This week, I’ve been working my way through Forrest McDonald’s 1962 book Insull about Samuel Insull, the man who worked as secretary and financial manager under Thomas Edison but also was associated with large wealth destruction that resulted from centralizing electricity—one of his famous techniques was helping companies create large amounts of new issuances in stock to bring new shareholders, saying “if everybody owns the company, nobody owns the company.”
His lack of concern about regulated monopolistic powers meant that he frequently gave advice on how corporate management teams could avoid being hassled by shareholders, and he recommended annual but modest dividend increases and the issuance of new debt or bonds to fund the necessary improvements to ensure permanent job safety—as long as the new management has a new project to tout to shareholders, and if the annual cash payout grows, you can put together a nice career without being called out.
This situation isn’t something I worry about too much because a cursory analysis of a company will let you know when there are problems. Take something like Middlesex Water—it’s a somewhat storied company in that shareholders have been receiving dividend increases for 41 years running. If you have been a super long-term holder of the stock, it’s definitely been nice owning something that has sent you 160 cash payments, which have been bumped up now 41 times along the way.
But I can’t imagine it ever being something that someone would look at and conclude, “This is the best company I could purchase an ownership interest in right now.” Over the past ten years, the annual profits have increased from $8.4 million to $17.4 million. I bet you’re thinking, hey, doubling your money over the course of ten years isn’t the worst fate.
And here’s where it gets trickier: What is important is not just how much the company grows its profits over the course of a particular period (in this case, ten years), but how much your proportional share of the company’s profits grow over that time frame. In this case, Middlesex Water diluted shareholders by creating 5 million new shares so that it could pay its dividend and invest in new projects simultaneously. In 2004, each dollar the company made in profit had to be broken up into 11.3 million pieces. Now, ten years later, each dollar in profit gets divided into 16.1 million pieces.
Breaking out the math, here’s what happened to someone who owned 100 shares and collected the dividends over the past decade:
In 2004, your 100 shares meant that you owned 100/11,300,000 or 1/113,000 of the entire company, and the water utility generated $73 in profit on your behalf and paid you $66 in cash.
By 2014, due to share dilution, those 100 shares only entitled you to own 100/16,100,000 or 1/161,000 of the company, and the water utility only generated $110 on your behalf while paying out $76 in cash dividends.
See what happened there? The company’s profits doubled, but your proportional share of the profits did not—instead of experiencing a 100% increase in ownership wealth like you might expect over that ten-year frame, you only experienced a 50.6% increase in wealth as earnings per share only increased by 50.6% from $73 to $110. That’s the effect caused by the creation of those 5 million shares.
This, incidentally, is why investors that focus on companies with dividend growth rates in the 8-12% range (which have been going on for a long time) still end up with very good investment returns even if they lack sophisticated accounting skills. Coca-Cola can’t increase dividends by 9% for two decades unless it currently has the cash on hand to support the payment, and management is confident that it can permanently make the payments going forward.
It’s stating the obvious, but it’s nice to remember: you can’t fake a dividend—you either have the cash on hand in the corporate treasury to make the payouts to the owners or you don’t. This fact deters a lot of clever crap from happening.
When you look at Middlesex Water, the dividend payment has only gone up by a penny per year. The ten year annualized dividend growth rate works out to 1.5% annual increases. The low growth rate of the dividend foreshadowed the low growth of the company itself. When you’re managing a company that has raised its dividend for 41 years straight, you’re not going to bite off more than you can chew and give 8% dividend raises when your profits per share are just limping forward.
Perhaps I’m being too hard on Middlesex Water; in the end, it does build wealth, albeit a slow pace. Based on the current fundamentals, I just cannot understand why someone would choose Middlesex Water over Coca-Cola, Visa, Johnson & Johnson, or Colgate-Palmolive. The future growth profile at Middlesex is substantially inferior. You’ve got a business that’s been earning 5% returns on capital each year for over a decade, pays out a dividend around 3-4%, and dilutes shareholders to the tune of 2%, 3%, or 4%, depending on the year. The end result? You compound your wealth at a 4% annual rate over ten years, turning $1,000 into $1,500. Even in the universe of stodgy water utility stocks, there are companies like Aqua America growing profits per share at 8.5% and growing dividends at 7.5%.