Someone recently asked whether I think of myself as Russian, or American. My initial response (without thinking) was – American. But as I gave this question more thought I realized that the answer is more complex. First of all, the question is incomplete, as I have another identity – I’m Jewish (we’ll come back to it). But when it comes to national identity, I think of myself as American. I moved to the United States in 1991 when I was 18 years old, and this country has been incredibly kind to me. I received my undergraduate and graduate education here. I speak, read, and write much better in English than in Russian.
Let’s say I was watching the Olympics and the American team was playing a team from any other country (including Russia). I’d be rooting for the Americans – I wouldn’t have to give this a second thought.
However, as I got older, I started to appreciate that when it comes to some elements of culture, I consider myself Russian. For instance, Rachmaninoff and Tchaikovsky are my composers. I cannot really describe what “my” means, but their music speaks to my soul. I experience a connection to their music that is unique.
That is really all I had to say here, but writing is very psychotherapeutic; it’s like being on the psychiatrist’s couch without a $200 bill. As I’ve been typing away at this, I have realized that there may be a logical reason why Russian music is “my.”
Tim Urban estimated that by the time you finish high school you have spent 93% of the total time you’ll ever spend with your parents. Today I spend at least six hours a day with my kids and another 20 hours on weekends. When kids live in your house they are completely dependent on you, especially younger ones. Let’s take my five-year-old Mia Sarah and thirteen-year-old Hannah, for example. Neither one drives, of course, and my wife won’t let them past the porch without adult supervision (she’d put a leash on Mia Sarah if she could).
When they go to college, get married, and have their own offspring, we’ll be lucky to see them six hours a month (though I hope it will be more than that). We are getting a small taste of what’s to come with my seventeen-year-old Jonah, who is a senior in high school and still lives with us. He has a car, girlfriend, study groups… we’ re lucky if we spend two hours a day with him during the week.
How does this relate to my being culturally Russian?
My parents loved classical music, and they especially loved Russian composers, Russian writers (my father read to me almost every day before I went to sleep), and Russian painters. So, what I am today, at least culturally, was planted in me during 93% of the time I spent with my parents, before we left Russia. So, on some (Freudian) level, maybe Russian composers are my composers because they are my parents’ composers.
And then there is being Jewish. I’ve been thinking about this a lot lately. For some people being Jewish means one thing: religion. Not me. To me being Jewish means three things: religion, tradition (philosophy), and nationality.
I didn’t realize that there was such a thing as Jewish religion until I was in my late teens. Soviets were not big fans of religion (they indiscriminately disallowed all of them), as it competed with their own version of religion – communism.
I was always reminded that my nationality was Jewish, because my parents’ (and later my) passports said that. Since I was a little kid I knew that my being Jewish was not a good thing, as if my nationality was not as clean or as good as everyone else’s. That feeling of being ashamed of my nationality completely went away after I moved to the US.
I recently took the 23 and Me test and learned that I am 97.5% Ashkenazi Jew. (There was not much surprise there – just take a quick look at my photo at the bottom).
And then there’s the second part of my being Jewish – tradition and philosophy. Neither my parents or grandparents were religious, but Jewish traditions and philosophy were deeply ingrained in them. I lump tradition and philosophy together because often you don’t know where one stops and the other begins. Religion and harsh external environment (for centuries Jewish people have not had easy lives) have helped to shape both.
Anyway, this is a very, very long introduction to the music I wanted to share with you today, Piano Concerto Number 4 by (my composer) Sergei Rachmaninoff. Rachmaninoff wrote the original version in 1926, but it received a very muted response. Rachmaninoff revised it twice, and his final version (completed in 1941) is the version usually performed today. However, in 2000 Rachmaninoff’s estate allowed the original version to be published, and thus we now have two versions to compare.
Click here to listen
A client asked recently for my view on Japanese conglomerate SoftBank Group and its substantial investment in WeWork, whose CEO evidently has sold WeWork stock to buy properties in New York City and California that he has leased back to WeWork. The question on my client’s mind is whether this transaction is a conflict of interest (SFTBY)
The truth is that my firm is not as big a fan of WeWork as is Softbank’s CEO and Chairman, Masayoshi Son. WeWork is to us a real estate company that borrows long-term by buying office real estate or entering into office leases, and lending short-term by breaking large office spaces into small offices and leasing them out fully furnished for periods ranging from days to months.
