THE CONSERVATION OF VALUE

The idea is there, locked inside.
All you have to do is remove the excess stone.

—MICHELANGELO

Mergers, stock splits, stock dividends, cash dividends, share repurchases, stock sales. Many potentially confusing corporate actions seem difficult to assess. Which are good for shareholders? Which are bad? Which are meaningless?

Once again, John Burr Williams helps clarify our reasoning, this time with his Law of the Conservation of Investment Value: The value of a firm depends on the cash it generates, regardless of how that cash is packaged or labeled. Nothing is gained or lost by combining two income streams or by splitting income in two and calling one part one thing and the rest something else. Many seemingly important corporate decisions are, in fact, nonevents that do not leave $100 bills on the sidewalk.

STOCK SPLITS

A Business Week article was titled “How to Double Your Shares Without Spending a Dime.” The secret is to buy a stock before it splits 2-for-1, doubling the number of shares you own. Sounds great, right? Just be sure to buy the stock before it splits. In the Sopranos television show, Carmela has been nagging Tony to buy a stock. Finally, Tony says, “Let’s buy that stock.” Carmela makes a face: “It split. It’s too late, we missed it.”

If it’s so great for shareholders, why don’t all companies split their stock? The answer is that stock splits do nothing at all for shareholders. A stock split increases the number of shares, true enough, but it reduces the value of each share proportionately. The real mystery is why companies split their stock.

Consider a company with one million shares valued at $60 apiece, or a total market value of $60 million. If the stock splits 2-for-1, with no change in the company’s operations, its aggregate market value should stay at $60 million, implying a $30 per-share market value: A doubling of the shares halves the value of each.

If stock splits are nonevents, why do firms bother? One explanation is that if a company allows its price to rise to $200, $500, or $1,000 a share, some investors cannot afford buy it. Periodic splits that keep the price per share under $100 keep the stock affordable.

In a market dominated by large institutions, the affordability argument is a bit strained and sometimes preposterous. American Telnet, a television production firm, went public in March 1979 at 50 cents a share. By August 1980, the firm had yet to sell a television show and the price had sagged to 43 3/4 cents. At this point, the firm split its stock 5-for-1 so that, according to its president, the stock would be “more affordable.” Given the structure of brokerage commissions, however, it doesn’t make sense to buy just one share of an 8-cent stock, and there is no real difference between buying 1,000 shares at 40 cents each or 5,000 shares at 8 cents each.

A somewhat more satisfactory reason for stock splits is that, traditionally, blue-chip stocks have traded in the $20 to $100 range, and some companies like to stay in that range. If a stock’s price goes up to $80 and the firm declares a 2-for-1 split, reducing the price back to $40, the split signals to investors that the board of directors is confident that the run up was justified—not mindless speculation that, when it has run its course, will cause the price to collapse to below $20, where lesser stocks trade.

A stock that falls below $20 could do a reverse split—for example, a 1-for-2 split that halves the number of shares and doubles the price. However, resorting to this tactic would be a damaging admission by the company’s board that the firm’s prospects are not bright enough to increase the price soon.

On April 23, 2014, with Apple stock trading at $524.75, Apple announced a 7-for-1 split. Apple generally has very good reasons for doing what it does, so many investors thought that the highly unusual choice of a 7-for-1 split reflected the company’s belief that the stock price would soon approach $700, which would be $100 after the split. They were right. Four months later, Apple popped through $100.

For American Telnet, a logical explanation for the 5-for-1 split is that splitting its stock down to the penny range may attract speculators who habitually restrict their attention to penny stocks. In sharp contrast, Berkshire Hathaway, run by Warren Buffett, has never split, even when its shares cost more than $100,000 apiece. In a Christmas card to a friend, Buffett wrote, “May you live until B-H splits.”

