home finances
Growth investing has an addictive quality
Growth investing has an addictive quality. Just as the alcoholic rationalizes away hangovers and arguments in the belief that the next bottle will bring happiness, the growth investor rationalizes away P/Es, asset prices, burn rates, and all other measures of financial value for the dream of finding the next Microsoft. When growth slows and the stock price collapses, unhealthy investors try to get even. Rationalizing away the recent collapse, they invest their remaining funds as well as new savings and borrowings. A fresh collapse can then send them into deep depression.
Only investors aware that they are buying a fantasy will be comfortable with growth stocks. Idea people have fun with growth stocks. There is always a new idea that could grow into a world-beating company. Number people suffer from growth stocks. Number people do fancy calculations of sales, earnings, book value, return on capital, and growth rates to determine the likely price of a stock in five or 10 years. Number people are heartbroken when all their fancy calculations turn into losses.
Worker bees will have fun with micro cap stocks. These are companies too small to be included in the indexes or to be owned by the mutual funds. No analysts cover these companies. If you enjoy discovering stocks no one has ever heard of and are interested in working hard at finding and analyzing these companies, the financial rewards are high. You will not be able to toss out the names of your stocks at parties because no one will know what you are talking about. Patience is required because these things take time to be found by other investors and bid up in price. This is often a lonely but rewarding business.
Investors without patience or research skills may be tempted to buy micro cap mutual funds. Unfortunately, the micro cap mutual funds have all the problems of other mutual funds: they all buy the same stocks, get caught up in manias such as tech mania, tax you for gains that were not yours, siphon off fees, and focus on gathering assets and marketing rather than increasing your returns. And micro cap funds buy such large amounts of stock that they bid up the price of shares as they buy, then they depress the price as they sell. Micro cap mutual funds have many built-in resentments.
Overview of the Dividend Policy Decision
In practice, dividend policy is not an independent decision—the dividend decision is made jointly with capital structure and capital budgeting decisions. The underlying reason for joining these decisions is asymmetric information, which influences managerial actions in two ways:
- In general, managers do not want to issue new common stock. First, new common stock involves issuance costs—commissions, fees, and so on—and those costs can be avoided by using retained earnings to finance equity needs. Second, as we discussed previously, asymmetric information causes investors to view new common stock issues as negative signals and thus lowers expectations regarding the firm’s future prospects. The end result is that the announcement of a new stock issue usually leads to a decrease in the stock price. Considering the total costs involved, including both issuance and asymmetric information costs, managers prefer to use retained earnings as the primary source of new equity.
- Dividend changes provide signals about managers’ beliefs as to their firms’ future prospects. Thus, dividend reductions generally have a significant negative effect on a firm’s stock price. Since managers recognize this, they try to set dollar dividends low enough so that there is only a remote chance that the dividend will have to be reduced in the future.