My firm spent a lot of time analyzing WeWork’s competitor Regus a few years ago. Regus actually pioneered this business model. We came to the conclusion that the only number which matters for this business is utilization (percent of real estate leased). If WeWork is able to lease out 90% of its space, it will be a highly profitable enterprise. If the utilization drops to, let’s say, 60%, then it will start losing money and implode. This is a classic high-fixed-cost business with variable and cyclical revenues.
In contrast, Son looks at WeWork as the future of the collaborative workplace. We have our doubts. Softbank’s Vision Fund invested a few billion into WeWork, valuing it as high as $40 billion. Then came the Wall Street Journal story about WeWork CEO Adam Neumann buying properties in New York City and California and leasing them back to WeWork.
Here’s our view: By buying Softbank’s shares we effectively hired Son — a brilliant investor, a visionary — on the cheap (we are paying a 50% discount for Softbank’s shares relative to our estimate of their value) to make capital allocation decisions for us. Do we agree (or even understand) every capital allocation decision he makes? Absolutely not. He has a unique view of the world and has built an enormously successful company from scratch by getting a lot more things right than wrong.
Does Son make mistakes? Of course. Do all his bets play out? Absolutely not. Investing in private or public companies is not an exact science; it’s a messy, nonlinear, probabilistic endeavor. We analyze Softbank and Son the same way we’d want to be analyzed as money managers. We are asking the same question that our clients should be asking about every decision we make, namely:
• Does Son have integrity and intelligence?
Son’s decisions over the last 30-plus years are in the public record. We have never, even once, questioned his integrity, and he is one of the most brilliant people we have ever admired from afar.
• Does Son follow a deliberate decision-making process?
Son thinks about the future, identifies inevitable future areas of transformational growth (in the ’80s personal computers, in the ’90s the internet, in the 2000s wireless internet, smart phones, and ecomerce in China; and today it is the Singularity — computers becoming smarter than humans) and then finds the best ways to bet on that future.
Vision Fund is a brilliant way for Softbank shareholders to bet on the future. It is basically a $100 billion private equity fund run by Son. But instead of paying Son typical hedge-fund fees (2% management fee and 20% from profits) – you as a Softbank shareholder collect those fees.
Softbank put in $25 billion of capital, and $75 billion came in the form of common and preferred equity from the likes of Qualcomm, Apple, Oracle, and the Saudi wealth fund.
Here is the best part: In our analysis of Softbank, due to the company’s undemanding valuation we have the luxury of ignoring the value of Vision Fund. In the fourth quarter of 2018 Softbank took its largest nonpublic asset, a Japanese telecom business, public at a very attractive valuation. Today we can value all of Softbank’s holdings by using public prices. If we add up the value of Softbank’s stake in Softbank Telecom, Alibaba, Yahoo! Japan, Sprint, and Arm Holdings (at the price Softbank took it private), we get a value price somewhere around $70-80 a share.
This analysis completely ignores the value of Vision Fund. We really don’t know what it is worth. But we guesstimate that if it achieves an 8% rate of return over the next 10 years, it may create as much value as what we are paying for SoftBank’s stock today.
• Are Son’s incentives aligned with ours?
You need a lot less integrity from a manager when he eats from the same dish as you. Son owns 20% of Softbank shares, and thus his incentives are completely aligned with ours.
• Is Son transparent in his decision making? Does he admit mistakes when he makes them?
We have been listening to Son’s investment calls for years, and we have watched dozens of interviews with him. Yes, some of his remarks are boastful, but that doesn’t make them any less true. At the same time, he admitted that he made a multibillion-dollar mistake in first buying Sprint. (Son thought he’d be allowed to merge it with T-Mobile. The merger was initially blocked under the Obama administration, but now stands a good chance of being approved.) Then in 2018 he apologized for botching negotiations with T-Mobile, which cost Softbank billions.
Accordingly, in the grand scheme of things, Softbank’s investment in WeWork won’t matter that much.
If you are new to SoftBank, read my analysis: Buying Warren Buffett, Richard Branson and Steve Jobs at a DiscountRead This Before You Buy Your Next Stock
On June 12-14, my company, IMA, will host the eighth annual VALUEx Vail conference. I borrowed the idea for this conference from my friend Guy Spier after attending his conference in Zurich in 2011. (If you missed my thoughts from his 2019 conference, you can read them here).
I must admit that there is a very selfish reason why my company and I organize this nonprofit conference: I make new investment friends who share similar values (of value investing). IMA and its clients have benefited tremendously, because the conference has allowed us to build a large global network of value investors from whom we can learn and share ideas long after the conference ends.
