Saturday, November 12, 2011

Howard Marks on how earnings lead to stock appreciation

From "Returns and How They Get That Way" (November 2002):
"The vast majority of stocks are bought for the stream of earnings the companies produce.

But how do those earnings affect investors – get through to investors – if not in the form of dividends? That's the question that drove me in the 1960s. It almost verges on metaphysical. If a company has great earnings but those earnings aren't ever paid out in dividends, are they still of value to investors? If it makes a bunch of money but just hoards it, or reinvests it in new products and facilities that generate future earnings that also are not paid out, in what way are its profits of value to investors? That's kind of like the old question, "if a tree falls in the forest but there's no one around to hear it, does it still make noise?"

There are two possible answers:
  • Eventually, earnings must be paid out. Commonsense tells us that, sooner or later, every company will run out of good reinvestment opportunities, and the cash will then go to dividends, or to stock buy-backs, which have the same effect but better tax treatment. (Of course, the record suggests that when they run out of good reinvestment opportunities, companies often prefer bad reinvestment opportunities to giving the money to the shareholders.)
  • Alternatively, if cash builds up in a company and its stock doesn't rise to reflect the buildup but instead languishes "too cheap," someone will bid the stock up in order to take over the company. This is economics at work: the value of every asset is the present value of the cash flows it will produce in the future, and eventually the market will price the asset to reflect that value, because there are ways to reap it."