Monday, November 29, 2010

How would you like your cash back, sir?

We have examined how, despite Modigliani-Miller's theorem, in the real world we should prefer most firms, under most circumstances, to return to their shareholders some (a sustainable fraction) of the free cash flow resulting from operational earnings -- not to the point of incurring avoidable debt (except in cases where some debt can be had under very favorable conditions, and be wisely used to leverage the firm up in sectors requiring high capex but with a very steady and predictable cash flow as the result -- regulated utilities being the prime, classical example of this situation), but also avoiding excessive accumulation of cash hoards which yield very little (except in rare cases where a company has a proven track record of profitable acquisitions, with successful integration of the acquired firms, and requires substantial cash reserves to continue on that strategy going forward).

If you're still a Modigliani-Miller fan, I'd recommend taking a look at  this article.  By the way, as an aside, I do strongly recommend the site -- it's very cheap and really chock-full with interesting and directionally-right information, even if you're a more experienced investor than they aim to.  (if you're a  beginning investor, AAII membership is really, truly, seriously, I-mean-it a must, BTW;-).

So anyway, back to the AAII article I just pointed to, which summarizes and discusses Arnott's and Assness's immortal 2003 article in "Financial Analysts Journal".  To summarize the summary of the summary: companies that pay dividends have better (not worse, as M-M would predict) capital gains returns, too.

One of the possible explanations is that "high earnings retention and a low dividend payout may signal an attempt at empire-building by current management" -- in other words, such a high retention with low dividends is a negative signal, pointing at the risk of out-of-control acquisition spreads.

Some companies (a very few, with a proven historical track record) can retain earnings and use them to fund acquisitions in a way that's accretive of value to shareholders; by far the greatest majority just can't, and history proves that clearly.  Arnott and Assness's "screen" may screen out companies likely to go on shareholder-negative acquisition binges -- and that may explain a lot of why it's predictive.

So, let's accept (for the sake of discourse) the overwhelming evidence that companies who do return some (reasonable, sustainable) fraction of earnings to shareholders, overall (i.e., always excepting many possible exceptions, which, in real-life, do abound), outperform those who hoard that cash.

There remains a problem -- per the title of this article: as an owner of some part of the company, accepting that it should return some of its cash to you, how would you rather get it back?

The main possibilities are, share buybacks, and dividends (which can take many forms).  Dividends are "all the rage", lately... and, as a contrarian, I'm always especially wary when I find myself agreeing w/the hoi polloi... but in this one case I have to admit I can't really, credibly, disagree, either;-).

So, I'll follow on with posts on buybacks (when are they good, when are they a problem) and dividends (and the various forms they can take... though today's typical US investors may not realize dividends' multifarious possibilities and their pros and cons!-).

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