ERICOPOLY

I know they are all limited with investment choices. However I figure they still have a place in my overall planning. For example, that can be a place where I make my super-safe bond investments. The emergency "do not break glass unless severe Depression hits" cash can go there. It stands a chance of maintaining it's purchasing power given the bond income is tax-deferred. You are almost certainly going to lose purchasing power in a high tax bracket invested in bond funds. I wanted to do something like this with variable annuities but the annual expenses are too high. Here, they are not.

I know about the contribution limit, but there is a grey area I'm unsure about with regards to inheritance. Is it treated as a contribution when somebody inherits a 529 plan? So if you establish a $300,000 plan for yourself and it grows to $600,000 over ten years... can your child inherit your $600,000 plan? Or would he be limited to only a $300,000 inheritance? Or would he be able to inherit none of it if he already had over $300,000 in his existing plan? Plus I believe when you inherit a 529 plan you can spend the gains on whatever you choose without that 10% penalty for non-qualified withdrawals. And I believe you can leave the money in there for the rest of your life without being forced to draw it down early. Compare that to inheriting an IRA plan where you are forced to liquidate it within the first 5 years (not sure if it's 5 years exactly, but it's a pretty quick forced withdrawal period). Roth IRAs also (as of now) have no forced withdrawal timeline. Also, does anyone know if creditors can raid 529 plans?

For the following comments lets assume it's in a tax-deferred account (no dividend tax): I'm going to write about how much value is created if instead dividends were paid and reinvested in the stock through a DRIP. Of course, if you get paid a dividend when the price of stock is very low... you wind up with more buying power for additional shares. And when you get paid a dividend when the price of stock is very high... you wind up with less buying power for relatively fewer additional shares. So an observer would notice that the total effect on the portfolio is that more additional shares are purchased if dividends were paid when the stock was low versus when it was high priced. Thus, more value was created. So is management no less shrewd to return capital via dividend when stock price is low? Again, assuming no taxes. The moral of this post is that it simply matters that capital is returned, by either method, as vigorously as possible when the stock price is low. Neither method creates more value than the other. But when taxes come into play, it's better to return capital via share repurchase. But what about when stock price is high and stays high for a decade? Should management not return any capital at all by either method? I think they should return capital by the method that results in the least amount of tax. The guy can destroy just as much value by plowing the dividend into more shares as compared to management buying back shares. The shareholders needs to be personally responsible -- if he can decide when not to buy more shares, he can also decide to sell the incremental fractional ownership that management keeps on buying on his behalf. The higher the dividend tax rate, the more difficult it is for management to make the "wrong" decision by repurchasing shares. The shares need to be overvalued by 50% too high above fair value before we even get to the break-even tipping point when the dividend tax rate is 33%.

A couple of things I noticed tonight about 529 accounts which compound tax-deferred. 1) you can set up a 529 plan for yourself as beneficiary, no matter how old you are (for your future education) 2) later you can transfer the funds to another beneficiary's 529 plan (like in 30 years when you have grandchildren, you transfer it to their 529s) 3) withdrawals for qualified education expenses are completely tax free 4) non-qualified withdrawals are usually assessed a 10% penalty and gains in the account are taxed as income 5) there are exceptions to #4. Such as if the original beneficiary had died, and you inherit the account, then withdrawals can be made without the 10% penalty -- but I think the person inheriting the 529 has no requirement of withdrawing the money, unlike the recipient of an IRA account. Also if the beneficiary becomes permanently disabled (under IRS definition) he can take non-qualified withdrawals penalty free. Another thing I noticed is that annual fund expenses in a Vanguard 529 account are generally 40 bps lower than annual expenses in a Vanguard variable annuity. Over 30 years that amounts to 12% of extra expenses in the annuity -- which is actually greater than the 10% non-qualified withdrawal penalty in the 529 plan. So I had a quiet thought -- if you are going to lock up the money for 30 years or so, it might be cheaper to put it into a 529 plan even if you never intend to use it for education -- I mean, compared to the costs of a variable annuity invested for 30 years, the 10% penalty seems relatively cheaper. Plus, if you die during that period your heirs can take the gains without the 10% penalty -- so it's cheaper than the variable annuity no matter what (as long as you intend to not spend it for 30 years or your death, whichever comes sooner).