Most importantly, over the last eight years I have made a lot of close friends. Twenty years ago, when I started investing, I could draw a clear distinction between my personal and investment friends, but not anymore. I spend as much time talking with my supposedly investment friends about our families as about stocks and the economy.
A small group of us get together a few times a year for a few days, each time in a new city (in 2018 we visited Fort Lauderdale and Dallas). This is not your Hangover 1, 2, or 3 movie type of event, but more like Hangover for Geeks: We visit three or four companies, debate stocks, and enjoy local food. Every single person in this group I met through VALUEx Vail, and every single one of them is a dear friend!
Unlike traditional conferences, every attendee at VALUEx conference is expected to present, and thus the conference is as good as the people who attend it. That means organizing VALUEx Vail is becoming more and more difficult each year. We limit the conference to only forty attendees. The number of applications we receive greatly exceeds number of spaces available. It is easier to get accepted to Harvard than to VALUEx Vail. The worst part is that I have to be a bad guy and say “sorry” to a few dozen people. That’s something I really dread. (I taught a graduate investment class at the University of Colorado for seven years, and one of the reasons I stopped teaching was that I hated giving out bad grades. I don’t like disappointing people.)
If you apply to attend and are not accepted, just know that I feel very bad when I write the “Sorry we don’t have a spot for you this year” email. To learn about VALUEx Vail and to apply, visit https://valuexvail.com. Also, don’t forget to peruse the presentations from previous years on the website.
Application deadline is April 15 (just like IRS).
This article is Part 3 of a 3-part series discussing how investors can avoid acting irrationally. Read Part 1 and Part 2.
Investors are prone to two opposing but equally debilitating fears: the fear of missing out when times are good, and the fear of loss when markets are volatile. These two fears have a zero-sum relationship with rational decisions. The more you are dominated by these fears, the less rational you are.
So what can we do, as investors, to move toward maximum rationality? Here’s one piece of advice: Turn off the TV.
We rarely turn on business TV in our office. Stock market movements throughout the day are completely random. The same actors that are influencing the up-and-down ticks of individual stocks–actors whose goals and time horizons may have nothing in common with yours–are driving market movements. I feel for TV producers who must provide a continuous narrative to explain this randomness.
Business TV presents additional dangers to your rationality: It reprograms you to think about the stock market as a game. In encouraging you to play that game, it puts you at risk of nullifying all the research you’ve done, as you let your time horizon dwindle from years to minutes.
It also threatens to strip from you the humility that is so needed in investing. Business TV guests who provide their opinions on stocks have to project an image of infallibility (the opposite of humility). Again, I sympathize with them – they are there to market themselves and their business, and thus they must project the image that they have an IQ of 200, holding forth on every possible topic.
You are never going to hear from them the words that are the essence of investing: “I don’t know.” Being unable to admit uncertainty is dangerous, because it may cause you to stop thinking about investing in terms of probabilities. If you start thinking that the future has only one path, you may ignore other paths and thus other risks in your portfolio construction. If you tell yourself that you’re an expert on every company, then your circle of competence has no boundaries and your overconfidence may take you to places (and into investments) where you have no place being.
Also, since “I don’t know” is not part of their vocabulary, business TV guests will confidently answer questions that should never be asked, such as “What will the economy and stock market do next?” If you have been investing long enough, it is hard not to develop opinions (hunches) about what the stock market and economy will do next. However, good money managers work diligently to extinguish these hunches from their investment process, because those hunches lack repeatability.
If you get the next leg of the stock market or economy right, that’s just dumb luck – nothing more and nothing less. Economic and stock market behavior, especially in the short term, are very random. God forbid your recent forecasting success goes to your head, because your ability to predict what will come next is not much different from your predicting the next card to be turned up in blackjack.
Be an investor, not a forecaster
My colleagues and I used to identify with our self-proclaimed “I am a long-term investor” brethren. However, over time this phrase has morphed to mean “I am a buy-and-hold (and never sell) investor.”
Also, the term long-term investor, in our view, is a bit redundant, since there is no such thing as short-term investing in the stock market. If you are investing in stocks, then your time horizon should automatically be long-term; otherwise you are just a trader deceiving yourself into thinking that you’re an investor. However, investing is not just about the holding time horizon. The analytical time horizon is just as important.
