Summary and Discussion – Chapter 19 – Shareholders and Managements: Dividend Policy
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created August January 25th, 2015
Last updated February 1st, 2016

Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

• As a shareholder, you are a partial owner of a business. Through your shares, you have the right to vote on crucial business decisions.
• Some “activist investors” specialize in using this power to generate returns.
• The relationship between shareholders and management is always changing.

One of the principles that Graham stresses throughout The Intelligent Investor is that investors should think of themselves as what they are—partial owners of a business. It is easy to overlook the fact that, as partial owners, investors are legally entitled to vote their shares and thereby exhibit some influence over the management of the business. More often than not, however, shareholders (particularly retail investors) fail to exercise their rights. Proxy votes quickly pass from the mailbox to the recycling bin, which has the de-facto effect of transferring retail investors’ voting rights over to large institutional shareholders. The net effect of this is that management teams are less accountable to retail investors than they otherwise would—and should—be.

This complacency among shareholders matters little, as long as the businesses in which they invest are managed in the shareholders’ best interest. Yet, in situations where this is not the case, it is hard to look at shareholder complacency as anything other than a lost opportunity. “Shareholders are justified in raising questions as to the competence of management,” Graham writes, “when the [performance] results [of management] are (1) unsatisfactory… (2) … poorer than those obtained by [comparable competitors], and (3) have resulted in an unsatisfactory market price of long duration.” [1]

Shareholders have every reason to resist management incompetence; after all, they are literally invested in the matter. Yet Graham notes that, at the time of his writing, virtually nothing had been accomplished “through intelligent action” by shareholders. [2] Graham does cite one exception to this trend, however: the phenomenon of takeover bids.

The term “takeover bid” refers to a situation in which an individual or group seeks to take control of a publicly traded company by acquiring a significant portion of its shares. Once a sufficient number of shares have been purchased, the individual or group can exercise its voting rights in order to influence the company. This influence could theoretically result in major changes, such as allowing for the reorganization of the corporation’s senior management or Board of Directors, modifying the company’s dividend or share repurchase policies, or even causing fundamental changes to the company’s strategic direction.

Investors who frequently engage in this type of activity are colloquially referred to as “activist investors”. Because of the significant financial resources it requires, it’s fair to say that only a small fraction of investors can afford to invest in this manner. Nonetheless, there remains a small but active community of activist investors today whose decisions are closely watched by other investors.

Are Takeovers Good or Bad?

So, does the presence of activist investors benefit the average shareholder? It depends.

On the one hand, activist investors are fundamentally concerned with their own self-interest, and it is therefore not necessarily the case that the changes they bring about will benefit all shareholders equally. For example, an activist investor might implement changes that result in attractive short-term gains at the expense of the company’s long-term prospects, thereby benefiting short-term speculative shareholders at the expense of long-term “buy and hold” shareholders.

On the other hand, there are reasons to believe that activist investors have an important and constructive role to play in the overall financial markets. For one thing, the mere existence of activist investors might encourage companies with relatively poor corporate governance to maintain minimal standards—if only to avoid appearing on the radar of an opportunistic activist investor.

Another area in which activist investors benefit other market participants is with respect to highly distressed companies. For example, consider a company that is no longer generating any meaningful revenues and whose market price has fallen below its theoretical liquidation value. In principle, a business such as this would be more valuable dead than alive: if its Board and management simply closed the business, sold its assets, paid off its liabilities, and distributed the remaining cash to shareholders, the amount of cash that those shareholders would receive would theoretically be greater than the market value of their shares before the liquidation of the business. On paper, there is therefore no reason for the business to continue as a going concern.

But look at the situation from the perspective of the company’s senior management and Board of Directors. For them, the cash on the company’s balance sheet isn’t just a source of potential profit for shareholders. Rather, it’s also the source from which their own salaries and other forms of compensation are paid! In other words, liquidating the business would effectively mean terminating their own employment as the management and Board of that business. It’s no wonder, therefore, that the relationship between a company’s management and its shareholders can sometimes resemble that of a parasite to its host. Rather than doing what’s best for the shareholders, some unscrupulous management teams would rather keep riding the gravy train for as long as they can. In a situation such as this, it’s clear that intervention by an activist investor would almost certainly be preferable to the slow but certain death represented by the status quo.

