by Jacob Taylor
“I guess she’d want it to be as fair to everyone as possible?” I said.
“That’s a good start,” he said. “So how could she keep the playing field level so they weren’t taking advantage of each other?”
I thought for a moment while he seemed to be concentrating on breathing. I finally said, “Ideally, you’d want the price of a share to change hands at the exact intrinsic value of the business. That way, both the exiting partner and the new incoming partner are each getting their money’s worth.”
“That’s right,” he said with a new vigor. I wasn’t sure if it was the supplemental oxygen or talking about business that was revitalizing him. “One of your responsibilities as the CEO of a publicly traded company is to make sure partners who need liquidity are able to get it. You don’t know what’s going on in their lives and why they might need cash. Maybe they have a sick relative they’re taking care of. Or maybe they have a charity project that desperately needs funding. I believe you have a moral obligation to make sure they aren’t taken advantage of when they sell. Does that make sense?”
I nodded. The old man’s sense of fairness and morality definitely didn’t mesh with the stereotype of the money-grubbing tycoon. He was performing quiet, heroic corporate deeds that no one knew about.
“We have a policy at Cootie Burger,” he said. “We will make our best effort to provide liquidity to any partner who needs to get out. At a minimum, we’ll give them dollar-for-dollar what the accountants say the net worth of the company is. We think the partners should benefit from the business doing well, not by taking advantage of each other through opportunistic buying and selling.”
“That sounds fair, but how do you actually do all of that?” I asked.
“It’s actually simpler in practice than it sounds in theory. Our policy is to do corporate share buybacks any time the company’s stock price approaches that accounting net worth number, also known as book value. We’ll put in buy bids at book value should the stock trade down to that level. We buy back a partner’s shares and make sure those who really need the cash can access it without being harmed.”
“So that would mean the price of your stock will never go below book value?” I said.
“Well, if everyone decided they wanted to sell at once, we wouldn’t be able to meet them at book value,” he said. “They would overwhelm our cash balances. But we make our best effort, and I think our partners appreciate it. In fact, even announcing our intentions has a way of putting a floor under our stock price. If you were one of the partners and knew that we intended to give you at least book value, you’d have to be pretty desperate to sell for anything less than that. If you gave us enough time, we’d likely make sure you got book value.”
“I’ve noticed you are using the term partners instead of shareholders. Why is that?” I asked.
“Legally, there isn’t a big difference in terms,” he said. “But I purposely refer to Cootie shareholders as ‘partners’ for a reason. Word choices impact our thoughts. If I think of them as my partners in the business, I make better decisions on their behalf. Not everyone thinks this way, but I’m not just their CEO. I serve as their fiduciary. I take full responsibility for their financial well-being with respect to our stock. I want to be an example of the good that can come from business done right.”
“I understand why you put in a floor by doing stock buybacks,” I said. “What do you do when the stock price goes too far in the other direction and becomes overly optimistic? It seems like if it’s too high, the outgoing partner wins and the new incoming partner is starting at a disadvantage.”
“That’s a very good insight,” he said. Warm feelings. “Too much enthusiasm for our stock can be hard to control. Our only move is to try and talk our stock down from that ledge.”
“What do you say then?” I asked.
“We tell everyone we believe the price of the stock has gotten out in front of the true worth of the business. What we refer to as intrinsic value.”
“Do you tell people what you think that intrinsic value number is?” I inquired.
“Let me first ask you a question,” he said. “What determines the intrinsic value of a business? Said another way, assuming you had perfect information, what would you add up to come up with a single number?”
This concept has recently come up in school, and I had tucked the information away in case this question should arise. I said proudly, “The intrinsic value is the net present value of all of the cash that can be taken out of the business during its remaining life.”
“Alright,” he said. “But how about in plain English?” Ummm...
“Isn’t it nothing more than counting the cash in the business now and what we expect will be there in the future?” I said.
“That’s better,” he said. “The truth is, there’s no single right answer for intrinsic value. In fact, the right way to think about it is a probability distribution of outcomes that form a range of prices.”
“What does that mean?” I said.
“Think about it. There are different future scenarios which lead to very different amounts of cash in the bank,” he replied patiently. “What if there’s a recession? What if competition intensifies? What if in the case of Cootie, people stop eating hamburgers?”
“That’s hard to imagine given what I ate earlier,” I said. “I’ve yet to have a bad meal.”
“I think you’re generally right, but dietary habits change over time, just like anything else. There’s a persistence to technology--the longer it’s been around, the longer it’s likely to be around. Remember our chairs-on-Mars conversation?”
“I do. Are you saying two buns and a patty are a technology?” I asked.
“Sure, they fulfill a human need or desire, don’t they? And they keep you from getting ketchup and mustard on your hands,” he said. “Now where was I before you derailed us?”
“I think you were explaining how to figure out what a business is worth?”
“Ah, yes. So the total amount of cash a business generates in its lifetime could be a lot of different numbers based on what happens in the world. There’s so much that can go right and wrong. Anyone who says they have exact numbers about the future is dangerously overconfident. There’s more though...” he said, pausing for a brief coughing session.