To us, being investors means having an attitude with which we look at stocks and process information. We buy businesses that happen to be listed on public exchanges, but our attitude toward them would not be much different if they were private. We view all news, be it quarterly guidance (whether it’s “great” or “disappointing”), upgrades or downgrades by analysts, or any headline crossing our screens in the context of one question: How does this impact the value of the business?
This perspective is liberating, because you start to process the news flow very differently. You develop a resistance to the distractions of the everyday news dump. Quarterly earnings stop being about “beating” or “missing” guidance. Ultimately, this simple question, “How does it impact the value of the business?” filters out 90% of the noise and puts us on a solid investment footing.
This article is Part 2 of a 3-part series discussing how investors can avoid acting irrationally. Read Part 1 and Part 3.
Investors are prone to two opposing but equally debilitating fears: the fear of missing out when times are good, and the fear of loss when markets are volatile. These two fears have a zero-sum relationship with rational decisions. The more you are dominated by these fears, the less rational you are.
So what can we do, as investors, to move toward maximum rationality? Here’s one piece of advice: Don’t constantly watch your portfolio.
Next time you notice the price of a stock you own moving up or down, think about the factors that may be influencing that move. Stocks are owned by people who have very different time horizons. You’ll have mutual funds and hedge funds whose clients often have the patience of five-year-olds. They are getting in and out of stocks based solely on what they expect them to do in the next month or six months – a rounding error of a time period in the life of a company that lasts decades.
Some buyers and sellers are not even humans but computer algorithms that are reacting to variables that have little or nothing to do with fundamentals of the company you invested in – these players have a time horizon of milliseconds.
You will also have folks who are buying and selling a stock based on the pattern of its chart. Not that they don’t know what the company does; they will tell you they don’t care what it does. For them it’s just a chart with one squiggly line crossing another squiggly line.
Then there are folks who spend more time researching the next movie they are going to see than the stock they’re about to buy. Some of them buy a stock after reading a single article on the internet, while many others buy on the advice of their brilliant neighbor Joe, the orthodontist.
The active dangers of passive investing
Deciding not to constantly look at your portfolio is not necessarily the same thing as embracing the latest craze – passive investing. This one is a bit personal and requires a small detour.
Interest rates are the foundation of the discount rate (also known as the required rate of return) that investors use to convert future cash flows into today’s dollars. Think of the discount rate as being composed of two layers: the foundational layer, or the risk-free rate (the interest rate, let’s say, on the 10-year Treasury); and a risky layer that should compensate you for additional, asset-specific risks.
During the great recession, when central banks artificially changed the price of money by buying trillions in government and corporate bonds, they made the Soviet planned economy look like child’s play. Instead of messing with kiddie stuff like setting prices on shoes and sugar like Soviet central planners did, a few dozen “free market” central bankers set the price of the single most important commodity, the risk-free rate, which is at the core of most economic decisions and the valuation of all assets.
Valuation of companies whose earnings lie far, far in the future benefits dramatically from falling interest rates, while the valuation of companies whose earnings are not growing as much and are concentrated in the present and near future doesn’t enjoy that benefit.
A similar dynamic happens in the bond market: Bonds with short maturities (similar to value stocks) are impacted a lot less by declining interest rates than long-term bonds (similar to growth stocks).
As the impact of suppressed interest rates rippled through the markets, active managers that had even a modicum of discipline in their stock selection found themselves trailing their benchmarks and even getting fired, while customer money flowed into index funds that indiscriminately buy what is in the index.
What is in the index, you may ask? Most popular indices today are constructed based on companies’ capitalization. Thus, companies that have done well lately (for example, the tech giant “FANGs”–Facebook, Apple, Netflix and Alphabet’s Google), get a much greater portion of new capital – in fact the FANGs account for about 10% of the S&P 500 Index. So “high-duration” companies are benefiting from both low interest rates and the “dumbness” of the indices.
However, as investors who hold long-term bonds in 2018 are discovering, rising interest rates can hurt. We don’t know what interest rates will do in the future. But today the U.S. government is running a trillion-dollar budget deficit at a time when the economy is growing at a rate of almost 5%, before adjusting for inflation. What do you think the deficit is going to be when growth slows down or turns negative during a recession (yes, those things do happen)? To make things worse, these deficits add to the $21 trillion of U.S. debt, which doubled over the last 10 years while the government’s interest payments didn’t change (thanks to low interest rates). Higher, maybe even much higher, interest rates are not unlikely going forward.
