Probably the biggest single lesson of the last few years outside monetary policy has been that the contract between top management and shareholders is broken. Top management rewards itself with ever more grandiose bonuses and option payments, while shareholders are fobbed off, not with dividends which have value, but with “share repurchases” which do not. It is truly time for shareholders to “Occupy the C-suite” (of high corporate officials who are determined to be chiefs) and demand fair treatment
Dividends are the key to sound corporate governance. They are also the solidest and most transparent method of providing shareholders with a return on their money. The solid dividend stocks of yesteryear provided the best investments of all for individual investors, because their dividends tended to increase with inflation, unlike bond coupons. Those about to retire could do no better than buy solid dividend stocks. The stocks’ fluctuation in price was of no consequence, provided the dividend continued to be paid reliably, with occasional adjustment for inflation.
This comfortable world was disrupted by the arrival of Modern Finance, in particular the Modigliani/Miller Theorem. Prior to its arrival, finance executives had calculated a company’s debt capacity by examining the worst possible recession, then ensuring that the company’s debt service (including principal repayments) would be covered by a comfortable margin during that recession. Debt was known to be cheaper than equity, but the dangers of loading up with debt had been only too clearly demonstrated during the Great Depression, at a time when bankruptcy often meant liquidation.
The Modigliani/Miller Theorem changed all this by postulating that a company’s cost of capital did not vary with its capital structure. Then the fact that debt interest was tax-deductible while equity dividends were not made leverage economically attractive. The 1978 Bankruptcy Act, allowing corporate management to stay in control (and keep getting paid) during a bankruptcy, further removed the barriers to leverage, since it now seemed that bankruptcy had cost primarily for the creditors, and not for the company itself or its management. Shareholders lost out in bankruptcy of course, but if the company was leveraged enough, their economic loss was minor and they had been paid for the risk involved. The leveraged buyout boom of the 1980s and subsequently and over-expansionary monetary policies from 1995 exacerbated the trends to leverage, short-termism, management control and speculative corporate finance.
A substantial role in this unpleasant long-term trend has been played by a further development, the replacement of dividends by stock repurchases. According to their propagandists, stock repurchases are as beneficial to shareholders as dividends, but more tax-efficient. Instead of getting returns in highly-taxed (until 2003) dividends, shareholders would make their money through capital gains, which would not be taxed at all until the shares were sold, and then only at capital gains rates.
As a replacement for dividends, stock repurchases are very unsatisfactory. For one thing, unless the company conducts a (rare) formal tender offer individual shareholders do not actually get their stock repurchased; the repurchases occur between the company and large brokers and institutional investors. Further, while stock repurchases increase nominal earnings per share, if they are carried out at prices above the company’s net asset value they dilute its net asset value per share. Thus whereas individual investors get their fair share of $100 million paid out by the company in dividends, they get nothing like their fair share of $100 billion in stock repurchases above net asset value, since the asset backing for their shares shrinks by proportionately more than the share count.
The opposite is of course true for managers whose remuneration is partly or wholly in the form of stock options. Dividends are unattractive to such management, because they reduce the share price and the value of their options. Conversely, stock repurchases both increase the value of the shares into which their options can be exercised, and ensure that the issue of shares through their options is not in itself dilutive. In extreme (but quite frequent) cases companies match stock purchases to generous options grants, without paying cash dividends. In such cases, management gradually takes control of the company, whose asset base is hollowed out by repeated stock purchases at a premium to net asset value, leverage increases ad infinitum and individual shareholders get nothing until the company maybe goes bankrupt in the next downturn, wiping out their stake altogether.
It does not help that stock buybacks are generally laughably mistimed. Modern management, obsessed by budgets, almost always fails to spot downturns in its business and the economy generally, while assuming that periods of prosperity will continue ad infinitum and indeed improve (as their budgeting process forces them to assume). Consequently, in innumerable cases (think of Netflix last year) stock repurchases are made at grossly inflated prices, intensifying the bubble in a particular stock, and are then halted after the business and the stock have turned down and management discovers there’s no money left. Worse still are the cases, frequent in 2008-09, in which stock repurchases at inflated prices are succeeded by an emergency stock issue in a bear market, as the company is found to have inadequate funding for the recession.
Now Finnov, a research collaboration sponsored by the European Union, has proposed banning stock repurchases. The group points out that such repurchases were banned in many European countries before 1996, being considered a manipulation of the market. In Europe as in the U.S. such programs have proliferated, rising in London from a value of $2.6 billion in 2000 to $14.7 billion in 2008. Finnov makes the same points as above relating to value destruction and destabilization of companies.
In the United States, we can at least take away the tax advantage of share repurchases over dividends. Dividends should be made fully tax-deductible at the corporate level, and fully taxable at the individual level, thus removing their double taxation. By doing this, much of the political salience of the “Buffett rule” would be removed, since rich people’s dividends would be taxable at income tax rates above 30%, while in reality suffering less overall tax than now. Egregious under-taxation of millionaires would then be confined to capital gains tax and to loopholes such as the charitable contributions deduction and the “carried interest” under-taxation of private equity returns.
This would give shareholders more incentive to demand dividends from managements, but the British experience of 2000-08 shows this may not be enough – in Britain the “Advance Corporation Tax” system achieves much of the effect of dividend tax-deductibility, albeit at the cost of horrendous tax complexity. Management’s incentive to engage in share repurchases could be further reduced by allowing stock option exercise prices to be adjusted for dividends paid, with appropriate tax payments by their beneficiaries when they did so. While the EU’s proposed prohibition against stock repurchases may be too draconian, they should at least be restricted to formal tender offers open to all shareholders, so that individuals can participate properly.
Overall, we must return to a financial system in which companies are built for the long term, and investors’ ideal retirement portfolio consists of shares in substantial companies, paying 5-6% dividends. The current system, in which the retired are supposed to invest in bonds with pathetically low interest rates, or speculate short-term in the stock market, buying and selling like day-traders in the hope of capturing capital gains, is far too demanding of individual investors and turns the market into a casino.
In a well-ordered financial system, the majority of shares are owned by individuals, whether in taxable accounts or through their retirement accounts. Those shares provide primarily a steady and increasing flow of dividends, suitable for investors seeking income in retirement. There are a number of changes needed for this to happen, from cutting back the estate tax (so that company founders have an incentive to keep the company in their families) to restoring monetary policies that encourage saving and depress stock prices (thereby increasing yield and reducing volatility). Recent changes in accounting standards need to be reversed, so that “mark to market” accounting of derivative positions and balance sheets and creative goodwill accounting are not allowed to distort financial statements beyond the comprehension of anyone without an advanced degree in finance. But the most direct means of moving towards this objective is simple: removing the double taxation of dividends and ensuring that management avoids stock repurchases except through formal tender offers open to all shareholders.
Shareholder capitalism is the most effective mechanism for wealth creation known to man. Managerial capitalism offers no such advantage.
There are no guarantees that dividend paying stocks will continue to pay dividends. In addition, dividend paying stocks may not experience the same capital appreciation potential as non-dividend paying stocks.
(Originally appeared in The Bear's Lair.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005)—details can be found on the Web site –and co-author with Professor Kevin Dowd of “Alchemists of Loss” (Wiley – 2010). Both now available on Amazon.com, “Great Conservatives” only in a Kindle edition, “Alchemists of Loss” in both Kindle and print editions.