There are many misconceptions about what matters when researching companies to invest in. In this module, you’re going to learn about some of the most popular ones. A lot of this advice is peddled in the mainstream and you might be surprised to hear that some of them are incorrect.
Keep an open mind throughout this module and evaluate the arguments we make for yourself.
Dividends are a good thing to have in stocks, and we do not deny that. However, there is a lot of investing literature out there that has elevated dividends to a God-like status. Dividend investors claim that the presence of a dividend alone justifies investment because it signifies that the stock has a ton of advantages within it.
Chief among these is the argument that dividends ensure that management will not act recklessly since they know that they have to pay the dividend. This makes them take fewer risks and thereby guarantee a safe and steady income stream. Let’s start with this claim and look at some of the purported advantages to see whether they make sense.
Dividends Ensure Stability
The presence of a dividend does ensure stability but only to a point. The fact is that managers routinely maintain dividend payments for fear of adverse effects on the stock price. Some investors believe this is a good thing and that it scares management into doing the right thing.
This kind of thinking happens because investors are unable to evaluate the quality of a company’s management effectively.
Poor management is perfectly capable of paying a dividend and still running a company into the ground.
Let’s say poor management takes over a company and carries out some less than favorable projects. Revenues decline, but management knows that as long as they can maintain the dividend, stock prices will remain steady. This is because many investors favor dividends far too much.
However, since revenues are declining, the dividend comes to represent a greater portion of the company’s earnings. As this proportion (called payout ratio) increases, there’s less money available to allocate to projects that will ensure the company’s competitiveness is maintained.
In short, the dividend causes management to stop looking at the future and start focusing on the present instead. This is the exact opposite of what proper management does. Notice that the presence of the dividend cuts both ways. In the presence of good management, it is a good thing, but it can turn into a disadvantage when poor management is in charge.
Therefore, the dividend by itself means nothing. Using it as a barometer to measure stability is incorrect. A business is a multi-faceted entity, and reducing the question of stability to a single factor is wrong. Don’t misunderstand this point to mean that poor management will always pay out a greater proportion of earnings than good management.
It all comes down to the nature of the business. Some businesses don’t require much reinvestment, and therefore, a 90% payout ratio might make sense. This is the case with Real Estate Investment Trusts (REITs). Some businesses require significant reinvestment and in such cases, paying even 10% is a considerable feat and is an indicator of excellent management.
Another argument posits that stable companies in stable industries pay dividends. This is true to an extent. However, it ignores the fact that an unstable sector does not necessarily mean that the companies in it are bad investments. If you had a chance to invest in Google back in 2004, would you take that chance today? What about Amazon in 2001 or Facebook in 2013?
None of these companies pay a dividend, and they probably never will. This doesn’t mean they’re bad investments or that they’re unstable. As an example, Berkshire Hathaway has never paid a dividend since Warren Buffett bought it in 1964. He purchased the company for $11.50 per share. The current stock price is $282,600 per share. It’s safe to say his investors are quite happy with his performance.
Dividends Represent Shareholder-Friendly Managers
The term “shareholder friendly” has been turned and twisted to mean a lot of different things. These days the very presence of a dividend gives management an automatic “shareholder friendly” label. From the scenario presented in the previous example of the poor management maintaining the dividend, is this really a shareholder-friendly thing to do.
Surely, the better thing to do would be to suspend the dividend and absorb the short term blowback. As long as the long term investment plays out, who cares what the stock price will do in the short term. Shareholders who value the business and understand the long term consequences of the decision will find this a lot friendlier than the ones that insist on investing on the basis of a few media tropes.
Dividends Over Capital Gains
A particularly problematic attitude that accompanies dividend investing is that dividends matter more than the capital gains a stock provides. Here’s the thing that many dividend lovers miss: Capital gains will always be a more substantial portion of your investment return than dividend payments will be. The average dividend payment represents between one to two percent of the stock’s price.
A rise of even 3% per year in the stock price means that capital gains outstrip dividend gains. Where do capital gains come from in the long term? From earnings, of course. This is also where dividends come from, or stable ones at the very least. The lesson here is that you need to pay attention to the earnings prospects of the stock and not just its dividends.
