Dividends, Stories, and Gambling: The Three Layers of a Stock and Their Risks

The same stock is a different object in different eyes. To some it is a claim on a company’s dividends; to others it is a chip at the gaming table.

The dividend layer

The bottom layer of a stock is sharing in the profits. Historically, companies have made money and been happy to share it with shareholders through dividends or buybacks. Kweichow Moutai and Tencent Holdings are companies of this kind. The risks here are:

1. The company is not really making money; it only looks like it on the statements
   1. Profit with no cash flow;
   2. Risk deferred — banks and insurers, for instance, may look profitable today while concealing enormous bad-loan or claims exposure;
   3. Accounting fraud
2. The company makes money but does not share it with minority shareholders
   1. No dividend, buybacks only at inflated prices, and the cash flung at random investments
   2. Management siphons value out of the company through related-party dealings of every kind
3. The company used to make money and is now in decline, with no more to be made
   1. The company decays and loses its competitiveness
   2. It is disrupted from above and its industry turns into a sunset industry

At this layer we must put a price on the earnings and the dividend, and judge whether they can last.

The story layer

Building on the eventual sharing of dividends, the market reaches a consensus that a company will make a great deal of money in the future. That usually gets told as a coherent story: EVs will replace combustion cars, and Xiaomi will become an EV giant; AI is rising, and Baidu will be great again; Pinduoduo will use China’s vast manufacturing capacity to find markets for goods and own the “save money” mind. For such companies every first-layer risk is present, and there are more besides:

1. The story is right, but the company is not the protagonist — AI really is rising, and it may have nothing to do with Baidu;
2. The story is simply wrong — EVs replacing combustion cars may not be a real trend at all.

At this layer we must price the story, and the difficulty rises by perhaps an order of magnitude. There is some venture-capital logic in it.

The gambling layer

One level above the story, we sometimes need not believe the story at all; we need only believe it is the hot speculation of the moment. That is the gambling layer — a casino needs something to bet on. Under gambling logic the risks of the first two layers cease to be risks. There is only one:

1. Hot themes rotate at any moment, and what the market will be betting on next is impossible to predict. At this layer there is no way to price anything at all; perhaps only high-frequency quant funds find an edge.

As an investor I care only about the first two layers, and I want most of my position in the first and a small part in the second. Stay away from the third.