Dividends, Where'd They Go!?
Daniel Peris on the "Retreat of Dividends"
“[I]nvestors always prefer more wealth to less and are indifferent as to whether a given increment to their wealth takes the form of cash payments or an increase in the market value of their holdings of shares.”
- Merton Miller
Unfortunately, we must begin this inquiry with some esoteric regulatory review. We must because the current arrangement between companies and shareholders is a historical aberration. “For most of its history, the stock market was based on a presumed, and usually an actual, cash relationship between companies and their owners, particularly for larger, more successful businesses,” Daniel Peris, PhD and portfolio manager, writes in American Affairs. That is, investors judged the quality of a stock primarily on its dividend, the security of that dividend, and the potential for its growth.
In 1982 the SEC adopted rule 10b-18 which codified open market share buybacks. It isn’t accurate to say buybacks were “illegal” prior to 10b-18 but they did expose companies to claims of stock manipulation. Of course, many companies (famously Teledyne) repurchased their shares prodigiously, but they did so through a transparent tender process.
The adoption of rule 10b-18 provided “safe harbor” from liability so long as companies went about their share purchases in specific ways that limited share price manipulation. This provided a new capital allocation tool for managers and the standard of cash dividends began to fade.
While open market share buybacks may have inflicted the first wound, consistently declining interest rates, a shift to less capital-intensive industries and an abandonment of cash primacy in academia have all but killed the dividend.
“For the first two centuries of the U.S. market, companies were raising capital, not retiring it.”
As Peris lays out, the combination of a changing economy and the popularity of certain academic ideas around valuation changed the role dividends played in capital markets. For most of the 20th Century and prior, companies were highly capital consumptive. Railroads, manufacturers, and defense contractors needed to make significant investments in physical capacity to maintain and service growth. Those investments required fresh equity and to entice investors to be buyers of stock, companies needed to provide a cash dividend.
Make your way to your local library. Review its copy of Moody’s Manual of Corporation Securities, the subsequent Moody’s Analysis of Investments, the long-running Commercial and Financial Chronicle (CFC), and others of their ilk from the late nineteenth and early twentieth centuries, and you will observe the same thing. That’s not to mention the more obviously named Moody’s Dividend Record, a publication started in 1930 that continues to this day as the Mergent Annual Dividend Record. Apparently stock dividends were important enough to investors to have their own publications.
Peris notes that this relationship was explicit, the Moody’s Analyses of Investments included a calculated dividend available per mile of railroad. Today, by contrast, the largest and most successful companies are driven by intellectual, not physical capital. They are largely self-funded from cash flow and don’t require the constant cooperation of capital markets to grow. It is admittedly paradoxical that the industries that were most capital-intensive paid the most cash out to their shareholders, while today’s less capital-intensive industries tend to hoard cash.
The Tax Paradox
A commonly cited reason for the preference for buybacks, as opposed to cash dividends, is tax treatment. Buybacks, it reasons, are taxed at the lower capital gains rate, thus an improved after-tax outcome for shareholders. In reality, this is not so straightforward but let's focus on the underlying suggestion: Companies, uncharacteristically highly attuned to the tax status of their shareholders, have opted out of cash dividends into share repurchases because of the tax rate? Or rather perhaps, investors themselves have moved away from equities paying a cash dividend to those returning capital via the more tax-efficient buyback? Peris:
After the introduction of the federal income tax in 1913, dividends were exempt from taxation for decades. For the fifty years following the introduction of dividend income taxation in 1954, the rate varied but was often similar to the levy on normal income. That did have an impact on the academic perception of businesses paying dividends, but seemingly little impact on investor practices, at least until the 1990s, when other factors came into play. A notable irony is that for the past twenty years, starting in 2003, dividends have been taxed at a favorable rate, lower than ordinary income for high earners and similar to the rate for capital gains. So when not taxed at all—the first period—dividends defined the market. When highly taxed—the second period—they were still omnipresent, until the world went topsy turvy in the 1990s. And then when they were less taxed versus the prior decades—the third period—they essentially disappeared and have remained a minor component of our current investing climate.
So as a quick review, when dividends were taxed at a high rate and industries were their most capital intensive, dividends were an important factor in market structure. Today, when the tax rate of dividends is historically low, and companies are the least capital-intensive they have ever been dividends are all but vanquished from the equity market.
Until the 1990s, dividends mattered. And then they didn’t. As of June 30, 2022, the S&P 500 index had a trailing cash yield of 1.69 percent. That’s nonsensical from a cash investment or business investment perspective, but such nonsense has been tolerated for years by investors and company executives alike.
“Try as they might, the most visible and vocal finance professors still cannot find a logic to the most natural and logical form of rewarding minority-stake investments.”
In my last post how I reviewed how Michael Mauboussin had addressed the glaring reality that many of the academic models of financial markets fail to capture the clearly observable truths about how they operate. The treatment of dividends in valuation models is no different. Nearly every model of valuation leans on cash flow. How that cash flow is measured and to whom is clearly relevant to the outside, passive, minority investor. “Not so,” say the giants of financial academics:
Franco Modigliani and Merton Miller (popularly known as M&M) made what was then and still is a commonsense argument in 1958 that the value of a firm should be based on its assets and earnings potential, not on how the entity is financed or the precise nature of its capital structure.
The basic premise was that if a company pays out its cash to shareholders, it will simply need to raise capital in another form to finance its growth. As such, the capitalization of a company should have no bearing on its valuation. M&M could be forgiven for this view as their underlying data set consisted primarily of the capital-intensive companies discussed earlier. They regarded internally financed companies as “extreme” or “special” cases, in which the decisions around dividend policy are “indistinguishable from investment policy.”
M&M do not like the analytical implications of this scenario at all. They go so far as to call it “treacherous.” In other words, what was once dismissed with some degree of contempt now applies to the vast majority of the U.S. stock market landscape.
Today, M&M’s theory has been dangerously expanded to a blanket dismissal of dividends. Further, there is a signaling element that a company that is returning cash to shareholders expressly must be out of internal investment ideas, its days of innovation behind it. Even today’s technological behemoths, awash with cash pay sheepish dividends while lavishing their employees with share-based compensation, then turn around and sterilize these awards via buybacks. As Ben Hunt of Eplison Theory aptly puts it:
I believe that there has been a truly astronomical transfer of wealth - well more than a trillion dollars - over the past ten years from shareholders of publicly traded companies to managers of publicly traded companies. Not founders, not entrepreneurs, not risk-takers ... managers.
A Shift Afoot?
Like all financial considerations, the three-decade decline in interest rates has obviously impacted the necessity and role of dividends. When the carrying cost of cash is effectively zero, the impulse to hoard it goes unchecked. Similarly, when fixed income fails to offer a compelling alternative, investors are willing to hang their hopes of a return on capital gain. Put more academically, they are willing to put a higher present value on cash flows further out, however specious.
Petis points out that all of the trends that have caused the retreat of dividends may well reverse. The decade ahead may find investors more eager to see their cash returned in a more traditional manner. In periods of higher rates, whose hand cash is in becomes a more relevant consideration for managers and investors alike.
Further…
Daniel Peris has an upcoming book about dividends from which the American Affairs piece was adapted. The Ownership Dividend: The Coming Paradigm Shift in the US Stock Market will be released in 2023.
Beyond the scope of this article but relevant is a 2003 research report by Robert Arnott and Cliff Asness that showed that dividend growth was predictive of earnings growth.
This was a great read, thanks!
Looking forward to the book!