In the USA, the qualified dividend rate is the same as the long term cap gains rate. All of my comments pertain to the USA if there was any confusion. Any place where your cap gains rate is higher than your dividend rate (like Warren Buffett at Berkshire) you can take the other side. So that guy is no worse off if he chooses to sell tiny amounts in lieu of a dividend. And he's better off if he wants it reinvested (tax free reinvestment). And being an old guy, his heirs probably want that as well given that it will all be stepped-up in cost basis upon his death. They can either sell his shares (getting all those reinvested buybacks tax-free), or they can choose to keep the shares and start selling pieces to offset buybacks -- with the cap gains paid at the new stepped-up cost basis. I guess that's right, but there is no cost to get the dividends whereas he has to pay commissions to sell bit by bit. I think ultimately the biggest reason to pay the dividends is to broaden the investor base. What is the advantage of broadening the investor base? You are certainly not the first person I've heard talk about that, but it's never something that I've ever quite understood why it's so important.. There are some admired companies like MKL and Berkshire that have a great shareholder base -- but they don't pay dividends. What would improve if they attracted dividend investors? Alright, if somebody says it would boost the share price, I could always say that it would only help the investors who are cashing out and not the ones who are sticking around. Let's say I am going to be a long term investor -- is it important that I have a broad base of fellow shareholders? Not to me personally. What matters more to me is when I get more in dividends than I spend, so I have to reinvest a good portion on an after-tax basis. Then I've only got 67 cents on the dollar left to reinvest. And that's really destructive to my buying power. A dollar of dividends comes from a blue chip stock, but I only keep 67 cents after paying tax. Where the heck am I going to find blue chip stocks priced at less than 67 cents on the dollar??? That's why dividends are value destructive. I basically get payed only 67 cents and then wind up investing it back into the stock which is priced near a full dollar (most blue chips are not heavily discounted). The dividend rate for me is up to about 33% now -- 20% Federal, then 13% California, then the extra Obamacare/Medicare (or some sort of new health related) investment surtax crap. That takes my $1 of dividend down to only 67 cents. That's practically 2/3. It's just as value destructive as paying 150% of fair value in a stock buyback! So when people say (like it's some religion) that buybacks only make sense under fair value, I think not! There's a lot of room above fair value before they are more value destructive than dividends. Additionally, if I'm going to be losing 33% of value, I'd rather it go to fellow investors than the government tax collector.

In the USA, the qualified dividend rate is the same as the long term cap gains rate. All of my comments pertain to the USA if there was any confusion. Any place where your cap gains rate is higher than your dividend rate (like Warren Buffett at Berkshire) you can take the other side. So that guy is no worse off if he chooses to sell tiny amounts in lieu of a dividend. And he's better off if he wants it reinvested (tax free reinvestment). And being an old guy, his heirs probably want that as well given that it will all be stepped-up in cost basis upon his death. They can either sell his shares (getting all those reinvested buybacks tax-free), or they can choose to keep the shares and start selling pieces to offset buybacks -- with the cap gains paid at the new stepped-up cost basis.

But if you were speaking on behalf of Berkshire shareholders, well then you very well may be very resistant to my scheme. Berkshire pays 35% tax rate on capital gains and 14.5% tax rate on dividends. So, where do you think their spokesperson stands on this issue? Eh?

I don't follow here. Well, the shareholder is no longer getting a 28 cent per quarter cash dividend any longer (it was cut to zero). Let's say the shareholder has 100,000 shares. In the old days, he would get $28,000 of cash dividend each quarter. Under my regime, the company will be using that very same $28,000 (28 cent per share per quarter) to repurchase shares. Now (under my regime), he just sells shares each quarter amounting to $28,000 cash proceeds. He might not even owe any tax on this (depends on his cost basis). Potentially he sold for a capital loss and can actually take the $28,000 distribution completely tax free, as well as reducing his capital gains tax bill from other sales. Compared to the world where he's automatically paying tax on $28,000 of dividend, that's a huge leap forward for mankind. And what about the little shareholder who only owns 1 share? Well, tell me this -- how in the hell is he going to reinvest a 28 cent cash dividend when the brokerage charges him $8 per transaction? He's better off just having it reinvested back into the shares because an investor that small suffers too much expense drag from commissions. And when the share count gets too low from years of constant share repurchases? Just split the stock.

Let's take it without the inverted offering. Let's say, for example, that I'm running Coca Cola (KO) as dictator of the company. I simply convey that I'm going to cut the dividend to zero and instead purchase 28 cents per share of stock every quarter, trying as best I can to make an even-sized purchase each and every day. The shareholder merely needs to make 28 cents worth of sales, each and every quarter. Voila! The prices each shareholder sells at might not be exactly the same (sometimes higher, sometimes lower), but over time that will completely wash out. After all, we're talking about long-term shareholders, right?

