Friday, April 6, 2012

Emotions, Intrinsic value and Dividend Clienteles: The Apple trade postscript

Now that I have read some of the reactions to my post on "folding" on Apple, I would like to respond to at least three issues that were raised in these responses. The first was that my sale of Apple seemed to be grounded more in emotional than in fundamental reasons. The second and related point was that the sale of the stock at a price that was below my own estimate of intrinsic value was not consistent with intrinsic value investing. The third was a more general question of whether or when I would return to the fold of Apple stockholders.

1. The "emotional" trade
To those who have charged me with being "emotional" on this trade, rather than "rational", I plead guilty, but I do think that I made clear in both my posts on Apple that I was incapable of being rational in my decisions on the stock. In fact, I will go further and argue that if the sale of Apple was partly driven by emotional factors, the original investment in Apple was also not entirely a "rational" one. It is difficult for those who have grown up with Apple as the dominant player in the smart phone and tablet market to visualize Apple as it was in early 1997: a company that seemed to have run out of ideas, with new products that no one wanted to buy, facing  a dominant player (Microsoft) that was threatening to eat them as a snack. I would love to tell you that I did an intrinsic valuation of Apple in 1997, saw the miraculous recovery in my crystal ball, and bought the stock but I did not. The truth is that I bought Apple for three reasons and the first two could only be classified as emotional.
  1. The first was the "pity" factor. I bought Apple stock because I felt sorry for the company and was perfectly willing to write off my investment in the stock as my charitable contribution for the year, if it did not make it. Having enjoyed its products for its lifetime, I felt I owed the company that much. 
  2. The second was the "protest vote" factor. I bought Apple in 1997 for the same reason that some Russians voted against Vlad Putin a few weeks ago in the Russian presidential election. While I saw little chance (then) that Apple would beat Microsoft, I wanted to go on record my opposition to what I saw as the Evil Empire. 
  3. The third and only financial reason for buying Apple in 1997 was that the optionality that I saw in Apple. At the time, notwithstanding its troubles some of the best design people in the world were still employed by Apple and the company still had the best operating system in the world (in my biased view). If they could get their act together, I felt that they could still find a way to get back to the big leagues. It was a deep out-of-the-money option and I was open to the possibility that it would never pay off. I am glad that it did, big time, but I would attribute it more to luck than my stock picking skills. After all, I have made similar option plays every year for the last 20 years and quite a few of them did what out of the money options tend to do: end up worth nothing. (My Eastman Kodak bet did not do so well...)

Will the Apple trade change the way I invest?  I don't think so, but the lesson that I  take out of my experience is to pay more attention to the one option play I make each year. I have started my search for a company that has significant competitive advantages (that it has wasted) and is down on it luck (and price). Perhaps, I can find the next Apple in the debris...


2. A betrayal of "intrinsic value" investing
One puzzling aspect of my "sell decision" on Apple was the intrinsic valuation of the stock; at my estimate of $710/share, the stock continues to be under valued. Some of you took me to task for ignoring my intrinsic value and selling a stock at a price below that number, just because I am uncomfortable with the changing stockholder composition. I think your criticism is merited but you and I may disagree on the essence of intrinsic value. While we probably are in agreement that the intrinsic value of a firm is determined by its business acumen and operating decisions, I also believe that attracting the wrong type of stockholders to your company can reduce your intrinsic value. To back up my claim, let me start with two facts.

(a) Companies vary widely on dividend policy
Looking at 2011 data for US companies, for instance, here is what I see. Of the 5897 firms in my sample, 4435 paid no dividends and the distribution of dividend yields among companies that did pay dividends is captured below:
The median dividend yield among companies that pay dividends is about 2% but there is wide variation in yields across companies. (With its proposed dividends, Apple would be in the 40th percentile of dividend paying stocks in terms of yield.)

(b) Investors pick stocks based on dividend policy: Investors form dividend clienteles and buy stock in firms that have the "right" dividend policy. Thus, companies that pay no dividends tend to attract investors who care little about dividends, but have a much higher attraction for growth and price appreciation. Companies that pay high dividends attract dividend seeking investors who like price appreciation, but view dividends as the central to equity investing.  