“Keep going,” I said quietly when he’d recovered.
“You said the intrinsic value is based on the net present value, right?” he asked.
“Yes, but what does that actually mean?”
“All it says is that a dollar today is worth more than a dollar tomorrow. Likewise, a dollar available ten years from now is worth quite a bit less than a dollar in your pocket today. Do you know what dictates how much less it will be worth?”
“Isn’t it interest rates?” I said.
“That’s right, have you been studying without me?” he said. “The higher the interest rate, the less that dollar ten years from now is worth. So even if we had a crystal ball and knew the exact quantity of cash that we’d get out of our business from here to eternity, different interest rate assumptions would make that pile of cash worth more or less today. You can start to see why interest rates have a big effect on asset values. They’re like the gravity of the financial world. They’re everywhere and always tugging.”
“The interest rates on my credit cards feel like a black hole,” I said.
“Be careful with those,” he said. “They’re like financial barnacles.”
“No kidding, where were you a few years ago to tell me that?” I said. “So when interest rates are low, there’s less discount applied to the pile of cash, so the intrinsic value appears higher. Which in turn makes the prices of everything higher. Am I thinking about that right?”
“You are,” he said. “But don’t forget, there’s no single interest rate. Just like there’s no single point of gravity in the universe. There are different rates for different risk and reward profiles. Did you know that the sun is 99.8% o
f the mass of our solar system?”
“I didn’t. I guess it’s pretty big.”
“Indeed. Well, the sun in our financial solar system are the central banks. They have a huge effect on interest rates. Given humanity’s track record with managing complex environments, it’s surprising we’d trust a handful of academic bureaucrats to decide the amount of gravity. But I’m getting us way off track.”
“That’s OK.” That’s usually my job.
“Back to what we tell our partners,” he said. “Very smart people could look at the exact same set of facts and calculate two different intrinsic values based on their view of the future. There’s nothing wrong with that-- diverse views make for healthy markets. We simply provide all the facts as clearly as we can, just as we’d want to see them if the tables were turned. It’s the best we can do to be fair to our partners. Back to your original question about intrinsic value... a few words of caution.”
“I’m all ears,” I said.
“My observation is that CEOs and managers are like most investors and prefer the safety of the crowd,” he said. “They have a penchant for buying back their stock in boom periods when all is rosy and the general market is going up. Optimism fills the air. This behavior favors outgoing shareholders who sell back to the company at inflated prices. Incoming and remaining shareholders are harmed because value has walked out the door.”
“I have a question,” I said. “If you’re a CEO, but you know from experience you aren’t a very good investor, what can you do?”
“Let me reframe your question,” he said. “What if you’re a CEO, and you have no idea what the intrinsic value of your business is? What do you do then?”
“Yes, that’s better.”
“You should quit,” he said.
“Seriously?”
“No, I’m joking, but in my mind it’s a dereliction of duty. If anyone were to have a sense what a business is worth, it should be the CEO in charge. It’s one of your responsibilities as a steward of capitalism.”
“Fair point,” I said. “But what if that wasn’t your strong suit?”
“One possible option is going to be the same as any investor who can’t value a business. Use simple dollar cost averaging--nibble away over time by buying a little back regularly. You’ll buy low sometimes, and too high others. Sometimes you’ll benefit incoming shareholders. Other times it’ll be the existing group who wins. The idea is those errors cancel each other out and come out in the wash. At least you aren’t systematically favoring one side or the other and blindly following the corporate herd who usually buys too high.”
“Not the most rebellious approach, but there’s a logic to it,” I said. “Two wrongs making a right.”
“Something like that,” he replied. “Another word of caution: I saw a survey of CFOs that was conducted in the middle of the last bubble. The vast majority of them could recognize that all of their competitors were dramatically overpriced. But only a small percentage thought their own company was too expensive. We’re blind to our own circumstances.”
“Steph told me about something like that,” I said. “She called it the endowment effect. It showed that we generally think the things we own are worth more, just because we own them.”
“Smart girl,” he said. “It’s very easy during the boom times to make projections that current success is inevitable. That the graph goes in a straight line up and to the right. But that’s not how the world works. There are seasons and cycles--remember our humble pinecone? Reversion to the mean is incredibly powerful. It’s easy to fool yourself otherwise and commit suicide by extrapolation.”
“I see that a lot at Big Rock,” I said.
“I can only imagine,” he said. “Especially when that’s what the boss wants to see. Let me change gears. How do you make money as an investor or business owner?”
“Assuming there’s a market for shares of your company?” I asked.
“Sure,” he said.
“The share price can go up and what you own can be worth more, so you can make money that way,” I said.
“Not wrong, but let’s add a little nuance to your thinking. When the underlying business becomes more profitable, the intrinsic value goes up and the share price tends to move upward as well. Sometimes it can take longer than you’d ever expect for share price and intrinsic value to converge, but they eventually do. So yes, share price appreciation is one way. Remember, you only get that money when you sell though. A lot can happen between the market’s last quoted price and actual cash in your account.”