People who choose not to exercise their right to tender shares at X price indicate their intentions by a certain date, after which time the company offers that tender price 'X' to the open market. Therefore, the company will be able to distribute all the cash it intends to distribute. Those shareholders that wish to take their pro-rata share of cash will tender their shares at that X price. Those that don't tender their shares made a conscious decision to reinvest their share of the cash at that X price -- forever shall they hold their peace.

They can get out if there is a buyer -- and the company is that buyer. Therefore, there must be a way for them to get out of the shares that the company is repurchasing. There must be some way that a company can issue a reverse rights offering -- in other words, a right to sell at a certain price. Say you have 100,000 shares and the company issues you the rights to sell 1,000 shares at a given price. There you go, it's a tax-efficient way of returning capital to shareholders. Every shareholder can participate. Management should prefer this method of buying back shares because the shareholders can no longer blame management for the capital allocation decision -- it will be plainly obvious that it was their choice not to sell to the company, the allocation decision is squarely on the shoulders of the shareholder. To be sure, a shareholder cashing out via company repurchase is being bought out by the remaining shareholders. You can follow this process to its logical end, where just 1 share remains. But the final shareholder can't cash himself out at an inflated price. To update my previous example: 100 shares and $1,000 in net assets. IV of $10 per-share. 99 shares are repurchased for $10.10. After the repurchase, 1 share remains and its value is $0.1. The company can't repurchase this share, right? That's why I'm saying that as a group the shareholders can't get out. If the company can repurchase this final share, it certainly can't do it at a price above 10 cents. Contrast that repurchase price to the "bargain" repurchase price of $5 per-share. When 99 shares are repurchased, per-share value rises from $10 to $505. All that said, I'm willing to be wrong here. I'm glad you're willing to be wrong :D Kidding aside, My example was for an inverted rights offering. You see, the company gives each shareholder the right to sell 1% of shares back to the company. So you're wrong (and willing to be) if you were disagreeing with me -- the person isn't cashing out at the expense of remaining shareholders, he is merely cashing out at his own expense. In other words, the shares he cashes in are purchased with his pro-rata share of the company cash. Just like when he gets a 1% dividend -- it's not paid at the expense of other shareholders is it? No, it's paid at his own expense. Just like with the inverted rights offering, it's just his pro-rata share of what the company is returning in cash. The reason why I introduced this concept of inverse rights offering was to totally eliminate the argument that shareholders are being cashed out at the expense of existing shareholders.

They can get out if there is a buyer -- and the company is that buyer. Therefore, there must be a way for them to get out of the shares that the company is repurchasing. There must be some way that a company can issue a reverse rights offering -- in other words, a right to sell at a certain price. Say you have 100,000 shares and the company issues you the rights to sell 1,000 shares at a given price. There you go, it's a tax-efficient way of returning capital to shareholders. Every shareholder can participate. Management should prefer this method of buying back shares because the shareholders can no longer blame management for the capital allocation decision -- it will be plainly obvious that it was their choice not to sell to the company, the allocation decision is squarely on the shoulders of the shareholder.

Wise words. I find it hard to believe that Ben Graham "invented" value investing. Buy low, sell high is what merchants, investors, and bankers have been trying to do for aeons. Graham just created a nice intellectual framework for capital markets investing. Jeremy Grantham wrote something really funny about this in the April 2010 quarterly GMO report: So I have come, friends and Romans, to tease Graham and Dodd, not to praise them, even though this is the 75th anniversary of Security Analysis. And my second point of attack is that Graham and Doddery is all a little obvious. I was brought up by a Quaker and a Yorkshireman – that is known as “double jeopardy” in the frugality business. Quakers believe waste to be wicked and Yorkshiremen, who consider Scotsmen to be spendthrifts, consider itcriminal. The idea that a bigger safety margin is better than a smaller one, that cheaper is better than more expensive, that more cash is better than less cash, deserves, in modern parlance, a “Duh!” It is just rather obvious, and going on about it for 850 pages can get extremely boring.

If only we had a 300 year old investor on the forum. He'd probably tell us it was called something else before it was called "buy low sell high". Then later it was called "margin of safety". And he would expect if we waited long enough a new breakthrough label for it would be adopted. The new generation always wants to challenge the orthodoxy and create something new of their own. Leave their own thumbprint on time. But the more things change, the more they stay the same.

IMO, "margin of safety" is lipstick that an English major slapped onto "buy low".

"value" is implicit. Otherwise "low" isn't actually low, and "high" isn't actually high.

Buy low and sell high is an old fad, not a new one. I suppose you might question whether "value investing" is any different than "buy low and sell high"? Seriously, I don't think they are different.