There is a link between where companies are in the life cycle and what they pay out in dividends, with young, growth companies that face uncertain earnings and high reinvestment needs paying no dividends and mature companies that can count on earnings paying much higher dividends. If the investor make up (in terms of dividend preference) matches the company make up (in terms of where it views itself as being in the life cycle), you have stability, where firms with different dividend policies can co-exist, with little or no punishment being meted out for paying too much or too little in dividends. Each company has its own dividend clientele and tailors its investment, financing and dividend policies to keep the clientele happy.

There are three possible problem areas, where this stability can be put to the test:
  1. A company/clientele mismatch: You can get mismatches at both ends of the spectrum. A young, growth company that is held by "dividend seeking" stockholders will face unrealistic demands to pay dividends, even as it runs a cash flow deficit. At the other extreme, a mature company that is held by "growth seeking" stockholders will find itself under pressure to grow, when it has few growth opportunities. 
  2. A transitional company: Growth companies do transition to become mature companies and during that transition, the composition of their stockholders has to change as well. (In rare instances, you can have mature companies transition back to being growth companies...) In some cases, this change in stockholder composition happens gradually and relatively painlessly over time. In other cases, it can be tumultuous, but as the evidence of the transition mounts in the numbers (as declining growth rates, higher cash build up, more stable earnings), the "growth" seekers move on and leave the field to the "dividend" seekers.
  3. A mixed clientele: It is also possible that neither the company nor its stockholders is clear about whether the company is transitioning from one phase of the life cycle to another. In many ways, this is the most dangerous of the scenarios. It is made worse, if the evidence that comes out is contradictory (higher growth and more cash build up, at the same time) because each group sees in the evidence what it wants to see, forecasts out what it would like to see and pays a price based upon its view of the future. Eventually, a day of reckoning will arrive but neither group will give up without a fight.

So, where is the link to intrinsic value? There may be none, if management is secure, resilient and makes the right calls for the company. The problem, though, is if management gets stampeded or panicked by a mismatched stockholder group into acting in ways that hurt the company's value. The managers of a mature company that is held by growth investors may seek to buy that growth at any price (by doing acquisitions or taking value destroying investments), thus lowering its intrinsic value. A company with a mixed clientele may try to keep all groups happy and reap the whirlwind. Remember Lucent, the company that AT&T created to house the research powerhouse that was Bell Labs, and then saddled with old Ma Bell stockholders who wanted Lucent to pay large dividends (a payout policy that was at war with its status as a technology company that was seeking growth). Lucent paid the dividends (to keep its dividend seeking stockholders happy), took its risky, growth investments (because it wanted to be a growth company) and paid for them with borrowed money, a toxic mix that ultimately devastated the company.

So, what does this have to do with Apple? Apple's dividend announcement could represent one of three possibilities. The first and most benign one is that Apple's managers see less growth ahead and that they are readying the company for a transition to mature company status. That will undoubtedly be a harsh surprise to those growth stockholders in Apple who continue to see another decade of innovation and profitability like the last one, but they will move on. The second and more disquieting possibility is that Apple is unsure about whether it is a growth or a maturing company right now and wants to attract both groups of stockholders.  To keep both groups happy, Apple will have to go through contortions, lurching from growth-oriented actions (announce a new product) to cashflow-oriented ones (increasing dividends). The third and most damaging possibility is that Apple instituted dividends because it felt pressure to do so, from some analysts and institutional investors, and not because of its view of the future. Think about  it. If it bends so easily to pressure when things are going well, how will it react to the ratcheting up of demands that will inevitably come, if things start to go badly? 

A battle between growth and dividend players in Apple would have had no effect on Apple three years ago, because Steve Jobs was immune from stockholder pressures (and that was both his strength and weakness). I don't see Tim Cook occupying the same position of strength. Thus, my concern is not that Apple will not react enough to investor demands but that it will become too reactive: acquiring companies it should not be (in response to the growth seekers demands), splitting its stock or increasing dividends (to keep the dividend seekers happy).

3. A return to Apple
It is possible (and maybe even likely) that I have over estimated the tensions between Apple's different stockholder groups and under estimated the resilience of Tim Cook and the current management team at Apple. The next few months will provide evidence on both fronts, as will Apple's reaction to its first big setback (which will come).  I will keep revisiting my intrinsic valuation, checking the price and looking at how Apple's management handles the pressure. I have a feeling that I will be a stockholder in Apple again one day, perhaps sooner rather than later. For the moment, though, I am in the strange position of not having any shares in Apple and being a recent addition to the  Microsoft stockholder base. I feel like I have lost my Jedi credentials and joined Darth Vader and Stormtroopers of the Empire!!!

