An Investor’s Second Competitive Advantage

I have written before that one of the best advantages that an investor possesses compared to the rest of the world is the ability to think long term. If you buy a stock that is expected to grow earnings over five years that would suggest a doubling in value, it is no big deal if nothing happens during the first three years and all the gains come in the latter two. In fact, if the company pays a dividend that you reinvest or repurchases its own stock, this method of delivering value would be preferable since you get an accelerator benefit when earnings growth travels at a faster rate than stock prices.

But there is another advantage that is rarely discussed which a retail investor can harness: the ability to go value investing when a company cuts its dividend due to a natural cycle that the company experiences. I spent part of my afternoon studying Warren Buffett’s investment into Harley Davidson in February of 2009, in which he sunk $300 million into the legendary motorcycle manufacturer and lender.

What most people don’t know is that Harley Davidson is more of a bank than a motorcycle seller. It makes over half of its profits from the financing associated with the motorbike purchase rather than the societal assumption that Harley makes its money based on the difference between the retail price of its motorcycles compared to the wholesale acquisition cost.

During the worst of the recession, Harley saw its cash flow fall over 75% but the company remained profitable. The difficulty for Harley was that the average borrower had a 632 credit rating (compared to the national average of 687) and saw its liquidity take a sharp dive as motorcycle sales fell contemporaneously with defaults from customers that had taken out a loan to purchase a motorcycle.

Harley, trying to do what was best for its shareholders under the circumstances, refused to dilute the shareholders by engaging in a secondary offering to raise capital. The stock was trading at only $11, and it would have been a terrible deal for existing shareholders to have their ownership pie divided up with owners at literally the lowest valuation point in the past generation.

Berkshire Hathaway and Davis Selected Advisors LP each offered unsecured debt (meaning it wasn’t tied to any specific assets of the company) of $300 million to Harley on five year terms in exchange for a 15% annual interest rate. That was best for both parties under the circumstances: Berkshire and Davis got huge dividends, and Harley avoided issuing new stock while the price was low. Harley had 238 million shares outstanding in 2007, and had 234 million by the end of 2009. The equity of the shareholders, despite the troubles, was treated well.

And as the world recovered? Harley saw its profits climb to $3.85 in 2015 from $1.38 at the end of the recession. The stock climbed from $11 to $45. The problem, though, is that some investors have gotten the idea into their head that a dividend cut is a worthy time to sell the stock. When Harley cut its $1.29 dividend in 2008 to $0.40 in 2009, the stock was moving towards it low of $8. It would have been the worst time to sell. Now, the dividend is up to $1.24, earnings at $3.85, and the price at $45. Knowing that the company was healthy and would recover during the change in the business cycle proved lucrative if you acted upon it: high dividends and capital gains awaited someone who purchased the stock directly in response to the dividend cut.

In real time, I see something similar going on right now with BHP Billiton (London Exchange ticker symbol BBL). The valuation of the company has tumbled to $21 per share, a low last seen in 2004, and there will almost certainly be a dividend cut within the next year as the $2.48 in dividend payments greatly exceeds the $1.31 per share in expected 2016 earnings and the collapse of the Brazilian dam as part of the Samarco venture with Vale. The high end projections of liability total around $5 billion.

As a result, many income investors which stock around for the $2.48 dividend payout are either leaving the stock prospectively ahead of a dividend cut (or will join a mass exodus out of the stock in response to the dividend cut). I believe this exit strategy is an error, and is a big reason why typical American investors only generated returns of 3% from 1993 through 2012 (according to the DALBAR study on the topic).

BHP Billiton has enough financial might to make $3.4 billion in net profits this year, a nice figure considering that the price of every single commodity under its belt fell in price over the past year. It derives most of its profits from oil, and joins the integrated giants like Exxon, Chevron, Royal Dutch Shell, BP, and Total SA in being able to remain profitable during this low point in the cycle (unlike an upstream like Conoco which is currently reporting nearly $1 billion in annual losses).

The dividend will need to be recalibrated, and there will be a hit to the balance sheet in terms of litigation costs and settlements coming from the Brazilian dam collapse. But $21 is an exceptional price to buy a firm that generates $3.4 billion in profits right now and can generate between $8 billion and $12 billion in annual profits based on current production and 2011 commodity prices.

When business cycles turn, stocks tend to get cheap as the emotions involved lead investors to punish the stock more than warranted. A dividend cut is also an event that leads to a price decline, as income investors shuffle out to make way for value investors. And bad news tied to specific one-time events put negative pressure on the stock.

All three conditions currently face BHP Billiton. That is why the stock is getting dirt cheap at $21 per share. Harley got dirt cheap in 2009 because the luxury good cycle turned, the dividend got cut, and there was uncertainty over the funding for the lending arm. BHP Billiton got dirt cheap in 2015 because the commodity cycle turned, the dividend will get cut, and there is uncertainty over the litigation settlement.

The same story plays out each cycle. It is a tremendous advantage to recognize this, and to appreciate the fact that the highest future income can come from companies that most recently cut the dividend. I have great respect for an analytical process that leads people to BHP Billiton. It shows an ability to think long range, dissociate emotions from underlying reality, and to reject herd thinking in favor of independent thought.

The rule to “sell a stock automatically” in response to a dividend cut is one of the greatest errors that I see well-meaning income investors regularly practice. If the firm is still profitable at the time of the cut, and the debt is manageable, and the company isn’t facing an existential crisis due to technology disruption or a superior market competitor, then selling the stock is almost surely going to cause regret years down the line. Despite the cuts to income, headline risk, and complicated emotions, running towards these types of firms is a lucrative application of a value-investing strategy.

Originally posted 2015-12-19 18:24:09.

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