In 1996, with Berkshire Hathaway selling for $33,000 a share, outsiders planned to buy Berkshire shares and resell them to investors in $1,000 pieces through unit investment trusts. Not wanting small investors to have to pay sales charges and other administrative expenses that such trusts would entail, Berkshire Hathaway issued Class B shares—dubbed “Baby Berkshires”—each without voting rights and worth one-thirtieth of the regular Class A shares. In January 2010, Class B shares were split 50-to-1, making each worth 1/1,500 the value of Class A shares. On January 10, 2014, Berkshire A closed at $171,322 a share and Berkshire B closed at $114.97 a share.

STOCK DIVIDENDS

A stock dividend is a stock split, only smaller. If a company declares a 5 percent stock dividend, stockholders receive five additional shares for every 100 shares they hold, which is effectively a 21-for-20 stock split. The conservation-of-value principle implies that the value of each share falls by 5 percent, leaving shareholders no better or worse off than before.

Nonetheless, Barron’s Finance and Investment Handbook made this silly claim:

From the corporate point of view, stock dividends conserve cash needed to operate the business. From the stockholder point of view, the advantage is that additional stock is not taxed until sold, unlike a cash dividend.

This claim is misdirected and misleading. Companies and their shareholders may well want to retain earnings to finance expansion. But there is no need to declare a stock dividend to do so. The company can expand as planned, and it doesn’t matter at all whether the company leaves the number of shares unchanged, declares a 2-for-1 split, or declares a 21-for-20 split (a 5 percent stock dividend).

As with any stock split, the question is why bother? A stock dividend costs the firm the expenses of administering it and doesn’t give shareholders anything. If stockholders feel better off having received a stock dividend, they apparently did not notice the offsetting dip in the value of each share, perhaps because a small price change is lost among the daily fluctuations in stock prices.

Andrew Tobias, a keen observer of the stock market, offers a similar explanation for why companies declare stock dividends:

The only difference between a stock dividend and a stock split is that, being a very small split, it is hoped that no prospective buyers will notice that it has taken place. . . . Sometimes it actually works.

By this logic, stock dividends are like candy-bar inflation: The company shrinks the bar and hopes that consumers will continue to pay full price. If so, Mr. Market is truly dumb.

Writing in the Harvard Business Review, a finance professor argued that stock dividends are real events and they are bad:

What about stock dividends, which are theoretically used as a way of sharing profits while conserving cash? . . . As I see it, the trouble with this approach is that shares outstanding increase at a compound rate. It’s a 5% stock dividend this year, but next year it’s 5% of 105%, and so forth. This pattern holds down growth in earnings per share.

Once again, the conservation-of-value principle guides us to the truth. Stock dividends are nonevents. Yes, stock dividends (like stock splits) reduce earnings per share, but they also increase the number of shares, leaving earnings per shareholder constant.

What this finance professor’s bogus argument really demonstrates is another reason why we should not worship earnings per share. There are lots of ways that companies can increase earnings per share without benefitting shareholders:

1.Invest in marginally profitable ventures.

2.Acquire companies with low price-earnings ratios.

3.Do a reverse stock split.

A 1974 Wall Street Journal editorial criticized the myopic focus of many corporate executives on earnings per share:

A lot of executives believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent any underlying economic change. In other words, the executives think they are smart and the market is dumb. . . .

The market is smart. Apparently the dumb one is the corporate executive caught up in the earnings-per-share mystique.

A handbook on management consulting printed this editorial and then stated, “Unfortunately, our experience shows that many corporate managers still worship earnings per share, and thus are still betting that the market is dumb.”

REAL DIVIDENDS

Dividends are paid to those who own the company’s shares on the record date. For instance, the board of directors might declare a $1 dividend to be paid on March 1 to those who own stock on the record date of February 15. To allow for the processing of transactions, the NYSE and most other exchanges use an ex-dividend (excluding dividend) date two business days before the record date; those who buy the stock ex-dividend do not receive the dividend.

The Get Rich Investment Guide published by Consumers Digest offered this moneymaking tip:

Obviously, one strategy is to know when the stock will go ex-dividend and buy a day or two before the cutoff. Then you can receive the dividends, and you can sell the shares as soon as you have [received the dividend].