If you own the S&P 500 (or long-term bonds), you implicitly think one of several things is true: (1) Interest have a zero or insignificant probability of going up; (2) I’ll be able to get out in time; or (3) I have a life-sized statue of John Bogle in my living room, and I have a very, very, very long time horizon.
Remember: You’re an owner
Back to various actors who are responsible for daily ticks of your favorite stocks. If you are a fundamental investor, you are not just buying stocks, you are buying fractional ownership in businesses.
You spend hundreds of hours on research, you read company financial reports; you talk to management, competitors, customers, suppliers. You build a financial model that looks years into the future to value a business, and also to predict what could kill it.
If after you’ve done all that, you still find yourself glued to the computer screen watching the price change tick by tick, you are basically giving credence to the idea that what a company is worth should be decided by algorithmic funds, the guy who reads charts but cannot even spell the name of your company, Joe the neighbor, and an ETF with the IQ of a Halloween pumpkin. (I don’t want to insult everyday pumpkins here.)
In short, the less time you spend looking at your portfolio, the more rational you are going to be.
This article is Part 1 of a 3-part series discussing how investors can avoid acting irrationally. Read Part 2 and Part 3.
The stock market is not your friend. You want to approach it the same way the American president should approach a one-on-one meeting with the Russian president: Be respectful but cautious. He might smile at you and say all the right things, but despite the diplomatic niceties, your interests might not be aligned.
The stock market awakens a dangerous emotion: fear. It is sitting dormant in us all, awaiting an excuse to wake up. When stocks are going up, we may find ourselves engulfed in the fear of missing out (which is so predominant in our society that we even have an acronym for it – FOMO). When we are consumed by FOMO our time horizon magically expands. We tell ourselves we are long-term investors and our risk tolerance is infinite. Risk of decline? We puff out our chests and say “bring it on!”
And then when the market actually declines, a very different fear pays us a visit–the fear of loss. The invincible hero who conquered the FOMO moment shrivels to a husk of his former self when the fear of loss emerges. The chest collapses, and so does the time horizon, shrinking from “years and years” to months, days, or minutes.
These two fears are not compatible with successful investing and have a zero-sum relationship with rational decisions. The more you are dominated by these fears, the less rational you are.
Think of the total skill set of an investor as a multivariate equation in which all our skills are combined: the ability to value companies, to interpret financial statements, to understand and apply macro- and microeconomics, to be an independent and creative thinker, etc.
And then that grand sum must be multiplied by your ability to remain rational. Think of your ability to remain rational as a number between 0 and 1. If you are totally rational, you are a 1.
If you let the emotions generated by the last tick of the market seep into your investment process and dominate your buy and sell decisions, then it won’t really matter what the sum of your other skills is. That sum will be multiplied by a big fat zero, and thus your total skill level as an investor will be exactly that – yes, zero. You’ll be doing what the average investor does – buying high and selling low.
Thus, rationality is one of the most important qualities I’d be looking for in a money manager. Recent market volatility – a code word for when the market doesn’t just go up but also declines – makes the rationality discussion even more pertinent.
Staying rational is a very proactive, not a reactive, journey. Smart investors deliberately structure their lives and design our investment process to protect us from the toxicity of the market. The more you let the stock market into your life unguarded, the more room you create for fear – and the more your rationality slips from one toward zero.
Corporate acquisitions often fail for one simple reason: the buyer pays too much. An old Wall Street adage comes to mind: Price is what you pay, value is what you get. It all starts with a control premium. When we purchase shares of a stock, we pay a price that is within pennies of the last trade. When a company is acquired, the purchase price is negotiated during long dinners at fine restaurants and comes with a control premium that is higher than the latest stock quotation.
How much above? Acquisitions have the elements of a zero sum game. Both buyer and seller need to feel that they are getting a good deal. The seller has to convince both directors and shareholders that they are selling at a high (unfairly good) price. The buyer, meanwhile, must convince those same constituents that they are getting a bargain. Remember, both are talking about the same asset.
This is where a magic word — which must have been invented by Wall Street research labs — comes into play: synergy. The only way this acquisitions dance can work is if the buyer convinces his constituents that, by combining two companies, they’ll be able to create additional revenues otherwise not available to them, and/or they’ll be able to eliminate redundant costs. Thus, the sum of synergies will turn the purchase price into a bargain.
