Dividends, Where'd They Go!?

Daniel Peris on the "Retreat of Dividends"

Nobel Prize-winning economist and University of Chicago Professor Merton Miller

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“[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

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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: