EYE-BALL’s Herman on – Materialism Part V – Capital Retention by joint stock companies (BHP)

October 18, 2011
Herman O'Hermitage
Materialism Part V – Capital Retention by joint stock companies (BHP)
By: Herman O’Hermitage

Herman O'HermitageThe merger of BHP and Billiton was and remains a classic reverse takeover.

The saddest part is Australia (the regulator, the government, the sharemarket as a whole) sit by watching it happen too senseless to stop it.

BHP’s ridiculously low dividend payout ratio is part of this, where despite all market speculation most of their retained earnings will in time be used to buy BHP shares. Thereby diluting Australia’s most prized asset and moving it offshore to foreign hands. Already BHP is a supra national, beyond Australian, and this will sadly continue unabated. Simply another example of Australia being slowly stripped of its birthright, it natural resource endowment.

 In the post Materialism Part IV [linked here] – I wrote:

“Their dividend policy is nonsense” referring to BHP. This is a critical argument to the economic concept of “efficient allocation of resources”.

 Warren Buffett’s Berkshire Hathaway does not pay dividends at all. It is a unique case. The company is Warren Buffett and is widely criticised for not having any succession planning. Mr Buffett is old, has no plans for retirement, and has no apparent heir. You can only wonder what will occur upon his death. His business model is based upon buying high alpha returns, where alpha in this case is excess and consistent after all Capital Asset Pricing Model considerations. The typical examples are Coca Cola, Nike and Gillette. He has several other investment guidelines and this is not meant to be a study of Berkshire Hathaway. This is addressing efficient allocation of resources. Coca Cola, Nike and Gillette each enjoy massive mark ups where advertising is disproportionate to manufactured product cost. Once more simple materialism. Why is Coca Cola “happiness” or “it” or “Life” or any of the other advertising slogans attributed throughout the years?

Microsoft went through the late 1990’s not paying dividends and that too is quite unique, where in our information age, the frontier was (present tense included) computer software. The returns from technology were and remain both high and high risk (highly volatile).

Capital retention in high risk scenarios has some merit. In mature industries, this is not so. BHP has massive forward sales of commodities at some partly predictable price. It should maintain exploration but basically intends to do that by buying successful speculators cheaply, and requires some money for resource development. The question is how much? Conventional wisdom dictates about 70% dividend payout ratio and 30% capital retention. Valuations of immature miners will always be widely explosive, (non dividend paying speculative stocks) – overvalued at the peak of the cycle and undervalued at the bottom of the cycle. Surely BHP wants to reduce this explosiveness (volatility in its own share price). It is a fiduciary obligation of the board. An excellent case study is Apache Oil of the USA.

 Mr Buffett knows that his Berkshire Hathaway is subject to violent swings in underlying valuation, according to the economic cycle. In fact, Berkshire Hathaway will be highly correlated to the S % P 500 where the alpha component should be consistently positive over performance. That is the business model. Just by way of example shares as measured by S & P 500 in the 20 years from 1985 to 2006 (base year end 1986) earned over 13% where risk free (treasury notes) earned a bit over 7% (simple geometric mean) and Coca Cola earnt over 21% (equivalency) and Johnson and Johnson earned 24 nearly 25% (equivalency). (For reasons of simplicity I have ignored company betas but Johnson and Johnson has a lower beta than Coca Cola, I simply want to highlight this alpha component).

BHP must have a beta higher than one, but a well intentioned board wants to reduce volatility (minimise beta). This means, BHP will always overshoot the index (out performing in boom time, and underperforming in lower world demand for resources). This brings us to two separate arguments; mature industries and indexed funds. The argument does have some convergence.

An index fund assumes that no investor (like Warren Buffett) can consistently outperform the market (pick high alpha returns) therefore it is nonsense to try, equity represents higher returns than bonds over the medium term, and the average investor (superannuation fund) would be best off by just earning the average market rate. While that argument is laced with leaps of faith, you should begin to understand why for most average superannuants it is all too confusing and best left to the professionals.

Wesfarmers in Australia is a darling of the self managed super funds particularly with the “Mums and Dads” of WA and it is an interesting comparison. It maintains a high payout ratio, is diverse, and maintains a dividend reinvestment plan. It has massive shareholder loyalty. In 2008 as it was finalising the Coles takeover, it was caught requiring a large borrowing to finance the cash component of the takeover bid, and quite likely could have tapped the equity market for fresh capital, but still paid the outrageous risk premium in the bond markets at the time because of the dilutive effect of a fresh equity raising at the time. Somewhat excellent long-term planning. Many Australian companies like the banks or IAG had little option but to dilute their existing shares.

I expect in time you can look back at Wesfarmers and show high alpha, compared to S & P 200 and that is despite it being a diverse conglomerate.

It would be there over the last 10 years possibly longer. This will not be so of BHP when the world demand for resources stops.

On BHP this year they have a payout of USD1.10 on eps [Earnings per Share] – of $4.27. They have retained approx 75% of eps. (That is also longer term, and during the early part of the 2000’s this was to it’s merit. Now the volatility is frightening). There are constant rumours of their next likely takeover

(Woodside) and proponents of merging with Rio. BHP have retained approximately 16 billion of their earnings. This tends to pacify index funds, as their indices do not need to be as realigned as if BHP had paid out $16bn and maintained closer to $6. The great moral dilemma here is who are more efficient at allocation of that capital, into new expansion, the BHP Billiton board or the shareholder? Would the shareholder even allocate that capital to resources, or maybe other frontiers, or maybe even less risky allocations (what they call cyclicals or defensive stocks).

In a perfect world, the BHP Billiton board as agents for the equity owners would leave that decision to shareholders, and could offer something like dividend reinvestment at a small discount to prevailing market conditions to fund expansion. Over the medium term, this loyalty would be rewarded. As it stands, if you do not like the BHP dividend payout ratio, the most practical solution is to sell your shares, and reinvest elsewhere. You are simply not going to have a portfolio of only Wesfarmers shares. That is in itself breaking all rules of a diversified portfolio, and how would you start to address diversification?

Today as Telstra have voted overwhelmingly to accept the NBN’s offer for their copper and fibre optics infrastructure, a debate as to the cash that emerges is there, should it be retained by Telstra, to be reinvested, or returned to shareholders, for reinvestment? In the case of Telstra the case is evolving, as they must still separate into a carrier and point of sale distributer. That story would be an excellent case study itself, and highly recommended for shareholders.

Dividend reinvestment plans were the darling of the marketplace 2 decades ago because they encouraged shareholder loyalty. Into this century they became too dilutive of existing equity particularly when shares are selling at lower pe’s. Throughout this time of high volatility, the only answer is to reduce the payout ratio, does that promote economic efficiency?

To the board of BHP Billiton may you choke on your own greed. Inversely, wake up Australia.


Herman …

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