This is a common pitfall that many investors walk right into. They read the news and feel that they have to be a part of the industry of the future. Alternatively, they feel that some company has been in the news quite a lot recently and therefore, it must be a good investment.
A good example of this is Tesla. This company has been in the news right since its birth. They developed the first electric sports car, are headed by a billionaire who is more of a messiah than a businessman and it’s in the electric vehicle space which means that it fits right in with the overall conversation about climate change.
Elon Musk is covered in the same way rockstars are, and his quotes and thoughts are repeated with breathless excitement. Musk is a very passionate man, and he knows a lot about building successful companies. However, does any of this make Tesla a good business to invest in?
The company makes sleek looking cars, but it hasn’t earned a cent of profit as yet. In 2019, the company lost close to $862 million (Tesla, 2020). This was a good year, comparatively speaking.
To be fair, the company did post a steady increase in profits and sales to close out the year. However, none of this addresses the fact that there is probably a good reason traditional car manufacturers haven’t entered the electric vehicle field as yet. It’s prohibitively expensive.
Does it really make sense to believe that the likes of Mercedes, Porsche or Honda, all of whom have grassroots motorsport testing programs along with Formula One hybrid engine development experience, do not have the expertise that Tesla has? Honda developed an alternative fuel source car back in 2006!
Many companies manage to attract shareholders by being media darlings. A great example of this is Enron. The energy firm was once the golden child of Wall Street, and named “America’s Most Innovative Company” for 6 years straight. In 2001, Enron declared the largest bankruptcy in history, after it was revealed that systematic accounting fraud had plagued the company for years. In just 18 months, the share price went from $90 to zero.
There is no shortage of opinions when it comes to stock analysis. We’re not talking about the casual gossip that occurs between you and those around you. Professionals indulge in gossip-mongering as well. The difference is that they get paid to do it.
Wall Street analyst opinions hold great sway over the short term movement of the stock’s price. A sell rating or a downgrade (which is when an analyst becomes less bullish on a company’s prospects) can cause the price to move down in a hurry while a strong recommendation can create hype that pushes its price up equally quickly. This happens because there are large numbers of people who hang onto these analyst ratings as a crutch and use them as a substitute for conducting stock analysis themselves.
However, examining the relationship between analysts, the trading desk of an investment bank, and the companies they analyze is instructive. A good case that highlights this relationship is that of Amazon back in 1997. This was the year that Amazon filed its IPO.
Filing an IPO is not an easy task thanks to the large number of regulatory hurdles that exchanges and the authorities impose. Companies have to hire an investment bank to ensure the process is carried out smoothly. Often, investment banks prepare years in advance in anticipation of a possible IPO. It was no different with Amazon.
The company was a darling of Wall Street thanks to Jeff Bezos’ efforts and analysts regularly touted its strong balance sheet and earnings prospects. The primary driver behind such reports was the fact that the number of users on the internet was set to explode, and this put Amazon in prime position to capture their shopping activity.
There was just one problem. The company wasn’t making any money. Amazon famously pushed everything back into its businesses to achieve size, and for many years, its free cash flow was dangerously low. None of this mattered to analysts, however. Asking whether Amazon was capable of riding out such low levels of cash with constant venture capital injections was a reasonable thing to do.
Yet, no one did this. A big reason for this was that Wall Street was actively courting Amazon in anticipation of its IPO. Morgan Stanley was the firm that ultimately won the contract, in no small part due to its analyst Mary Meeker’s glowing reports of the company. Meeker denied that the business she generated for Morgan Stanley had anything to do with her ratings (Schwartz, 2000).
In contrast, the lone analyst that questioned Amazon’s business policy found himself pushed aside by his firm Lehman Brothers. IPOs are especially profitable for investment banks since they earn money in two ways: The first is via fees, and the second is through trading profits.
The stock that is initially sold to the public comes directly from the promoter or investment bank. Naturally, the aim here is to sell it for as much as possible since this results in the highest amount of profit. Given that analyst opinions count for so much, it stands to reason that the analysts at the bank would talk up the stock.