“Like what?” I asked.
“Think about it this way,” he said. “Say you and I owned a lemonade stand, fifty-fifty. I agreed to sell you my half for five billion dollars one day. The market price would say our company was worth ten billion based on that transaction. The next day you agree to sell it to me for fifty billion. The headlines would read we own a one-hundred billion dollar company based on the market price. Is our lemonade stand really worth that, just because of two transactions? Are either one of us really billionaires?”
“You still are, but not because of the lemonade stand,” I said. “I get your point. The quote on your investment has to be taken with a grain of salt until it’s actually liquid and in your pocket.”
“You said it better than I did,” he said.
“First time for everything,” I shot back.
“What’s another way for you get paid on your investment and business ownership?”
“If the company pays out dividends?” I said.
“Yes, and you might be surprised to learn that almost everyone is doing dividends wrong,” he said.
“Hard to imagine a rebel allocator like you has that opinion,” I joked. “How so?”
“I’m not actually a rebel,” he said. “Just someone who uses common sense in a world where too few do. But back to dividends. Most executives believe that once they pay a dividend, they have to keep paying it. Maybe even increase it a little every year. They think they have to give the shareholders their allowance to keep them happy. It becomes the price to rent capital and keep their shareholders at bay.”
“That sounds logical,” I said.
“I guess it is to an extent,” he said. “It’s not entirely the fault of management. Shareholders have been conditioned to expect a little treat every year, so CEOs are doing what they think they must to keep the natives from getting restless. But it’s dead wrong.”
“How should they think about it?” I asked.
“If you’re one of the partners in a successful business, you should want to keep as much of your money as possible invested there. That assumes the business is doing good things with the money, by which I mean earning high returns on invested capital and redeploying the money intelligently. Do you remember our lessons on ROIC and compounding?”
“Yes,” I said.
“The same magic of compounding can happen inside a company when a high ROIC strategy has a long runway to absorb a lot of capital and keep providing high returns. It acts like a golden goose,” he said. “If you’re an investor, you want management to unlock the compounding machine inside the business. Then you have to do all you can not to take any money out of it. You want to keep your money tied up in this machine that feeds itself and keeps growing. Taking money out would be a terrible idea--including to pay a dividend.”
“How might management think about dividends then?” I asked.
“Paying a dividend should be the last resort for a rebel allocator. It’s like a confession that they have a lack of attractive ideas. It says a lot actually: I can’t reinvest back in our business and find profitable growth. There are no acquisitions that would be productive for our partners. There are no marketable securities I could buy on your behalf that are undervalued. The price of our own stock is high enough to be inappropriate to buy back. In essence, they’re saying I can’t find anything smart to do with this money, so I’m giving it back to my partners.”
“That
really does say a lot,” I said. “But I learned that something like eighty percent of public companies pay a dividend?” I asked.
“I believe the number for the S&P 500 is around there,” he said.
“So your thinking on this is quite contrarian,” I replied.
“It is,” he said. “But that doesn’t mean I’m wrong. In some instances, especially for an older, established company, paying a dividend could make sense. They may have a profitable business that simply can’t absorb new reinvestment. They’re out of other good opportunities and are sending the money back to owners. If that was the reasoning used, it’s very honorable to pay a dividend rather than have the hubris of reinvesting in value-destroying projects. I’d call that commendable even. There are a lot of unforced errors made in Corporate America from trying to jam money into empire-building, self-congratulatory BBQ projects. It’s slower to grow with the mindset of a good capital allocator, which is why it’s so rare; but my belief is it’s longer lasting.” Ouch, sorry Corporate America. “There’s another problem with dividends.”
“What’s that?” I asked.
“When a company issues a dividend, it gets applied to all of the owners equally. That may sound like a good idea to treat everyone the same, but what if you’re an investor who doesn’t have any use for the money at that time? Too bad, everyone has to take the dividend when the corporation says so.”
“I see,” I said. “Instead, the people who have expenses they need to pay can sell a little of their stock when they need the cash. For everyone else, they get to keep their money in and hopefully compounding. You get to self-select.”
“Correct, a dividend takes away that freedom of choice. One of the arguments in favor of fat dividends is you can’t trust management to make smart decisions with the money. A dividend takes the money out of management’s hands before they do something boneheaded with it. If that’s the case, I’d rather just find more capable management.”
“Have you ever paid a dividend at Cootie?” I wondered.
“We haven’t, despite some begging from shareholders and displeasure from the media. My thought has always been, if we can keep the money earning twenty percent for our partners, do they really want it back that badly? How are they planning to make that kind of return on their own? There have been a few points where we’ve come close to paying a dividend. The tax laws were changing to make dividends more favorable, and we didn’t see a lot of great reinvestment options at the time. But with a little patience, opportunity came knocking, and we were back to work compounding our partners’ money.”