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Just one word: Dividends
A Dialog with Daniel Peris, author of "The Ownership Dividend: The Coming Paradigm Shift in the U.S. Stock Market"
The issue is one of gown and town. We look to the gown to come up with models of human behavior. To do so, they make certain assumptions. Those assumptions make the models possible. It does not mean that the models are right, just possible.
The Gordon Growth Model, the simple formula for valuing a company solely on its current and future dividend prospects is deceptively simple. It illustrates the foundational components of discounting, but few look to it today as a practical valuation tool. However, when Myron Gordon and Eli Shapiro published their work in the 1950s it was less illustrative.
As Daniel Peris writes, “For most of its history, the stock market was based on a presumed, and usually an actual, cash relationship between companies and their owners.” Peris has expanded the ideas we covered last November into a book coming out in February titled, The Ownership Dividend: The Coming Paradigm Shift in the U.S. Stock Market (Pre-Order).
Peris makes the case that a combination of declining interest rates, lower cash returns and an overly academic understanding of value has left both investors and managers ill-equipped. The new paradigm of higher rates will result in a primacy of cash returns. His ideas are not theoretical. They are practical and they speak to the philosophy of investing as a form of business ownership:
Whether in theory or in practice, these two activities—on one hand, clipping your coupons; on the other hand, going out and selling securities—are most certainly not the same. Having capital gains depends on market sentiment, on the views of people often far removed from the activities of a company. In contrast dividends are a function of a company’s operations. A dollar may be fungible; how it is generated is not. Drawing this distinction—between a capital markets activity and a business outcome—may be the most important assertion in this book. The rest of the argument follows naturally from it.
Enjoy our dialog with Daniel Peris:
LE: Daniel, while your book is framed as a treatise on dividend investing, it is really more a philosophy of business ownership. You make a key distinction that a dividend is a natural outcome of business ownership (participating in a share of profits), while a share repurchase is a financial transaction. From the perspective of the passive investor, why do you think this distinction is so important?
Daniel: Just to clarify, the first two books, from 2011 and 2013, were directly about dividend investing. A lot of nuts and bolts stuff, but also important assertions about “stocks following the dividend” over long measurement periods. That can seem strange to younger investors raised on stocks without dividends, but it’s an important thread running through the entire complex. Getting Back to Business, from 2018, was a historical critique of Modern Portfolio Theory, arguing that while MPT solved problems at the time (the 1950s and 1960s), it is now so out of date as to be just wrong, or at least quite misleading to investors. The Ownership Dividend, coming out now, does indeed further develop the idea of business ownership through the stock market.
In that regard, the issue of a dividend versus a share repurchase is huge. Academic finance treats them as equal for all intents and purposes. And for several decades, investors have essentially done without dividends and relied on harvested capital gains–supposedly fed by share repurchase programs. Why is that so important? Because in the new paradigm that we are now entering, those harvested capital gains–and the logic of the big corporate buyback programs–will be challenged. As you note, buybacks (and harvested gains) are a market outcome, whereas a dividend is a business outcome. The return of risk rates will, I believe, have a big impact on companies’ ability to spend billions on share buybacks. Note that the rise of the buyback and the decline of interest rates have been parallel phenomena, not surprisingly. With rates no longer dropping, I argue that buybacks–this artificial (or at least synthetic) way that investors have been funding consumption in lieu of dividends–will have a hard row to hoe.
LE: As you mention, academic finance is relatively decisive about these forms of return of shareholder capital being equivalent, or irrelevant, from a valuation perspective. This understanding leans heavily on Franco Modigliani & Merton Miller’s seminal work, what issues specifically do you believe they overlooked, oversimplified or just got outright wrong? Or rather, is it a matter of the fundamental structure of the market changing?
Daniel: Great question. Two reasons. First, they were engaged in an academic exercise. Markowitz chimes in with the same condition that a dividend payment and capital gain are for all intents and purposes the same. For all the academics working in the 1950s and 1960s, it’s a standard assumption. In a blackboard exercise, they really couldn’t do otherwise, because IN A BLACKBOARD EXERCISE, THEY ARE EQUIVALENT. The issue is one of gown and town. We look to the gown to come up with models of human behavior. To do so, they make certain assumptions. Those assumptions make the models possible. It does not mean that the models are right, just possible.
The second reason is that the first one was a pretty unremarkable assumption in the 1950s and 1960s, BECAUSE MOST STOCKS HAD DIVIDENDS, AND MOST HAD MATERIAL ONES. That is, they were not giving much up by making the assumption. Stocks had dividends; rising dividends meant rising share prices. Declining dividends meant declining share prices (over time). So the assumption of a relationship between an asset price change and a dividend payment or trajectory was not unreasonable. One could be (somewhat) indifferent because they led to the same outcome.
It only becomes a more aggressive and a potentially problematic assumption when dividends disappear from the market in the 1980s and from the 1990s onward. Now you have two things that are unlike one another: share prices moving around on their own, on one hand, and share prices moving around very much in regard to their dividends, on the other. They are now separate phenomena.
