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Why do companies disregard taxes and their negative effect on compounding value?


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There are two decisions most companies make that I don't understand at all:

[*]They pay a dividend instead of investing the money or buying back (undervalued) stock;

[*]they optimize for high earnings – which normally get taxed at a high rate – instead of optimizing for cashflow that is immediately reinvested into growth (think John Malone).

There is no doubt in my mind that over longer periods of time both decisions have huge detrimental impacts on shareholder value building up within these companies because of the law of compounding.

 

A. Why do they do it? B. Why do shareholders demand it (if this is your answer to A.)?

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Simple really, CEOs are incentivized to maximise earnings to get their bonuses. So increasing profits through accounting is an easy way to do it.

 

You will find rare cases, like Microsoft, where they minimize profits to reduce the tax bill, but it only takes one CEO to change it and then all the ones after him/her are never going to go back.

 

On dividends, I just think they are more popular among the average investor, so usually can support the stock price and allow a CEO to make more money cashing in his options. Its far more obvious that a share is low-priced if it has a large dividend yield than one that just buys back shares.

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There are two decisions most companies make that I don't understand at all:

[*]They pay a dividend instead of investing the money or buying back (undervalued) stock;

[*]they optimize for high earnings – which normally get taxed at a high rate – instead of optimizing for cashflow that is immediately reinvested into growth (think John Malone).

There is no doubt in my mind that over longer periods of time both decisions have huge detrimental impacts on shareholder value building up within these companies because of the law of compounding.

 

A. Why do they do it? B. Why do shareholders demand it (if this is your answer to A.)?

 

A. The markets like dividends and GAAP profits.  The stock trades higher (creates shareholder wealth), which lowers the cost of equity, which can create shareholder wealth. 

 

It's a market preference issue mostly.  People will do what is rewarded in the short term. 

 

B. It's easy to measure the dividend and GAAP profits.  It's harder to judge the effectiveness of a buyback and whether a metric other than GAAP profits should be used.

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These types of issues are a bit naive.  It is only in the sheltered world of the (value) investor that people believe that the primary goal of every company with outside shareholders is to maximize shareholder value.  Believe it or not, not every CEO is greedy because they focus on other things.  There are many constituencies from suppliers to debt holders to employees.  Everyone's interests need to be balanced.  Squeezing everyone other than equity holders to get that last penny is viewed as producing "mouth watering" returns to stockholders, but it isn't real life in most cases. 

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Good answers above.

 

I'd add: A lot of it is short-term thinking vs long-term thinking.

 

Also, capital allocation is basically investing, and as we know, that's simple but not easy. Most CEOs might be good salespeople or good operating people,  but they are poor investors.

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These types of issues are a bit naive.  It is only in the sheltered world of the (value) investor that people believe that the primary goal of every company with outside shareholders is to maximize shareholder value.  Believe it or not, not every CEO is greedy because they focus on other things.  There are many constituencies from suppliers to debt holders to employees.  Everyone's interests need to be balanced.  Squeezing everyone other than equity holders to get that last penny is viewed as producing "mouth watering" returns to stockholders, but it isn't real life in most cases.

 

But you would certainly agree that paying taxes – which is what I'm talking about – is not on the list of these goals you mentioned? 

 

Call me naive but it bothers me to no end that paying a dividend is still the standard capital allocation policy in nearly every large company. This is simply a waste of money. Warren Buffett got me really thinking about this in his 2012 shareholder letter (page 19-21). It just doesn't make any sense, neither short nor long term.

 

I don't think it has anything to do with CEOs being greedy. They just don't think about it. Buffett thinks about, Malone thinks about it – every single CEO in Thornton's Outsiders book thinks about it – but most of the CEOs don't. And what amazes me is that even most of the investors don't.

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These types of issues are a bit naive.  It is only in the sheltered world of the (value) investor that people believe that the primary goal of every company with outside shareholders is to maximize shareholder value.  Believe it or not, not every CEO is greedy because they focus on other things.  There are many constituencies from suppliers to debt holders to employees.  Everyone's interests need to be balanced.  Squeezing everyone other than equity holders to get that last penny is viewed as producing "mouth watering" returns to stockholders, but it isn't real life in most cases.

 

But you certainly would agree that paying taxes – which is what I'm talking about – is not on the list of these goals you mentioned? 

 

Call me naive but it bothers me to no end that paying a dividend is still the standard capital allocation policy in nearly every large company. This is simply a waste of money. Warren Buffett got me really thinking about this in his 2012 shareholder letter (page 19). It just doesn't make any sense, neither short nor long term.

 

I don't think it has anything to do with CEOs being greedy. They just don't think about it. Buffett thinks about, Malone thinks about it – every single CEO in Thornton's Outsiders book thinks about it – but most of the CEOs don't. And what amazes me is that even most of the investors don't.

 

Hello,

 

It comes down to incentives.  CEO's care about there yearly income and an appreciating stock price.  There job is to keep the status quo.  The ceo's you mentioned above are visionaries. They care about building an sustainable business for the long term.  They dont care about maximizing there short term income.

 

Most Ceos are highly educated intellectuals who have  read all the berkshire letters.  Yet, its human nature to focus on maximizing short term income. 

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Let me caveat this by saying that I think many companies over distribute, that in the current market dividends are overvalued and many companies don't buy back when the should be buying back..

 

If the stock is overvalued by more than your 1/(1-marginal tax rate) you'd prefer a dividend.  If the stock is undervalued but management and the board are inclined to reinvest the capital at a rate of return< tax adjusted cost of equity -you'd still prefer a dividend.

 

And there is lots of evidence that management teams in aggregate are terrible at determining their own intrinsic value.

 

It just simply isn't correct to say that dividends are always an inefficient way to return capital to shareholders.

 

BRK doesn't pay a dividend because shareholders believe that management can reinvest their cash at greater than their CoE.  That's rational.  Most businesses can't do that.

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also optimizing for Cash Flow vs P&L is a complicated topic and not every business is in a situation where they can do that.  In a rational world the accrual accounting and the cash flow accounting eventually matchup so that the only benefit is the time value of money.

 

that and there are in the long-term issues with optimizing for tax - especially for industries that sell to the public sector.

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Most Ceos are highly educated intellectuals who have  read all the berkshire letters.

 

Most?

 

What makes you say that?

 

I don't think most Buffett fans have read all the berkshire letters...

 

I think you are right. I made an assumption that most ceo's are the intellectual/curious type.  The intellectuals like to find models and copy the model. Over years refine the model to suit there style. Like, you mentioned above some ceo's are just salesman.

 

 

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Good answers above.

 

I'd add: A lot of it is short-term thinking vs long-term thinking.

 

Also, capital allocation is basically investing, and as we know, that's simple but not easy. Most CEOs might be good salespeople or good operating people,  but they are poor investors.

 

Good points.  One should be honest and know thy self.  After 7-8 years ( two business cycles) one knows there strengths and weakness's in business/investing. There is no shame for ceo's to outsource there investing to someone that is talented.  I think most ceo's think they are better than the results show. So its a ego and pride thing.

 

Rarely, is the Ceo a great capital allocator and operator. These guys are the superstars.  In a ideal world every ceo throws there ego to the side and hires./partners up with a talented operator or allocator. Creating a win/win for shareholders.

 

 

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I think you are right. I made an assumption that most ceo's are the intellectual/curious type.  The intellectuals like to find models and copy the model. Over years refine the model to suit there style. Like, you mentioned above some ceo's are just salesman.

 

Indeed. I think that many of the best CEOs out there have probably studied Buffett and other great capital allocators, at least a little, and some will still go against these teachings because they have compensation incentives that make it better for them to do so.

 

But when it comes to the average CEO, I have little faith in them having thought much about what their capital allocation framework is. They probably do things the way they've always been done at the firm, or copy what their competitors do, or follow the various fashions from the management consulting industry... Independent thinking is too rare a thing.

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These types of issues are a bit naive.  It is only in the sheltered world of the (value) investor that people believe that the primary goal of every company with outside shareholders is to maximize shareholder value.  Believe it or not, not every CEO is greedy because they focus on other things.  There are many constituencies from suppliers to debt holders to employees.  Everyone's interests need to be balanced.  Squeezing everyone other than equity holders to get that last penny is viewed as producing "mouth watering" returns to stockholders, but it isn't real life in most cases.

 

But you would certainly agree that paying taxes – which is what I'm talking about – is not on the list of these goals you mentioned? 

 

Call me naive but it bothers me to no end that paying a dividend is still the standard capital allocation policy in nearly every large company. This is simply a waste of money. Warren Buffett got me really thinking about this in his 2012 shareholder letter (page 19-21). It just doesn't make any sense, neither short nor long term.