17 comments:

Brian said...

Great response. It shows you are a mere mortal like the rest of us.

Would you mind commenting on the tax implications of your trade and the fortuitous timing given the changing of the tax code? Am I the only person in the world that thinks about taxes? The capital gains tax is going up 10 percentage points, per Donald Marron, or 66 percent from 15 to 25 percent (for high-income tax payers). Sellers who postpone realizing capital gains 1 day from Dec 31, 2012 to Jan 1, 2013 will pay 66% more in capital gains taxes. I find this to be fascinating. Interestingly, deferring the realization of a capital loss from Dec 31, 2012 to Jan 1, 2013 would increase the tax credit by 66%.

One of these days I'd love to hear your explanation of why investors prefer dividends to share repurchases? I understand that historically dividends have been viewed as "sticky", with share repurchases viewed as sporadic and temporary, but there is nothing intrinsic about a cash dividend distribution over a share repurchase that should make it any more sticky (again, other than decades of tradition which say otherwise). I also understand that some investors like a dividend because it saves them the hassle of selling, but I view this as a huge externality to impose on all other investors, many of which wish to buy and hold.

I'd also like to hear your thoughts on the reselling of repurchased shares. Why don't firms use treasury stock as a high yield savings account, yielding the cost of equity? Seems to me a much better place to temporarily stash unneeded cash, and could have served Apple well over the past few years. I suppose lack of diversification is a valid reason not to do this, just as it wouldn't be prudent of an individual to hold a disproportionate amount of her wealth in a single stock.

Aswath Damodaran said...

Brian,
i did a post on buybacks versus dividends, with and without the tax issue. It is not that all stockholders like dividends, it it that some them do. As for buying back stock and holding it as treasury story, you cannot do that for the long term in the United States, because it skews corporate governance. The managers control the bought back shares and can use it to further their own interests.

Brian said...

Thanks for the thoughts on repurchases vs dividends...I found and read your series of posts on the subject. I'll have to continue to go through the archives to find other gems that were published before I learned about the blog.

I was unaware that managers controlled repurchased shares...I thought the control rights were relinquished when it was in treasury stock, so I could definitely see how that would create agency problems.

Thanks for the great blog and insightful thoughts!

Jose Miguel said...

I have Read You have bought Microsoft . Can You explain the reasons tras justify your decision?

I live in Spain and I am very glad to find your blog because It is very useful and didactic.

Thanks.

Jatin Shah said...

Aswath,
I'd be very interested in why you purchased Microsoft. I know this has been covered widely in Barron's/WSJ, but want to know if you have any unique insight not covered elsewhere.

Jatin

The Contrarian Individual Investor said...

Especially like your comments on Apple becoming a transitional company. I find this phenomenon to be ultimately inescapable by very large successful companies at some point in their maturation. These transitions are often painful, punishing experiences for investors.

Your explanations are very insightful but you could also have very simply said based on your calculation on Apple's value (I get something more like $680) there are other more undervalued investments available in the market and hence better places to place your investments than somewhere with only 11% discount to intrinsic value and 2% dividend. If you subtract out Apples cash hoard which likely cannot appreciate at the same rate as the business can then your absolute value of the discount is even less than what it appears. You could hang around for a few years trying to reap this last 11% but for a fundamental value investor better to move to more fertile fields.

Anonymous said...

aswath,

thanks for addressing the "question of whether or when i would return". the stock market is -as bogle has so often suggested- driven vastly by short term emotions.

thanks also for recognizing that you were lucky with your investment: when you buy a stock you are speculating; many factors beyond your control -often quite lasting- drive a sock's price up or down.

now, going back to sooner or later: think sooner is better.

that is because besides its incredible growth story (and many other reasons lasting at least for the next 2 to 3 years in my opinion) apple is quite an anomaly:


money mangers are confused by it is it a growth or value story for example or is it too good to be true story??) and are also afraid to buy it: how can it continue to grow?

one think for sure: there is no other company that you can feel, connect with and assess the value of its products and utilities (think that is under appreciated and has room to grow) as an apple product.

keynes was well known in investing in just a few companies he perfectly understood how their products and services he could value: think apple would be his largest holding.

would appreciate your take on the above.

CRE Appraiser said...

Hi Prof,

Great post as always. I'm also a long time reader of your investment books and the blog.