LE: Even if buybacks and dividends were equivalent from a valuation perspective, does the overwhelming preference for buybacks over dividends have a meaningful impact in the real economy?
Daniel: Some economist somewhere has probably considered that issue–as to whether buybacks have greater impact than dividends on this or that or the other economic measure. I don’t know the answer. I do see dividends directly funding consumption. They clearly touch the real economy.
Buybacks are more a matter of shuffling the M&M ownership deck. That may have an impact or not on economic activity. I just don’t know. But it’s very certain that buybacks have a major impact on the Wall Street economy. And it’s all positive: turnover, commissions, optical EPS, executive paypackets, etc. Buybacks are a modern equivalent of Fred Schwed’s “Where are the customers’ yachts?” The commissions that used to finance the broker’s lifestyles have come way way down in recent decades. But buybacks now finance a lot of the good life for Wall Street.
I was recently baited to enter a Twitter fray about Ken French’s purported quip that: “Buybacks are divisive. They divide people who do understand finance from those who don’t.” I declined the offer, but my answer would have been along the lines of altering the saying to: Buybacks are divisive. They divide people who understand academic finance from those who own and operate businesses.
LE: That’s a great segue, how should investors internalize this? There has been a stigma attached with dividends that companies returning cash don’t have good reinvestment or growth prospects. Essentially that paying a dividend is a tacit admission that the company is no longer innovating. What changes when you want to evaluate an investment from a business ownership perspective?
Daniel: It’s a fair point. Insisting on dividends as a cash form of compensation for minority shareholders the past three decades has meant simply not owning (in this sense) any of the great tech companies (and the not great tech companies), and many other real-economy businesses that have chosen to go dividend free. I sleep well at night not owning them, but I realize others will want exposure to them, even if it is a cashless, stock ownership proposition. That’s fine, and understandable. And over the past few decades, and especially in 2023, insisting on a cash-based ownership has meant accepting modestly lower price returns from the marketplace. Again, I’m perfectly OK with the reasonable returns of the cash-based approach. Others will want more.
But the issue is, from my perspective, not that cash-based ownership suggests fewer growth prospects. That is absurd. The issue is really about buybacks versus dividends. Those companies without dividends have been buying back their stock hand over fist for the past decade, not necessarily investing it into growth projects. That logic will change in the new paradigm. I expect all companies to have to invest more back into their businesses. In the book, I forecast a 200 basis point margin reset for corporate America. Where will the cash come from? From the buyback budget, which is much larger than the dividend budget. Might investing in corporate America’s shift from efficiency to efficacy slow some dividend growth? Possibly, but most of the investment will come from the buyback budget. Proper risk rates–the 10 year at a normal 5% rate–will make buybacks look a lot less desirable than they did when interest rates were coming down year after year after year.
And then there are the immature start-ups/money losing unicorns/tech cos that perhaps shouldn’t be publicly traded at all. They are all about “growth,” and burning cash. The more they lose, the more the stock market has adored them this past decade, until recently. If you tell me that type of “growth” is superior to a modestly expanding, dividend-paying company that has run out of “growth” opportunities, I will respectfully disagree.
Let me be clear: economies/societies/markets need innovation. They need risk taking. The US stock market provides an outstanding platform for doing that. My firm, for instance, has a great franchise dedicated to dividend-free disruptive companies. It’s an absolutely critical part of the stock market. The challenge is one of balance: what part of the market is given over to reasonable risk taking and what part is given over to unreasonable risk-taking? As interest rates dropped for 40 years, the balance shifted. With rates no longer dropping, the balance will shift back. Remember: the 10-year at 5% is not high; it is normal. Which companies can operate and grow when the 10 year is at 5%. And which cannot? That’s what the next decade will determine.
LE: You have a chapter titled Truth & Clarity, which is a bit of a departure from the rest of the book, but personally one of my favorite chapters. It’s a more philosophical treatise on the “tao” of investing. You pull in ideas from everyone from Kurt Vonnegut to Barry Ritholtz. I’m curious what your goal with this chapter is, and really how you relate to the rest of the book? Is this chapter a reflection in some ways of your academic background in history?
Daniel: Thank you for calling that chapter out. I agree with you. It has nothing directly to do with investing, but it is the most important part of a book on investing! As in so many other spheres of life, setting expectations is critical. I’m not advocating setting low expectations vis a vis investing. I’m just saying finance and the stock market are a complex, multi-faceted system. Step back from the system and understand it (to the best of your ability) in terms of your life and what you need, not what is written on a chalkboard at the University of Chicago. What’s on that chalkboard may be a good overarching idea, but it will rarely apply to everyone all the time. Does everyone go to a football game for the same reason? Yes, they want their team to win, but there are many reasons why people are there. Does everyone go to the gym with an identical set of goals and plans? No, they share a common overall desire, but have many individual expectations that go beyond just looking like the supermodel or athlete of your choice. You get the idea.
I don’t know if the chapter is a reflection of my background as a historian, or my background as a human. I think more the latter…
The Ownership Dividend release date? Valentine's Day 2024! The perfect gift for your sweetheart — nothing makes the heart beat faster on Valentine's day than a book about the past, present, and future of the capital markets.
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