For example, General Electric has been a poor investment over the last two decades largely because of poor capital allocation. The company lost a lot of value in destroying acquisitions — they bought businesses at high prices, relied on false or unfulfilled synergies, and sold (divested) at reasonable (or low) prices.
Another reason mergers and acquisitions fail: “dis-synergies” (a term you’ll never see in an acquisition press release). Two corporate cultures simply may be incompatible. For instance, one company may have a strong founder-led culture, where decisions are made by a benevolent dictator, while in the other company, decisions are made by consensus. These two cultures will mix about as well as oil and water. Cultural incompatibilities only get worse when the buyer and seller are not engaged in the same business.
A prime example is Hewlett Packard (now HP) — the old grandfather of Silicon Valley — which has been substantially gutted by large acquisitions. When Compaq was acquired in 2002, HP’s unique engineering culture did not mix well with Compaq’s manufacturing culture. Then EDS (acquired in 2008) had a service culture, and Autonomy (in 2011) was a software company that actually ended up being a bag of bad goods (it used questionable accounting and overstated its sales). Each of these acquisitions severely damaged HP’s unique culture, and all were reversed through various spinoffs in recent years.
Acquisitions may also create a morale problem. The day before an acquisition is announced, people at the acquired company come to work as usual. They are not particularly worried about the future. The next day, though, their job security is suddenly at risk (remember, they are the potential “cost synergy”), and instead of hanging out on Facebook, they are now on LinkedIn updating their profiles and networking. They worry about the sustainability of their paychecks (and finding new jobs) a lot more than how they can help this great, new organization that in fact may be about to let them go.
Finally, integrating businesses is difficult. Aside from culture problems, companies have to realign global supply chains, move or combine headquarters, and integrate software systems. In large companies, this task is like merging two highly complex nervous systems.
Accordingly, while the acquisition press release may tout synergies, the price tags and dis-synergies (risks) that come with the deal are left unsaid.
Clearly, acquisitions can create value. But when a company grows through acquisitions, its management needs to have a specialized skillset that is often different from that used in running a company’s day-to-day operations.
It is important to examine the motivations of management when they make acquisitions. When management feels that their business, on its own, is threatened by future developments, their acquisitions will have a “Hail Mary” sort of desperation to them — and a corresponding price tag.
Like many professional investors, I love companies that pay dividends. Dividends bring tangible and intangible benefits: Over the last hundred years, half of total stock returns came from dividends.
In a world where earnings often represent the creative output of CFOs’ imaginations, dividends are paid out of cash flows, and thus are proof that a company’s earnings are real.
Finally, a company that pays out a significant dividend has to have much greater discipline in managing the business, because a significant dividend creates another cash cost, so management has less cash to burn in empire-building acquisitions.
Over the last decade, however, artificially low interest rates have turned dividends into a cult, where if you own companies that pay dividends then you are a “serious” investor, while if dividends are not a centerpiece of your investment strategy you are a heretic and need to apologetically explain why you don’t pray in the high temple of dividends.
I completely understand why this cult has formed: Investors that used to rely on bonds for a constant flow of income are now forced to resort to dividend-paying companies.
The problem is that this cult creates the wrong incentives for leaders of publicly traded companies. If it’s dividends investors want, then dividends they’ll get. In recent years, companies started to game the system, squeezing out dividends even if it meant they had to borrow to pay for them.
The cult of dividends takes its toll
Take ExxonMobil for example. It’s a very mature company whose oil production has declined nine out of the last ten quarters, and it is at the mercy of oil prices that have also been in decline. Despite all that, Exxon is putting on a brave face and raising its dividend every year. Never mind that it had to borrow money to pay the dividend in two out of the last four years.
I sympathize with ExxonMobil’s management, who feel they have to do that because their growing dividend puts them into the exclusive club of “dividend aristocrats” – companies that have consistently raised dividends over the last 25 years. They run a mature, over-the-hill company with very erratic earnings that have not grown in ten years and that, based on its growth prospects, should not trade at its current 15 times earnings. ExxonMobil trades solely on being a dividend aristocrat.
It is assumed that a dividend that was raised for 25 years will continue to be raised (or at least maintained) for the next 25 years. GE, also a dividend aristocrat, raised its dividend until the very end, when it cut it by half and then cut it to a penny.
In a normal, semi-rational world, dividends should be a byproduct of a thriving business; they should be a part of rational capital allocation by management. But low interest rates turned companies that pay dividends into a bond-like product, and now they must manufacture dividends, often at the expense of the future.
