What an Ice Cream Factory Can Teach You About Stocks

Lessons from Main Street for Wall Street

The market has been a source of great uncertainty for many Americans over the past few months. With equity prices falling and the credit markets freezing, rapid interest rate drops and liquidity infusions by the Federal Reserve have helped but not completely halted the tide. It was during these times that Ben Graham used to tell his students that one could think of himself (or herself) as a partial owner in a business and be content with collecting the cash dividends that came in the mail in the meantime.

There is great comfort in this psychological disposition. Today, for instance, I happened to be in Houston, Texas and visited a nearby community to see the factory tour of the Blue Bell Creamery, a large regional ice cream brand that is a favorite at the White House. As we were watching the machines filling the cartons with various flavors, it was obvious to me that a private business owner wouldn’t think of his “stock” going down when Wall Street ran into trouble; instead, he would focus entirely on his own bottom-line profits. Thousands of miles away from the brokers, analysts, and hedge funds that call Manhattan home, the yardstick of success would be measured in terms of the net income generated for the owners over the long-run, not the day-to-day fluctuations in daily shipments.

As a business owner, this is the same approach I take when valuing stocks. Declines, even substantial ones, don’t bother me in the least provided the underlying premise for my investment still remains intact. Success is measured by what Warren Buffett called “owner earnings”, especially as measured against the total capital invested. That is the estimated cash profits generated by a business after paying for capital expenditures if unit volume were to remain the same. In other words, if you wanted to take all of the net income in cash dividends each year to spend at Saks Fifth Avenue or to give to charity, how much could you take out without hurting the competition position of the company? How many people do you know actually think about this when they purchase shares of stock in their brokerage or retirement accounts?

This is one of the reasons that cash dividends have remained such an important source of total return for shareholders over the long run. Unethical, or just plain inept, management can often overstate profits through countless means, including adjusting depreciation schedules, pension assumptions, and health care costs. You can’t fake a cash dividend. When shareholders receive money in the mail or have it directly deposited into their bank or brokerage account, it’s a sign that the quality of earnings for a business might possibly be better than comparable firms because there was actual cash sitting in the company’s coffers.

For more information, you might want to take a few moments to read the following resources and articles:

• All About Dividends: An in-depth look at what dividends are, how they are approved, who sets the policy, how they can influence future growth rates, and much more.

• Adjusting Pension Assumptions to Manipulate Earnings: A look into how businesses can slightly modify a few key figures in their footnotes and report filings, generating millions of dollars in phantom profits.

• Calculating a Stock’s True P/E Ratio – A Look at Owner Earnings: A brief example of how owner earnings could differ substantially from reported profits, making stocks far cheaper or more expensive than otherwise may appear at first glance.