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Observations

There's an ancient Indian parable about six very wise, blind men who went into town one day because they heard that an elephant was there and they had never come across one before.

One of the men touches only the elephant's trunk and thinks it must look like a strong rope; another feels only its leg and believes the animal must look like a tree; yet another touches only the tusk and thinks it must look like a spear. All six eventually come away with his own view of what it looks like - none of which bear any resemblance to the animal itself.

I like to tell this story because it demonstrates the importance of making sure that you have grasped the whole picture before reaching a conclusion from examining only some of the parts.

And that's what Observations is all about. Allied Capital's BDC business model and the private equity industry are unfamiliar to most investors, so I'm sympathetic to the wise men in the parable. To help investors understand the many parts of our company, I'll periodically discuss key issues affecting Allied Capital and the marketplace in which we do business. It's part of our on-going commitment to providing investors with a more comprehensive understanding of our company.

The Dividend Discipline | 10.9.02

Back in 1962, when Allied Capital was in its infancy, a professor of finance named Myron Gordon authored a book called, "The Investment, Financing and Valuation of the Corporation." In it, he popularized a model for valuing a company's stock that has since become a staple of academic texts and investment research.

The model, which is today best known as the Dividend Discount Model (DDM), helps investors determine the absolute value of a company's shares. It does so by calculating the present value of the future dividends that the company is expected to pay to shareowners.

Why dividends, and not earnings, as the basis for determining value? As investment gurus Graham and Dodd postulated in an earlier era:

"The outside, or public, stockholder gets no tangible, realizable benefits from his investment except by way of dividends received thereon or through an increase in market price. The latter in turn is usually dependent upon the former. Assuming indefinite continuance of the business, the theoretical importance of earnings is confined to their effect on dividends, either current or future. To make an extreme case, if the outside investor knew that a profitable business was never going to pay a dividend and was never going to be sold out or dissolved, the value of the stock to him would be virtually nil."

The powerful hold that dividends have had on investing is reflected in a number of statistics. Until the early 1990s, nearly 75% of the real return from stocks has been generated by dividends, not capital gains, according to Professor Jeremy Siegel at The Wharton School. From 1871 until about the same time, the dividend yield of the S&P 500 never went below 3% except for a brief period in the early 1970s. Even in the late 1980s, the number of companies in the S&P 500 that paid a dividend approached 90%.

In more recent times, of course, the situation has vastly changed. The dividend yield declined throughout the 1990s and today is still below historical standards. And the percentage of S&P 500 companies paying a dividend is in the low 70s, also believed to be an all-time low.

Economists and academics would point to a number of factors, both historical and temporary in nature, to account for the shift away from dividends. Among the short-term factors is the decline in (or lack of) earnings stemming from the economic and market downturn that many companies are experiencing.

I believe that U.S. tax policy toward dividends is among the most important of the longer-term factors that have shifted investor sentiment towards capital gains. Simply put, dividends are taxed at higher rates than are capital gains. For most shareholders, ordinary income tax rates are well above capital gains tax rates, so why take $1 in dividends, taxed at a relatively higher level, when you can have $1 in capital gains, taxed at a much lower level?
Despite the seeming tax disadvantages of dividends versus capital gains, there are signs that the pendulum of investment sentiment is once again shifting. More and more companies - and investors - understand the importance of dividends in generating investment returns. Dividend payments by S&P 500 companies increased 4% for the first half of 2002 compared with the same period of 2001. Some investors are even calling for such growth company stalwarts as Microsoft and Cisco to start paying a dividend.

What's behind the shift? I think it is the same reason that investors prior to the growth stock and dot-com era used to demand dividends from companies they invested in. Paying dividends requires real cash, and in the words of The Wall Street Journal, "is an observable event, so chances are good that a company that pays them actually has real earnings."

Before modern investment and security analysis, and the invention of technologies that made information instantly available to all, investors really did not have that much to go on. Dividends - paid in cash - were required as evidence of a company's success.

Today, investors have many doubts about the quality of the information they see and the quality of the advice they hear. So instead of placing their faith in earnings and growth stories, they are increasingly turning to cold, hard facts - in the form of cash dividend payments. As one noted investment strategist put it, "The dividend in the hand bests the capital gain in the bush."

As investors in Allied Capital know, as a business development company (BDC) we pay out virtually all of our earnings in dividends to shareholders. So we have always operated in a "bird in the hand" world.

The fact that our earnings are paid to shareholders in cash also creates what we refer to as "the dividend discipline." Shareholders receive - and expect to receive - tangible value for their investment each and every quarter. They expect, and they get, cash. And they can rather easily determine where and how this cash was derived.

Because we pay almost all of our earnings out in cash, we do not retain much. Consequently, the primary way we grow our investment portfolio is if investors agree to commit new capital by purchasing equity or debt. This means that management at Allied Capital must focus first and foremost on generating an appropriate return on equity that is above our cost of capital. If we do not, then investors have no incentive to commit additional capital to us.

Contrast the discipline involved in Allied Capital's capital allocation process with that of other companies which typically retain earnings, and thus have excess capital, which they allocate to various activities (new products, acquisitions, etc.) in the hope of achieving superior returns. Shareholders do not have a say in whether the capital should be allocated or distributed. The difference in the two approaches is best summarized by Steven Galbraith of Morgan Stanley, who wrote: "History suggests that dividends can serve as a governor on capital profligacy."
As I mentioned above, dividend payments require cash, which means that we need to generate the earnings required to fund them. So that is why we are so intensely focused on developing and managing diverse revenue streams of interest, fees, and capital gains, all of which are included in our taxable income.

In the past, I have spoken quite a bit about how we manage the company to produce these revenue streams. But one area that perhaps needs a bit more explaining is how they all contribute to funding the dividend. It's an important point - one that I will return to in the next Observations.