So, $100 bills are lying on the sidewalk for anyone who can figure out when a stock goes ex-dividend? That doesn’t seem difficult, so there must be a flaw in this strategy. The flaw is that a stock’s price falls when it goes ex-dividend.

Consider a company with one million shares valued at $100. If the company pays a $1 dividend, the aggregate market value of the company falls from $100 million to $99 million, because its assets have been reduced by the $1 million it paid in dividends. The price of each share should drop to $99. Someone who buys the stock for $100 before it goes ex-dividend gets the $1 dividend, but can only sell the stock for $99. (I’m ignoring other, unpredictable price changes.)

If dividends are nonevents, why bother? Some shareholders may welcome using dividends to pay their bills, but they could always sell some of their stock. This is a classic puzzle in finance—why do companies pay dividends? One answer is that cash dividends are clear and unambiguous proof that the firm really is making money. Firms can use creative accounting to create an illusion of profits, but you can’t fake dividends. Firms that pay dividends are making real profits, not imaginary ones.

DIVIDEND REINVESTMENT PLANS

Many companies have dividend reinvestment plans that allow shareholders to use their dividends to buy additional shares of stock. Shareholders avoid brokerage fees and the company raises cash without paying fees to an underwriter. It sounds like win-win but it isn’t because shareholders must pay taxes on dividends they don’t receive.

Consider again a firm with one million shares priced at $100 a share, and suppose the company pays a $1 dividend and all shareholders participate in a dividend reinvestment plan. What happens? The total number of shares increases by one percent, and the value of each share declines proportionately. Each shareholder continues to own the same fraction of the company’s shares as before. The only difference is that shareholders must pay income taxes on dividends they didn’t get. It is as if the company sent a notice to its shareholders every three months: “The company is doing fine; please send money to the IRS.”

STOCK REPURCHASES AND SALES

A legendary fund manager wrote, “If a company buys back half its shares and its overall earnings stay the same, the earnings per share have just doubled.” The obvious flaw is that the firm may have to liquidate half its assets to buy back half its stock. How can earnings stay the same if the firm gets rid of half its assets?

Consider a company with 20 million shares outstanding, each valued at $20 (an aggregate market value of $400 million). This firm has $20 million in cash to distribute to its shareholders. One alternative is to pay a $1 dividend per share; another is to purchase one million shares at $20 apiece.

Table 8-1 shows the consequences for this company. Either way, the $20 million payout reduces the firm’s total value from $400 million to $380 million. If the firm pays a $1 dividend, there is a $1 drop in its stock price and shareholder wealth is unchanged. If the firm repurchases shares, the number of shares declines by one million, leaving the price at $20 and again making shareholders no better or worse off.

Remember that we are comparing purely financial transactions in order to show that share repurchases are equivalent to dividend payments. Repurchases would increase the stock price if the firm bought the stock with money that would otherwise be wasted on unprofitable ventures. But it is the abandonment of the money-losing projects that raises the price of the stock, not the decision to distribute the proceeds through repurchases instead of dividends.

A comanager of the Federated Strategic Value Dividend Fund gave this answer to the query, “Why isn’t it better for companies to engage in stock buybacks [instead of paying dividends]?”:

A dollar of dividends, albeit highly taxed, is still a check in the mail. A share repurchase goes off into the ether and never benefits Main Street. It’s just money that could’ve come to you that didn’t.

True, a dividend puts cash in shareholders’ pockets, but they can always get cash by selling some of their shares—in essence, a shareholder-determined dividend policy.

Taxes give share repurchases a clear advantage over dividends. Shareholders pay taxes on dividends, but they do not pay capital gains taxes unless they realize their gains by selling—and, even then, they don’t pay taxes on the entire sale, only the capital gain (if any). A dividend gives shareholders no alternative but to take the cash and pay taxes. With a share repurchase, shareholders have a choice. Either they can sell shares and pay taxes on the capital gains, or they can let their investment ride.

