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!!!