In spite of the recent rally, the viability of “stocks for the long run” is now in doubt more than ever. Even the investor in blind equity , the eternal optimist, seems to be concluding that the bottom line is being sliced and diced far too much leaving shareholders, the ultimate owners, with much less than they deserve for the risk they undertake.
The bottom line is being encroached by laws and regulations on a wide spectrum of issues ranging from energy to consumer protection to the environment to labor, pensions, and health, and much more.
There is also the dull tooth pain of the agency problem which equity seems resigned to have to live with. Long term investors buy stocks in a company believing that management will strive to maximize shareholder value while, in fact, management wants to increase corporate wealth, the assets which the corporation controls, because managers know that their pay increases in proportion to corporate wealth, not necessarily to shareholder value.
There is also stiff competition from foreign companies which are not operating under the same strains.
Some even believe that the shadow on equities is perhaps signaling an even more ominous one: the breakdown of the free enterprise system itself.
A topical question today, unfortunately, is: To what extent can the freedom attaching to physical and human capital be restrained but still left empowered enough to create the wealth on which we have come to depend? To what extent can freedom be squeezed out of the system – in the name of stability, the common good, etc - before our “free enterprise” or “capitalist” or “free market” system turns into something else (the subject of my piece “Capitalism and Freedom”)?
I do not think we have gone enough to break the horse’s back. Once the turmoil is over, we will shake off the dust from our boots, and carry on much as we did before. Equity is an optimist and believes if commerce does not provide the profit, the wall of money being pumped into the system eventually will. Markets will continue to go down but, of course, the past (good or bad) is no guarantee of the future.
As a trainee accountant, believing that dividends are decided upon by the board of directors in all its wisdom after due deliberation, I was shocked to my senses by this old man I used to work for who owned a holding company. My first November there he directed all companies to pay all profits as dividends to the holding company by February. I later learnt that this was a standard procedure the old man used to control his subsidiaries: they made profit and gave it to him and it was then he who decided where those profits went in subsequent years. No one got to keep the profit. A nice piece of education.
Later I came across literature which showed that US public companies with subsidiaries abroad use exactly the same procedure to keep them on a tight rein especially in cases where the legal environment in foreign lands was such that it was difficult for a company to protect its profits.
In Canada, tax on dividend is mitigated by a Dividend Tax Credit for personal income. In the United States, the 2003 Jobs and Growth Tax Relief Reconciliation Act lowered and, in certain cases, did away with the dividend tax until 2008, later extended to 2010. (It would be a pity if partisanship gets in the way of good policy on this.)
Some contend that tax on dividends should be completely removed because it provides a great excuse for managers of companies earning surplus cash flow not to pay dividends. This would go to increase corporate wealth to the detriment of shareholder value.
Expanding corporate wealth via retained earnings goes to increase the problem of agency encouraging companies to spend money on inefficient projects, value destroying takeovers, excessive executive benefits and perks, head office largesse, and the temptation to use corporate funds to fund personal political agendas.
The corporate agency problem relating to management, therefore, is compounded by ancillary agency problems by people benefiting from the increase in corporate wealth (in contrast to the more dispersed shareholder value), including contractors, target companies and their management, lobbyists and politicians.
Cuny, Martin, and Puthenpurackal (2007) found that the higher the executive stock options usage, the lower the total payout and that these payouts tend to occur via repurchases of stock in order to offset the dilution in earnings per share. In another paper, they report that since most managerial options have a fixed exercise price and are not protected for dividend payments, managers have an incentive to reduce dividends. They also quote Berger, Ofek and Yermack (1997) who suggest that firms whose managers have high levels of stock options also have higher levels of debt since debt increases volatility and thus the value of the options.
I described the agency problem as a “dull tooth pain” because it present investors with something of a moral conundrum which is hampering decisive action: we believe that one should get paid well for a job well done and that successful risk-taking should be rewarded. How, then, can one be grudging towards executive pay? On the other hand, my eyes popped out when I recently read in Gary Shilling’s March INSIGHT newsletter (very insightful!) that
From 2002 to 2008, the five largest Wall Street firms paid $190 billion in bonuses while earning $76 billion in profits. Last year, they had a combined net loss of $25 billion but paid bonuses o $26 billion.
Shareholders as captives.
Some argue that taxes on dividends paid by one company to another should be retained in order to discourage the formation of corporate pyramids. Pyramids are quite prevalent in Europe, though not so much in the UK, and involve core shareholders, such as a wealthy family, controlling a number of publicly listed companies via sizable core shareholdings such that the power of the family within the whole set of related companies is bigger than the wealth invested justifies.
Others argue that some tax on dividends received by individuals should be retained so as to encourage individuals to invest through tax exempt institutions, such as pension funds, which are better able to control the managements of corporations. However, recent developments, both in regards to the banking crisis and to CEO escalating pay, make one doubt how effective this institutional control is. Related to this is a very interesting judgment which came to my attention via Seeking Alpha by Judge Richard Posner, one of the Chicago School founders, of “waste is immoral” fame.
The complete removal of tax on dividends received by individuals should, on a policy level, assist shareholders to protect their property rights by removing one of managements’ major excuses for holding on to shareholders’ money. This would make for better stewardship of corporate assets. The removal of the tax would strengthen property rights, a central tenet of the free enterprise capitalist system.
In addition, cutting taxes on dividends should raise share prices and lower the cost of capital as well as encourage more investment in companies thus generating greater wealth.
Companies needing money for new projects have to raise capital via the issue of securities. As Michael Jensen (1986) puts it:
Payouts to shareholders reduce the resources under managers’ control, thereby reducing managers’ power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firms must obtain new capital.
The removal of the dividend tax would be one way to increase the flow of money from firms to shareholders which will both increase the velocity of money as well as the economic efficiency with which the money is used.
Corporations, instead of paying tax disadvantaged dividends, often resort to the repurchase of shares on the market. However, it seems that repurchases are used in lieu of extraordinary dividends, not ordinary dividends (Allen and Michaelly 2002). It is also well known amongst financial managers that individual shareholders prefer dividends (which they see in their bank accounts) to repurchases (which they cannot see and whose benefit can be easily neutralized by market movement).
Legislators and regulators should not neglect shareholders’ point of view if they believe that attracting capital (physical assets and human talent) to enterprise is still an important policy direction.
Cuny, Martin, and Puthenpurackal (2007), “Managerial Compensation and Corporate Payout”
Michael Jensen (1986), “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers”
Allen and Michaelly (2002), “Payout Policy”, in Handbook of the Economics of Finance, The Netherlands.
DISCLOSURE: None required.
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