Like many of the people here, I am also a firm believer in intrinsic value investing. But I was surprised by the number of people who would use valuation model as the only Rule (i.e. buy when the equation shows Current Price < My Value Estimate), instead I would use it as one of my tools. If I am risking my own money, I would use it in conjunction with many other tools (i.e. some contrarian technical indicators, flow of funds, etc.) to increase my odds.

The reasons you bought and sold Apple shares further reinforce my old belief of an old Chinese saying - "as long as you can get to the other side of the river, you are the god." As you pointed out in Investment Fables, luck overwhelms skill. Also, gut feeling counts. An analysis with more accurate assumptions doesn't guarantee a better return.

In my opinion, your successful run with Apple isn't luck. It required LOTS of patience and a big stomach. Even if we assumed Apple was a successful company in 1997, how many of us would buy a stock at $4.5 and be able to hold it to $600+? I bet most of us would have sold it before it hit $20. Finally, it certainly requires more insights and experiences to pick up a good debris out of 10 debris. An average investor may probably pick up 20 debris that all worth nothing at the end.

Immortal said...

Awesome! Well Explained! I feel Apple has reached its peak and with SJ absence the command/passion to create and find new products that will revolutionize the market will be a big challenge...at best they will improve the existing product lines but the market for replacement is not as huge and big as for the new product which puts apple into maturing company classification....WE all know what happened to APPLE when SJ had left though i want to be proven wrong and see apple continue to grow and find products that will continue to delight us!!

Anonymous said...

I think you made a good call. For starters, with size the returns from the ability to innovate is lower. Secondly, I am surprised that they have been able to hold margin and the competition at bay for as long as they have. Ultimately, once the innovating is done, it becomes a commoditized business with tightening margins (MOT with Razr; Sony with Walkman). Their success is at least in part competitors failure. Zune was good, but it died; HPQ came up with a decent Ipad alternate, it died. Their has been an unwillingness to compete; which surprised me.

Brian said...

Aswath,

It looks like treasury stock doesn't have voting rights: http://en.wikipedia.org/wiki/Treasury_stock#Limitations_of_treasury_stock. If this is true, this mitigates completely the agency problems you described.

If this is correct, can you sympathize with my argument of using treasury stock as a temporary, high-yield (yet volatile), savings account?

Forgive my ignorance if I'm missing the obvious.

dinesh said...

A beautiful explanation on the possibility of mixed clientele affecting the growth potential negatively. The points your critics use to demerit your sell action might all have truth to it - but the bigger question that begs to be asked is "Is all of that enough to pull the stock price/valuation down or to saturate its growth?" - And my answer to that is a resounding no. As long as the cash continues to flow, with all the pressure the management faces, ways will be invented to keep every one happy. The battles between investor groups will assume relevance only when the stock price reaches the point of being over valued. And with its current levels of earnings, the stock price will always struggle to reach the constantly revised (upwardly) valuation. The way I see it, exercising the momentum play or joining the band wagon will be the wise move until clear evidence of over valuation surfaces!

Paul K said...

May I submit a request for a follow-up post to this post that outlines your investment approach relative to selecting your one option play (last paragraph under #1). Competitive advantages like what? How do you define down on its luck (and price)? I enjoy your posts and appreciate you sharing all of this knowledge and always want to learn more. Thank you in advance for the consideration.

Paul

Vignesh said...

I am sure you would have an opinion on this news

http://blogs.wsj.com/marketbeat/2012/04/24/apple-earnings-thats-a-blowout/?mod=e2fb

Shivani said...

Sir, I am your online student and a big fan of yours!!

The biggest takeaway for me from this article was to understand how dis-alignment of management and stockholders interests could actually disrupt value and it is not always the shareholders who are right. We have read about the Management paradox but sometimes shareholders could also have negative effect on company's valuation. After all, the PE firms create value by restructuring the organizations, debt financing and higher alignment between management interests and shareholders.

Ed said...

I feel you're over-analyzing their dividend policy. Apple simply have too much cash which are yielding at 1%. It's better for them to return the cash to owners than to do something foolish with it. As for their day to day activities and growth, they still have too much cash to spend wisely and foolishly on research and development. But I argue maybe it would do their price momentum more good if they just hoarded more cash, say in 5 more years, with a 35% growth in cash, they could hoard up 500 billion dollars, which would make a 1 trillion dollar valuation much easier to grasp.

QUALITY STOCKS UNDER FIVE DOLLARS said...

Apple should pay a dividend.