You may be missing potential risks if you rely solely on the dividend. It may very well be a proof of real profits much of the time, but a company that has been paying a dividend for years and then starts having lower profits will be under intense pressure to maintain their dividend. Many investors will see any reduction in dividend as a serious problem and dump the stock.

This could easily lead to borrowing money, issuing new shares, selling assets or doing a merger or acquisition to create enough cash to maintain the dividend.

The question is: does the company STILL create enough cash and profit from operations to support the dividend. The fact that they paid the dividend for many years won’t help you if the company has recently started having profit issues.

Ed

Rod: I agree with you (and hope we’re both right :-) )

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Great comment. I agree completely. I don’t buy any stock directly either. I don’t have time to do the in depth research and I get to see the research and investing discipline of the world’s top investors – so I invest 100% with them.

Your question is perfect. Most individual investors don’t understand when a company announces higher profits and then the stock goes down. But is happens all the time and I don’t think anyone who doesn’t understand that shouldn’t be trying to pick their own stocks.

And by the way, I am planning to write a book. My plan is to write an article every week and get valuable comments from readers, as well as to see which topics readers find interesting. After a year or so, it should not take too much to piece it together into a book.

So, all the comments or any suggestions you readers make are very much appreciated.

Ed

You assume as an investor that a fund or company’s management is working for your best interest and that a profitable company will be a good investment. But if the managers want to benefit themselves, instead of you, there are lots of ways to do it.

It’s for this exact reason why I advise my own friends against independent investing. I ask them the old classic: “If you buy a stock at X and your stock reports better profits than last year, does your stock go up or down?”

The question is obviously fallacious to those with investing knowledge/experience. But generally demonstrates how little a potential investor may actually know. Mostly b/c people actually try to answer the question rather than simply saying that it’s a bad question.

Hey FT, with guys like Ed writing for you, we should be gathering heads and composing a book! ;)

Dividends do provide some protection, but a management that wants to, can easily find cash flow. They can sell assets, issue new shares or bonds or borrow money to pay dividends.

In fact, some income trusts paid out non-sustainably high distributions so that their share price would be higher.. Then they can issue shares to provide the cash for the distribution.

Securities legislation is all about disclosure – not protecting investors. Most investors don’t even look, though.

Some things investors can do is:

1. Read SEC reports and shareholder meeting reports to see if management is obsessed with their own compensation.
2. Avoid companies with multiple classes of shares in which some shareholders get many times higher votes than others eg. Magna.
3. Make sure most of the board of directors are independent – not part of management. Having the CEO and Chairman of the Board as the same person is a warning sign (although very common).
4. There should be independent committee that determines management compensation, an independent audit committee to work with the auditors and an independent nomination committee for nominating directors.
5. Be wary of firms where management gets too any options and keeps issuing options. Options encourage improving share price, but only short term and they encourage taking large gambles.
6. Find out about the reputation of the fund manager, CEO or Chairman of the Board.

You assume as an investor that a fund or company’s management is working for your best interest and that a profitable company will be a good investment. But if the managers want to benefit themselves, instead of you, there are lots of ways to do it.

Ed

The entirety of the markets are founded on trust. The American SEC was set up by FDR in the 30s after the big crash in an attempt to reinstate trust in the markets. But the SEC are pretty toothless b/c they can’t actually get you money when the company fails.

In fact the whole cycle is kind of convoluted. You see the books are managed by Accountants, the Accountants have agreed practices called the GAAP (Generally Accepted Accounting Practices), but the GAAP is actually assembled by other accountants. And who pays all of these accountants? The corporations! So the SEC can wander in and ensure that the accountants are following the GAAP, but the SEC doesn’t actually control the GAAP.

If you’re using a broker and not in a hedge fund then the SEC can investigate the broker on your behalf, but this has no guarantees either. You see in 1995, my recently departed step-father was advising people to invest in Pegasus Gold Bonds, according to the filed balance sheets, Pegasus had $500M in cash. Well, things started tanking and the bonds become worthless, but the balance sheets still had $500M in cash sitting around. One of my father’s clients filed with the SEC and the investigation followed, he was found innocent, b/c he’d followed all of the standard practices.

But, my father had been duped as well. At the time certain offshore holding were not required to be reported. So the books said that Pegasus had $500M in cash, but they actually had a $600M mine in Australia and all of that “cash” was vapor.

The guys in the Enron scandal were in similar deal. Accountants actually suggested to Enron that they use the Limited Partnerships method to “invent” money and keep the books clean. And technically it wasn’t illegal. They basically just used a loophole in the GAAP. And what can the SEC do? They don’t control the GAAP, the accountants do. The whole illegal part was the shredding of documents and shoving out of helicopters, etc. that ensued.

Not unlike Mr. Black in fact who, as you’ve mentioned, was charged for covering up evidence, not for actual racketeering.

At the end of the day, my father estimated that skilled accountants could manage the numbers about 50% up or down through various legal means. And he acknowledged that the SEC is basically toothless. Nortel may have seemed like some kind of victory, but the money took weeks to disappear and years to reclaim and no one is getting payouts from Enron.

The best you can do is protect yourself, b/c the SEC can’t protect you. Money, Cheques, T-Bills, Bonds and Stocks are all just forms of trust at their core, but understanding the limitations of a trust like Stocks and Corporate Bonds is definitely time well spent. I’d personally go so far as to say the Black’s behaviour is just barely outside the norm.

Thanks for the post Ed. These are always so fun :)

That gives you a level of transparency that I certainly aprpeciate.

Similar to FT, I always check on management’s salary and options. I also review insider trading histroy.