However, Wall Street insists that a so-called “Chinese wall” exists between the analyst and trading departments. The track record and ethics of this industry is a matter of public record. The reader can form their judgment about such claims quite easily.
The point here isn’t about whether analysts were right or wrong. In this case, Meeker was right about Amazon in the long run. However, it certainly wasn’t due to the reasons she cited in her original glowing reports. Amazon almost went bankrupt during the dot com crash around the turn of the millennium.
The thing for you to note instead is that analysts’ opinions and the consensus of the market isn’t worth the paper it’s printed on. There are many conflicts of interest inherent in the process, and the story of Amazon’s IPO and the role analysts played in it is instructive. Amazon fixed its issues, and despite this, the company was unloved in the mid 2000s. This was a case of analysts being wrong once again by holding onto outdated opinions.
While Amazon is an example of how things eventually worked out and how problems were brushed under the carpet, the credit crisis of 2007- 2008 is an example of when all these issues were laid bare. In that case, it wasn’t just analysts’ opinions that were the issue, but the same system was at work.
Analysts at ratings agencies rated complex derivatives as being investment worthy primarily because Wall Street banks would not approach them for business unless such ratings were provided. This caused sophisticated investors to invest in them, and the result was a complete meltdown (Lewis, 2011).
So, the next time you hear the chat on TV or social media saying that stock X is due for a rise or that stock Y is due for a fall, take it with a truckload of salt. There are other factors at play here. Acting based on hearsay is an example of groupthink. You’re better off following the simple analytical framework that we’ve already highlighted.
Closely related to groupthink is the phenomenon of market sentiment. Is the market going up or down? Popularly peddled financial wisdom often states that you should not try to time the market. But how the markets are covered causes investors to try to do this exact thing.
Who cares what market sentiment is at the moment? Remember that in the short term, prices are driven by emotions and not logic. By focusing on investing for the long term, you’re going to place yourself in the best position to ignore all the chatter that will cause you to sell low and buy high.
A great piece of advice on this comes from legendary investor Peter Lynch. We should note that this quote is from 1994, but you can reliably substitute newspapers for online news or social media.
“If you own auto stocks, then you shouldn’t be reading the financial part of the newspaper. Instead, read the section of your local paper about automobiles. See how they talk about new car models, which ones have good reviews and which ones stink. That is what you should be reading. You shouldn’t be checking stock prices 4 times a day. Checking stock prices first thing in the morning is not useful. You shouldn’t be dealing with the minutia of “what’s the market doing today”. Instead focus on “what is this company going to be doing 2 years, 3 years, 5 years from now.”
Numbers in isolation
There is not a single number on a balance sheet or financial statement which tells a company’s entire story. For example, Price to Earnings ratio (PE) is often touted as a good indicator of fair value of a company. But PE differs drastically between sectors. For example, healthcare services has an average PE ratio of 42, which is almost 3x the average of the entire market. So if you only decided to only invest in companies with a PE of 20 or less, you’d miss on great companies in the healthcare services sector.
The same goes for something like earnings growth. If a company is up 20% in the past year, that could be incredible. Or it could be worrying if all their competitors are growing at 100% during the same time period.
With any financial numbers, you need context. This is why it’s essential to analyze a company’s competitors during your research phase.
Read Books to Learn The Right Investment Mindset
A large part of successful investing is about Mindset. So I read many mindset books.
Recently, I read Rich Dad Poor Dad and found it quite interesting.
Through autobiography and personal experience, Rich Dad Poor Dad explores the steps to becoming financially independent and wealthy.
The writing style and framework of this book are narratives. This book focuses primarily on anecdotes with nuggets of supposed wisdom, not technical insight or investment math.
He compares the lessons he learned from his biological father (an intelligent, but financially inept father) with the lessons that he learned from his friend’s father (an uneducated, but smart and wealthy father).
It weaves through Kiyosaki’s life as he learns from his rich father and rejects advice from his poor father (thereby eclipsing typical working-class mindsets).
Some of the concepts in this book are, however, questionable. Read my Rich Dad Poor Dad review to learn more about my insights about the book.