 

I don't think it has anything to do with CEOs being greedy. They just don't think about it. Buffett thinks about, Malone thinks about it – every single CEO in Thornton's Outsiders book thinks about it – but most of the CEOs don't. And what amazes me is that even most of the investors don't.

 

Dividends push a company to be responsible with their capital.  A growing dividend and the expectation of a growing dividend are especially key.  I wish I could recall where I saw the data; the gist of it is that having a growing dividend equates to a growing stock price almost perfectly, over the long term. 

 

Buybacks are open to too much abuse:  Screw up an acquisition, cancel the buyback, have a single bad trade (London Whale), cancel the buyback; buyback shares at an all time market top (Potash).  Excepting 2008/09 you rarely see companies slash a dividend. 

 

Very few CEOs and companies do buybacks well.  The Outsiders is a subset who are good operators and good investors, which is a very rare combination.  Its that simple.  The major institutional investors and most individual investors want dividends.  The reasons are entirely rational.  If you have to pay the dividend it is proof that money is coming in the door.  Its that simple. 

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Good answers above.

 

I'd add: A lot of it is short-term thinking vs long-term thinking.

 

Also, capital allocation is basically investing, and as we know, that's simple but not easy. Most CEOs might be good salespeople or good operating people,  but they are poor investors.

 

Good points.  One should be honest and know thy self.  After 7-8 years ( two business cycles) one knows there strengths and weakness's in business/investing. There is no shame for ceo's to outsource there investing to someone that is talented.  I think most ceo's think they are better than the results show. So its a ego and pride thing.

 

Rarely, is the Ceo a great capital allocator and operator. These guys are the superstars.  In a ideal world every ceo throws there ego to the side and hires./partners up with a talented operator or allocator. Creating a win/win for shareholders.

 

I think there's a whole other discussion in there; where are you supposed to find great capital allocators?

 

There's a path within most businesses for great salespeople to climb the ladder and eventually reach the C suite. There's a path for all kinds of people, but there's not really a specific capital allocation career path in the lower ranks that feeds you the best capital allocators to the top. You almost have to be lucky and get a salesperson, or an engineer, or a bean counter who rises up the chain of command and who also happens to be great at capital allocation.

 

A lot of great capital allocators go into investing, and there's a path from there for them to take over a business and make it their vehicle, but even that is relatively rare and doesn't always work if they don't have the operating talent (or can't find it in others) to make that work.

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Good answers above.

 

I'd add: A lot of it is short-term thinking vs long-term thinking.

 

Also, capital allocation is basically investing, and as we know, that's simple but not easy. Most CEOs might be good salespeople or good operating people,  but they are poor investors.

 

Good points.  One should be honest and know thy self.  After 7-8 years ( two business cycles) one knows there strengths and weakness's in business/investing. There is no shame for ceo's to outsource there investing to someone that is talented.  I think most ceo's think they are better than the results show. So its a ego and pride thing.

 

Rarely, is the Ceo a great capital allocator and operator. These guys are the superstars.  In a ideal world every ceo throws there ego to the side and hires./partners up with a talented operator or allocator. Creating a win/win for shareholders.

 

I think there's a whole other discussion in there; where are you supposed to find great capital allocators?

 

There's a path within most businesses for great salespeople to climb the ladder and eventually reach the C suite. There's a path for all kinds of people, but there's not really a specific capital allocation career path in the lower ranks that feeds you the best capital allocators to the top. You almost have to be lucky and get a salesperson, or an engineer, or a bean counter who rises up the chain of command and who also happens to be great at capital allocation.

 

A lot of great capital allocators go into investing, and there's a path from there for them to take over a business and make it their vehicle, but even that is relatively rare and doesn't always work if they don't have the operating talent (or can't find it in others) to make that work.

 

Heres my take :

 

A great operator is a person that is willing to do the work.  So there is a willingness to copy and model things that have worked. They enjoy the day to day grind and are usually not very intellectual . They dont care about knowing the " how to" before doing things. They jump in and figure it out. They have a willingness to make it work no matter what.  They are less into theory and more into experiencing and doing.  Less into reading and more into experimenting. 

 

A great capital allocator i believe is unteachable.  Either you got the right stuff or you dont.  The great allocators have a ability to put numbers into context.

 

Great operator= Willingness to do what works and into experimenting novel concepts.