To Be Or Not To Be… An Activist Investor

Given all of the above, why wouldn’t somebody want to put on their cape and adopt the noble role of the activist investor? Leaving aside the question of whether the overall effect of activist investing is positive or negative, and ignoring the more practical concern that being an activist investor requires immense financial resources, we are left with one major roadblock:

Consistently successful activist investing is extremely hard.

So hard, in fact, that Graham concluded that “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.” [3]

Ouch.

Ultimately, Graham’s last word on this point (at least in this book) is that the most important act that ordinary investors can take with respect to encouraging corporate governance best-practices is to “[carefully read] any proxy material sent them by fellow-shareholders who want to remedy an obviously unsatisfactory management situation in the company.” [4]

Let’s Talk About Dividends

When you own a business’s shares, there are two ways in which you stand to earn a profit: selling your shares in the future at a higher price, and/or receiving dividend payments. In light of this, you may be surprised to learn that almost 90% of U.S.-listed companies pay no dividend at all! [5]

One explanation for this staggering figure would be to say that many of those businesses were struggling and therefore unable to responsibly pay out cash to their shareholders in the form of a dividend. Yet, among the ~90% of companies paying no dividend at all, only 17% were unprofitable. [6] Clearly, the vast majority of non-dividend-paying companies were not forced to pay no dividend out of sheer financial necessity.

So why aren’t more shareholders demanding a dividend? The answer consists largely of the fact that many investors believe that the companies they own can create more value (in the form of an increased stock price) if they keep the cash within the business rather than distributing it as a dividend. Moreover, Graham himself noted that this kind of investor psychology seems as prevalent among large companies’ investors as among those of small companies: “Nowadays,” he writes, “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.” [7]

Graham contrasts this attitude against “several strong counter-arguments” that had previously been widely popular among investors. Foremost among these were the views that:

1. “The profits “belong” to the shareholders, and they are entitled to have them paid out within the limits of prudent management;”
2. “…many of the shareholders need their dividend income to live on;”
3. “…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.” [8]

Ultimately, these views still survive, but they typically surface in relation to only certain kinds of businesses. For the most part, fast-growing businesses (which in recent decades have tended to revolve around information technology) typically don’t face investor demand for dividend payments, whereas companies in relatively “mature” or stable industries—such as utility companies or telecommunications providers—are expected to maintain or even steadily increase their dividend payments.

These matters may seem academic, but in actuality they have profound implications for how market participants assess the fair value of their investments. Investors who value fast-growing companies principally based on the rate at which they can continue to grow will likely react both negatively and harshly if the company’s rate of growth slows relative to his or her expectations. Conversely, an investor interested in mature dividend-paying companies would likely react strongly to any anticipated or real reduction in dividend payments or their rate of growth. To the extent that these priorities become widely shared among the investing public, they can have a significant affect on the course of market prices.

The key here is remembering that the way that the investing public assesses the value of businesses is not necessarily rational. There is no natural law stating that the wisdom of the majority is necessarily correct. If you believe that past generations of investors placed too much emphasis on dividend payments and that the relatively low prevalence of dividends in today’s market is therefore justified, you must nonetheless acknowledge that—viewed from the perspective of future generations—investors’ current attitude toward dividends could seem similarly misguided.

Ben Graham: The Final Word

Graham’s personal view was directly at odds with the “accepted wisdom” of modern investors. To him, the phenomenon whereby fast-growing companies forego dividends in favour of using those funds to expand their business is “illogical on its face, and should require both a complete explanation and a convincing defense before the shareholders should accept it.” [9]

We would be wise to heed his words.

Footnotes

[1] Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003. Page 487.
[2] Ibid.
[3] Ibid., 488-489. Emphasis added.
[4] Ibid., 489.
[5] This figure is based on data from Google Finance’s stock screener function and was computed on February 2nd, 2016. You can check for yourself by experimenting with the dividend yield criterion at https://www.google.com/finance#stockscreener.
[6] This was calculated using the same method as above, where profitability was defined as having a positive net profit margin.
[7] Benjamin Graham, The Intelligent Investor, 490.
[8] Ibid.
[9] Ibid., 492.