Let’s take AT&T. Today, the company is saddled with $180 billion of debt; its DirecTV business is declining; and it is also losing its bread and butter post-paid wireless subscribers to competitors. It would be very rational for the company to divert the $13 billion it spends annually on dividends, using it to pay down debt, to de-risk the company and to increase the runway of its longevity. But the mere thought of a lowered or axed dividend would create an instant investor revolt, so AT&T will never lower its dividend, until, like GE, its external environment forces it to do so.
There is a very good reason why investors should be very careful in treating dividend-paying stocks as bond substitutes. Bonds are legally binding contracts, where interest payments and principal repayment are guaranteed by the company. If a company fails to make interest payments and/or repay principal at maturity, investors will put the company into bankruptcy. It is that simple.
When you start treating a stock as a bond substitute, you are making the mental assumption that the price you pay is what the stock is going to be worth at the time when you are done with it (when you sell it). Thus, your focus shifts to the shiny object you are destined to enjoy in the interim – the dividend. You begin to ignore that the price of that fine aristocrat might be less, a lot less, when you and the stampede of other aristocrat lovers will be selling it.
For the last ten years as interest rates have declined not just in the US but globally, you didn’t have to worry about that. Dividend aristocrats have consistently outperformed the S&P 500 since 2008.
However, the bulk of the aristocrats’ appreciation came from a single, unrepeatable, and highly reversible source: price to earnings expansion. If you are certain that interest rates are going lower, much lower, then you can stop reading this, get yourself some aristocrats, buy and forget them, because they’ll continue to behave like super-long-duration bonds with the added bonus of dividends that grow by a few pennies a year.
If interest rates rise, the prices of dividend aristocrats are likely to act like those of long-term bonds. The price-to-earnings pendulum will swing in the opposite direction, wiping out a decade of gains.
Analyze management, not dividends
What should investors do? View dividends not as a magnetic, shiny object but as just one part in a multivariable analytical equation, and never the only variable in the equation. Value a company as if it did not pay a dividend – after all, a dividend is just a capital-allocation decision.
I know tens of billions of dollars have been destroyed by management’s misallocation of capital, be it through share buybacks or bad acquisitions. But as corporate management continues trying to please dividend-hungry investors, value will also be destroyed when companies pay out more in dividends than they can afford.
This is why analyzing corporate management is so important. A lot of management teams will tell you the right thing; they’ll sound smart and thoughtful; but their decisions will fail a very simple test. Here is the test: If this management owned 10% or 20% of the company, would they be making the same decisions?
Would GE, ExxonMobil, or AT&T have been run differently if they were run by CEOs who owned 10% or 20% of their respective stocks? It’s safe to say they would have put their billions in dividend payments to a very different, more profitable use.
I am launching something new: the Intellectual Investor Podcast. It has been in the works for a few months, and I cannot wait for you to hear it.
Let me tell you how this podcast came about.
I wanted to create my own podcast for a long time. Actually, no – my marketing guru, Anton, wanted me to create a podcast for a long time. I never saw myself as a podcaster. I’d tell him, I’m an investor who thinks through writing – that is why I write. Anton would always push back, which happens to be one of his best qualities. He’d argue that a podcast would allow me to reach a wider audience. People who don’t have time to read would listen to my podcast on the way to work or in the gym. It would help existing readers, too, as some of my articles get very lengthy. As much as I liked the idea, the podcast also required something from me that I did not have: time – a commodity that lately I have been treasuring above all else.
Thus, this conversation never went anywhere for a few years.
The Optimal Living Daily podcast took (with my permission) one of my articles and turned it into a podcast by simply having a professional narrator read it out loud. I shared it with my readers, and the response was overwhelmingly positive.
Two ideas came out of this: First, my articles can be turned into a podcast – they could be the sole content of the podcast. And second, someone else – a professional narrator – could read my articles. You benefit because listening to almost anyone but me narrating my articles is a much better experience. Anton went through fifty voice-over artists before he picked Elliott, a talented Canadian from Newfoundland.
Anton and my IMA team put everything together. I only had to do a few things:
First, I asked my brother Alex to draw a title picture for the podcast. Alex gave me a generous amount of hair – thank you, Alex!
Second, I selected my favorite articles to be read aloud. The inaugural article is a chapter excepted from The Intellectual Investor – the book I am still working on. The chapter is titled “Six Commandments of Value Investing.” We’ll add new articles to the podcast on value investing, classical music, and life immediately as I write them. Expect one episode a week.