Only if the company is repurchasing at prices below fair value. You should think of it as a dividend. Why is the stock valuation of any relevancy? It's the total amount of cash returned to investors that matters. Proof: each shareholder can sell an offsetting amount of shares at any price that the company buys it from them. Like a tender offer for example. The company can offer to buy out each investor's fractional ownership at a billion times IV. It won't matter, they'll each get exactly the same amount of cash as they would have received if instead a cash dividend had been paid. After the transaction, they will each own exactly the same % of the business as beforehand. Cash is the same as dividend. Ownership is the same as with the dividend. The only key here is that they need to do their part and sell some shares to offset the buyback. This whole thing about high priced buybacks destroying value is a hoax -- the shareholders are the ones destroying value by holding their shares instead of selling them. They're the ones making the bad capital allocation decisions, but ain't it convenient to blame management? Management is at least helping them with tax efficiency.

muscleman, Your prediction of $9 for MBI might be right!

True, I am being lazy with the definitions. I would say the relevant metric for DCFs should be "Adjusted FCF" = FCF - Buybacks. In your scenario, if the firm suddenly stops buying back, then Adjusted FCF = FCF, and then growth becomes 0, which essentially is the pre-buyback state, although now with higher FCF/s due to the buybacks. Now if the firm returned all its FCF to shareholders via dividends, and assuming that no other cash was returned, then in that case, I would not revise the FCF figure downwards, as all FCF immediately flows to shareholders, and more importantly that cash is not reinvested to create growth in FCF/share. Therefore Adj. FCF = FCF, and growth is unchanged. That still fails my code review. I would suggest you merely add back in the number of shares repurchased. After all, you are willing to ignore a dividend. So why not ignore the share repurchase? This is more straightforward. You can then think of the share repurchase and dividends as the same thing -- cash return yield to investors. That's what they are.

That gets a little weird if the firm were to stop buying back shares. You are going to have free cash flow jump from 700k to 1m in a single year, even though FCF isn't growing. That might sound like I'm bickering over semantics, but if I was collaborating with you on a software project I would mention that your choice of naming for variables makes the code difficult for others to understand/maintain. It might compile and run just fine though, no argument there. Let me ask you a question though. How would you go about it if you were instead looking at a company that returned cash to shareholders only through dividends. Would you ignore the dividend yield, or would you instead count the dividend and redefine "free cash flow"? Maybe there is another way without redefining what free cash flow is -- that's all I'm trying to say. I'm not saying that your end result would be wrong.

You can see the cash as soon as you sell the incremental % share ownership. I suppose "later" can asymptotically approach zero and still be defined as "later". Similar to a person who reinvests his cash dividends automatically on a DRIP plan. He too doesn't get the cash until "later". Does that not qualify as cash returned to shareholders?

Palantir, 1) Company buys back shares (packaging the payload of cash into the pool of existing shares) 2) shareholders who want to access their share of this cash then sell offsetting share(s) -- now they have cash. They have taken the knives out of the box. 3) Shareholders arguing that they didn't get any cash are just refusing to open the box of knives. But hey, it fools the tax officials so all the best! This is smarter than a regular dividend -- it achieves the same thing for the shareholders who are willing, and it launders the dividend as a capital gain. Those shareholders who are holding their shares at perhaps a capital loss are able to get their tax laundered "dividend" as cash while at the same time writing off a capital loss on their tax return. Otherwise, if you merely got a cash dividend, you would be owing dividend tax even if you held the investment for a total return loss! Boy that really sucks don't it!! And most of the time, even if you hold your shares for a gain, your cost basis isn't as low as absolute zero, so you certainly pay less in tax.

No, we are discussing continuing shareholders, not those that chose to sell back to the company. If you are a continuing shareholder, then you will never see the cash, and hence it is an outflow. You see the cash when you sell off the incremental % ownership. I could ship you a set of knives packaged in a box. You could tell me that you didn't get any knives, all you see is a box. I tell you to open the box.

I think you've got it backwards. Return of capital by definition flows to shareholders, it's not a reinvestment in the firm. It doesn't flow to shareholders. When a firm produces cash from operations it goes to the firm's equity, if it's used to buyback, it is an outflow that continuing shareholders do not see. Then you admit, it is an outflow. To shareholders. Continuing shareholders, if they wish to "see" it, merely need to sell a few shares -- bringing their % ownership back to the prior level. It's value given to shareholders (essentially identical to a dividend). IF you think the shares are overvalued, and the repurchase is a bad capital allocation decision, then the shares are too expensive and you shouldn't own them anyways. If you already own the shares, then they're overvalued and it's time to sell. This is the truth, amen brother.