforming the average stock in the same industry for a period of at least five years. No CEO ever deserves to make himself rich if he has produced poor results for you.

A Final Thought

Let’s go back to Graham’s suggestion that every company’s independent board members should have to report to the shareholders in writing on whether the business is properly managed on behalf of its true owners. What if the independent directors also had to justify the company’s policies on dividends and share repurchases? What if they had to describe exactly how they determined that the company’s senior management was not overpaid? And what if every investor became an intelligent owner and actually read that report?