Benjamin Graham on Dividend Policy

These calculations meant an assured arbitrage profit of $ 7.35 for each share of Guggenheim Exploration purchased, provided that simultaneous sales were made of the underlying copper companies. The risks lay in the possibility that the shareholders might not approve the dissolution, or that litigation might delay it. Another potential problem might arise in maintaining a "short" position in the copper stocks until the distribution was made to Guggenheim shareholders. Because none of these risks appeared substantial, the firm arbitraged a large number of shares. One of Ben's associates proposed that he manage his venture in Guggenheim in return for a 20 percent share in the profits. When the dissolution went through on January 17,1916, Ben's reputation and his net worth both grew. The years 1915-1916 saw the big bull market of World War 1. The typical U. S. corporation, still lightly taxed, benefitted hugely from war orders for munitions and supplies for England and France. Common stocks rose to unprecedented heights; the brokerage community prospered mightily; and Ben's salary did, too. In April 1917, when the United States entered the war, Ben applied for the Officer Candidate Training Camp, but he received a curt rejection because he was still a British subject. Ben joined Company M of the New York State Guard, whose most active participation was marching to the Guard's band led by Victor Herbert! Ben's success with the Guggenheim Exploration Co.

He listened courteously, but said the Foundation never interfered in the operations of any of the companies in which it held investments. At the 1928 annual meeting, Ben came supplied with proxies for 38 percent of the shares, guaranteeing the election of two directors. The president suggested that a single slate of directors be named, including any two from the rebels, except Ben. As this was unacceptable, the single slate included Ben and one of the lawyers. Thus, Ben became the first person not directly affiliated with the Standard Oil system to be elected a director of one of the affiliates. A few weeks after the meeting, the president invited Ben to his office and told him: "We really were never opposed to your idea of returning capital to the stockholders; we merely felt the time wasn't appropriate." He agreed to distribute $ 70 per share. It was later learned that when the Rockefeller Foundation returned their proxy to management, they indicated that they would favor a distribution of as much capital as the business could spare. Subsequently, the other pipeline companies made similar distributions of surplus capital to shareholders, no doubt since the Rockefeller Foundation had a number of uses for the surplus funds. The $70 distribution plus the value of Northern Pipe Line afterwards exceeded $100 per share, compared with the initial market price of 65 when Ben began his campaign.

MEETING THE BARUCHS As the Benjamin Graham Joint Account continued to prosper in other operations, it was necessary to move from the small office at Newburger, Henderson & Loeb into its own offices. These were in the same building with the main office of H. Hentz & Co., one of whose senior partners was· Dr. Herman Baruch. All three of Bernard Baruch's brothers made the not surprising choice of becoming Wall Street brokers. At this time Ben began buying shares in another former Standard Oil subsidiary, National Transit Company. National Transit operated a pipeline and also manufactured pumps. To counter Ben's proposal to distribute their surplus cash, management came up with a plan to use it in a rather unproductive manner. Herman Baruch and his clients joined in the purchase of National Transit shares and, after some prodding from the Rockefeller Foundation, a substantial distribution of cash was made to shareholders. In gratitude Dr. Baruch gave Ben the use of his fully manned yacht for a week--with Ben inviting some of his friends for a luxurious week. Ben's special interests became well known on Wall Street. One day a trader from a large over-the-counter firm came to Ben with an elaborate proposition to buy a large block of Unexcelled Manufacturing Company, the nation's leading fireworks company. The price of 9 was less than working capital and only 6 times earnings.

GEICO continues to have one of the lowest cost distribution systems in the industry, with expense ratios at 14 percent as compared with the industry's 28 percent ratio. The long-term future of the company still has to be determined, but for Graham-Newman investors it has been most profitable with very substantial dividends over the years plus interests in three GEICO affiliates (Government Employees Life Insurance Company, Government Employees Financial Corp., and Criterion Insurance). Ben summed up the fact that the decision to buy the half-interest in GEICO brought in vastly more profits than all of his other investments combined as follows: "An obvious (moral) is that there are several different ways to make and keep money in Wall Street." FAREWELL TO NEW YORK Ben's personality required a stream of new challenges. The Graham-Newman Corporation continued to prosper, essentially repeating the same processes for selecting undervalued securities. The fabulous success of the Government Employees Insurance Co. investment also blunted much of his never very great desire for financial success.had

Graham's nineteenth chapter takes up the question of what corporations owe their shareholders in cash, and when the cash should be distributed rather than reinvested. Graham's starting position is that the dividend is the shareholder's most reliable return. The capital gain is uncertain; the dividend, once declared, is paid in cash and reaches the shareholder's account on the schedule the company has promised. Graham's view is that the company that earns more than it can productively reinvest should distribute the surplus to its owners, and that the company that retains earnings without a credible reinvestment plan is, in effect, confiscating the owner's share of the cash flow. The dividend is, in this sense, the test of whether the company's reported earnings were real: earnings that never become dividends, over a long enough period, are earnings that the shareholder has not actually received. Graham is aware that some companies can reinvest retained earnings at attractive rates of return, and that for those companies a low payout ratio is the right policy. The test Graham proposes is the rate of return the company earns on the retained earnings, compared with the rate of return the shareholder could earn if the same cash were distributed. If the company can earn a higher rate on the retained earnings than the shareholder could earn on the distribution, retention is justified; if not, distribution is. Graham's instruction is that the company should justify its retention of earnings by demonstrating, over a period of years, that the retained earnings have produced a return at least as high as the shareholder's alternatives. Companies that retain earnings without that demonstration are, in Graham's framework, paying the shareholder in promises instead of in cash, and the shareholder's eventual return will reflect the difference. Graham's most pointed advice is that the investor should be skeptical of management's claim that retained earnings are being reinvested productively. The claim is, almost by definition, self-serving; the manager who retains earnings is also the manager who benefits, through compensation and perquisites, from the larger balance sheet that retention produces. Graham's prescription is that the investor should look for companies with a long record of paying dividends through the cycle, and should treat the dividend record as a constraint on management's temptation to retain. A company that has paid a dividend through a full cycle, and has raised the dividend over the period, has demonstrated a discipline that the non-dividend-paying company has not. The nineteenth chapter is, in this sense, an argument for the dividend as a governance instrument as well as a return instrument: the company that pays the dividend is the company whose owner-friendly posture is documented in the cash-flow statement, and not merely asserted in the chairman's letter.