Third, I had to select music for the podcast. That was more difficult than I thought. For copyright reasons I could not just use any published music, but only music that was licensable for podcasts. The selection of classical music I could buy was incredibly limited, thus I could not go with Tchaikovsky or Rachmaninoff and pay tribute to my Russian heritage.
The intro music you’ll hear is Beethoven’s Moonlight Sonata movement 3. The music you’ll hear in the outro is Edward Elgar’s “Nimrod,” from Enigma Variations. (My original choice was Chopin’s Prelude 4 in E minor – but both my wife and Anton told me it sounded too depressing – you decide).
My awesome team at IMA did everything else.
Before you leave this page, please subscribe to the podcast on iPhone or Android by clicking the following buttons. That way, when we drop a new article it will show up on your mobile device.
If you listen via Apple Podcasts and you like it, please leave a review for the podcast – it helps others discover it!
You can also listen online at investor.fm, on my YouTube channel, or in your podcast app of your choice: Spotify, Stitcher, and SoundCloud.
I really hope you enjoy it.
Opportunities like the following come along very rarely, so if you are a diehard value investor wannabe, read this very carefully.
Junior Analyst Position
We are looking to hire a junior analyst. For the right candidate this is an opportunity of a lifetime, as this entry-level position has the potential to evolve into a more senior one as the person learns, gets bruised by experience, and IMA continues to grow.
The candidate will work directly with IMA CEO & CIO Vitaliy Katsenelson, assisting him in researching stocks for IMA’s clients. About 25% of the job will consist of doing operational and administrative functions.
To learn more about IMA, visit imausa.com, contrarianedge.com, and investor.fm.
This is a part-time job (about 30 hours a week) that will evolve over time into full-time.
Qualities the candidate must have. (If you are missing even one of them, please spare your and our time and don’t apply.)
-Must live, breathe, and dream about value investing. Just like you can’t teach height in basketball, we can teach many things, but we can’t teach passion.
-Have a very good understanding of financial statements, how they work, how they interact with each other. If you have not learned this by now, we are not the right place for you.
-Be a voracious learner, reader, and thinker. Investing is learned by doing, reading, and thinking. We’ll help you with the “doing” part and we’ll even teach you. However, reading and thinking does not stop when you leave the office; it continues.
-Be a self-starter – you need to be able to bulldoze through difficulties on your own initiative.
-Must be a great fit with our core values – see below.
Knowledge of Excel, Google Sheets, and programming are pluses.
“I have never let my schooling interfere with my education.”
– Mark Twain
If you have a bachelor’s in business with an emphasis on finance or investing and are studying towards the CFA designation, we are not going to hold that against you.
However, we are willing to ignore a lack of formal (traditional) education for a self-educated candidate who is dripping with passion and has experience with investing and has been analyzing stocks since he/she was an infant.
When applying provide the following:
-A sample of a stock idea analysis (doesn’t have to be current; if you have Excel models include them, too.
-Write a few paragraphs about two people (dead or alive) that have impacted you the most and why.
– Write about three books that have impacted you the most and why (a few paragraphs per book is fine; don’t have to be investment books).
-Cover letter – tell us why we’d be making the biggest mistake of our professional lives by not hiring you.
To apply, email Barbara, email@example.comIMAʻs Company Values
Integrity: We treat everyone with honesty and respect.
Excellence and Curiosity: We are never at our destination; we are always on the way there. We are constantly improving and seeking excellence at everything we do. We are always wondering and learning new things.
Fun: Because life is too short (we have a “no jerks” rule at IMA). All of us want to do this work because we feel fulfilled and energized and love what we do.
IMAʻs Promise to Clients
IMA is anything but just another Wall Street firm, and therefore not everyone who knocks on our door is an appropriate client for us.
Our clients are our partners, and just like partners in a marriage, we need to share the same values. Our values are spelled out in Six Commandments of Value Investing.
We promise to be honest and transparent with our partners. We will invest their money with the same thoughtfulness, care, diligence, and slight hint of paranoia that we employ in investing our own (easy for us to do, as nearly all the liquid net worth of our portfolio managers and their families is invested in the same stocks our clients own).
We are a firm with a soul, and we’ll never do anything that would put our interests before those of our clients.
We’re not trying to be the biggest investing firm, just the best one. In addition to striving to provide great true-risk-adjusted returns, we’ll deliver excellent customer service and a one-of-a-kind client experience.