 

Great allocator=  Innate ability to turn numbers into a grand context. 

 

 

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I think there's a whole other discussion in there; where are you supposed to find great capital allocators?

 

There's a path within most businesses for great salespeople to climb the ladder and eventually reach the C suite. There's a path for all kinds of people, but there's not really a specific capital allocation career path in the lower ranks that feeds you the best capital allocators to the top. You almost have to be lucky and get a salesperson, or an engineer, or a bean counter who rises up the chain of command and who also happens to be great at capital allocation.

 

A lot of great capital allocators go into investing, and there's a path from there for them to take over a business and make it their vehicle, but even that is relatively rare and doesn't always work if they don't have the operating talent (or can't find it in others) to make that work.

 

I don't know if I'd go so far. It's certainly critical to have a good capital allocator at the top of any kind of conglomerate. Normally, though, operations are much more important for a company – you have to collect the cash before you can allocate it, after all. So, I think it makes sense for most companies to choose the salesman, engineer etc. to lead the company. What you want in any case is someone who thinks independently and for the long term. If he does that, he's going to make the right decisions on average – maybe also the right capital allocation decisions – but independent thinkers are very rare at the top of companies they didn't found.

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I don't know if I'd go so far. It's certainly critical to have a good capital allocator at the top of any kind of conglomerate. Normally, though, operations are much more important for a company – you have to collect the cash before you can allocate it, after all. So, I think it makes sense for most companies to choose the salesman, engineer etc. to lead the company. What you want in any case is someone who thinks independently and for the long term. If he does that, he's going to make the right decisions on average – maybe also the right capital allocation decisions – but independent thinkers are very rare at the top of companies they didn't found.

 

I agree that top notch capital allocation isn't as important in every company, but it's never a bad thing to have. Even a company as focused on products and organic growth as Apple became a better investment for shareholders when they stopped just sitting on their growing cash pile and started doing buybacks, dividends, raising some debt, etc.

 

And I wasn't saying that it's a mistake for most companies to pick internal candidates that might not have capital allocation experience. Life is all about tradeoffs and doing the best with what you have. Especially in tough businesses, having good operations is crucial above all else.  But it's still a shame that most companies are not structurally built to foster that kind of talent explicitly (there's a few companies that I like that train their managers to use all kinds of ROIC, cashflow, and capital intensity metrics and tie their compensation to those, and over time that makes them think in very clear real-economic terms that I think does help with company-wide capital allocation).

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whenever I read a report by them, it seems very well thought out and makes a lot of sense. Are there more interesting reports of them floating around out there?

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I don't know if I'd go so far. It's certainly critical to have a good capital allocator at the top of any kind of conglomerate. Normally, though, operations are much more important for a company – you have to collect the cash before you can allocate it, after all. So, I think it makes sense for most companies to choose the salesman, engineer etc. to lead the company. What you want in any case is someone who thinks independently and for the long term. If he does that, he's going to make the right decisions on average – maybe also the right capital allocation decisions – but independent thinkers are very rare at the top of companies they didn't found.

 

I agree that top notch capital allocation isn't as important in every company, but it's never a bad thing to have. Even a company as focused on products and organic growth as Apple became a better investment for shareholders when they stopped just sitting on their growing cash pile and started doing buybacks, dividends, raising some debt, etc.

 

And I wasn't saying that it's a mistake for most companies to pick internal candidates that might not have capital allocation experience. Life is all about tradeoffs and doing the best with what you have. Especially in tough businesses, having good operations is crucial above all else.  But it's still a shame that most companies are not structurally built to foster that kind of talent explicitly (there's a few companies that I like that train their managers to use all kinds of ROIC, cashflow, and capital intensity metrics and tie their compensation to those, and over time that makes them think in very clear real-economic terms that I think does help with company-wide capital allocation).

 

I agree 100%.

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whenever I read a report by them, it seems very well thought out and makes a lot of sense. Are there more interesting reports of them floating around out there?

 

Maybe it's also no accident that Michael Mauboussin seemingly feels comfortable at CS.

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A few related interesting questions are

 

  Why do governments tax the market's favored way of returning capital to shareholders disregarding its negative effect on compounding value?

 

or:

 

If every public company started favoring cash flows over earnings and shunning dividends in favor of buybacks, would the government simply find a way to tax that as well?

 

 

It could be just fatalism at work. The government is going to take its pound of flesh one way or the other.

 

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