If a share repurchase is like a dividend, issuing new shares must be equivalent to reducing dividends. It is.

Our conclusion is that except for the benefits from avoiding taxes on dividends, a stock repurchase is equivalent to paying dividends and a stock sale is equivalent to reducing dividends.

STOCKS AS A HEDGE AGAINST INFLATION

Investors ought to find protection from inflation by stockpiling things going up in price. If the price of soup is going up, buy soup before the price goes up. But it is impossible to store some things, such as medical services, and expensive to store others, such as automobiles. Some assets are beyond the budgets of most investors—Iowa farmland, Arizona shopping centers, Dallas skyscrapers. Perhaps one way to invest in real assets that may appreciate with inflation is to buy stock in companies that own land, buildings, and other tangible assets.

In the long run, dividends, earnings, and stock prices have increased faster than consumer prices. From 1900 to 2015, the consumer price index increased at an average annual rate of 3 percent while the S&P 500 stock index increased by 5 percent a year. If we add in dividends, investors have averaged more than a 6 percent annual real (inflation-adjusted) return from stocks.

In the short run, however, increases in the rate of inflation have not increased stock prices reliably. Figure 8-1 compares the high-inflation 1970s with the low-inflation 1960s. In each decade, real output increased by 30 percent. In the 1960s, consumer prices rose by 25 percent and stock prices nearly doubled. In the 1970s, consumer prices doubled and stock prices were virtually unchanged, causing the real value of stocks to fall by 50 percent.

Many investors who suffered through the inflationary 1970s drew the understandable conclusion that inflation is bad for the stock market. However, the facts do not support this simplistic belief any more than they support the equally simple belief that inflation is good for the market. Figure 8-2 is a scatter diagram of the annual rate of inflation and the return on stocks (dividend plus capital gain) each year from 1926 to 2015. The correlation is a meaningless 0.01. In the long run, stock prices have increased more than consumer prices. In the short run, there is no relationship between the inflation and stock returns.

One explanation is that stockholders are not buying assets. They are buying the profits that come from assets, and after-tax profits do not move in lockstep with inflation.

ACCOUNTING FOR INFLATION

After-tax corporate profits often suffer during inflationary periods because taxes are levied on profits calculated according to more or less standard accounting principles, and some of these principles don’t make much sense during inflations. For instance, accountants spread out the cost of buildings, machines, and equipment with an annual depreciation expense that, in theory, reflects what it costs to replace things as they wear out. In practice, depreciation expenses are based on original costs, which is like figuring labor costs on the basis of wages twenty years ago. The result is that inflation causes capital costs to be understated and profits to be overstated so that businesses, particularly those with lots of buildings, machines, and equipment, pay higher taxes.

On the other hand, conventionally measured profits are misleadingly low during inflations to the extent they ignore capital gains on corporate assets and liabilities. Just as households profit when they borrow at a fixed interest rate to buy a house whose value increases during an inflation, so do corporations that borrow to buy buildings and equipment. Yet such gains are not included in reported profits unless the firm sells its real estate or retires its debt.

A relatively straightforward approach for valuing stock during inflationary periods is to remember that investors are not buying some accountant’s reckoning of profits but the actual cash, the dividends, that stocks provide. Figure 8-3 shows real, inflation-adjusted dividends for the S&P 500 from 1950 to 2015. After growing at a 3.4 percent annual rate from 1950 to 1966, real dividends peaked in 1966 and declined sharply in the early 1970s. It wasn’t until 1989 that real dividends returned to the level reached in 1966. The 1970s were the most inflationary decade in memory, and dividends did not keep up with consumer prices.

If real dividends had kept growing at 3.4 percent annually during the inflationary 1970s, dividends would have been 70 percent higher in 1980. Real dividends have spurted higher since 2000, even though the annual rate of inflation has only been about 2 percent.

Yes, dividends have gone up faster than inflation in the long run. No, dividends do not reliably rise and fall with inflation.