Today I was reading Felix...
[F]or many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream -- one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.
In the late 70s and early 80s, the S&P 500's dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.
Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price.
And then Mish...
How many billions of dollars did GE [whose stock currently trades for about $18] waste buying shares back over the years at $40 or greater? $35 or greater? $25 or greater? $20 or greater? Think of where GE might be if it used the money to pay down debts rather than buy shares at absurd prices.
I see that GE is paying a dividend of 6.6% while borrowing money from taxpayers to fund operations. How long can that dividend last?
If you take an introductory finance class, you will learn that firms can return cash to their shareholders in two ways. They can issue dividends, or they can use the same money to buy-up shares from shareholders. Fundamentally, you will learn, these two approaches are equivalent: With a dividend, all investors receive some cash, but the stock they hold loses value. In a buyback some investors sell shares and receive cash, leaving investors who hold their stock with a less "diluted" claim on the assets of the firm, making the payout equitable to all shareholders.
To clarify, suppose there is a firm whose sole asset is $1,000,000 in cash and two shareholders. The firm could pay a dividend of $500,000, giving $250,000 in cash to each shareholder. Alternatively, the firm could buy out one of the shareholders, paying $500,000. In the first case, both shareholders end up with $250,000K worth of stock and $250,000 in cash. In the second case, one shareholders ends up holding $500K in cash while the other shareholder holds stock worth $500K. In financial terms, everyone gets a fair deal either way.
However, conventional wisdom has it that share buy-backs offer important advantages that may make them superior to dividends payments:
Preferential tax treatment — Investors are more lightly taxed with buybacks, especially if dividends are taxed more heavily than capital gains. With buybacks, those who sell are taxed only on net gains (a smaller amount than the cash actually received, and perhaps at a lower capital gains rate), while those who don't sell are not taxed at all until they sell sometime in the indefinite future.
Flexible reinvestment with low tax and transaction costs — With a dividend, people who want to stay invested in a firm have to accept and pay taxes on the dividend, and then incur transaction costs to reinvest the proceeds back in the firm. With a buy-out, investors who want to stay invested very efficiently do nothing, while those who want cash can sell into the buyback.
Cash-management flexibility for the firm — For whatever reason, firms are expected to keep dividend payments stable and increasing over time, even though business profits and cash needs may be very volatile. Firms that cut regular dividends are often punished by the market. Discretionary stock buyback programs allow firms to return cash to shareholders when business conditions permit and withhold payouts as cash needs grow while maintaining a smooth and stable dividend policy.
All of this would be well and good in a world with perfectly efficient markets, no asymmetric information, and investors whose portfolio preferences are continuously enforced.
But consider an uncertain world in which firms are frequently mispriced, and where many investors have limited attention and rebalance their portfolios only infrequently. (Among this latter group would be buy-and-hold investors who hold a fixed portfolio and either consume the dividends or reinvest them pro rata in a broad portfolio rather than in the issuing firm directly.) In this more realistic world, share repurchases benefit informed and flexible investors at the expense of their less informed or more rigid partners, while dividend payments reduce the ability of informed investors to profit at the expense of other investors.
Let's first consider the case where some investors know a firm's stock to be overpriced. Informed investors are more likely to sell into overpriced buyouts, extracting cash from firms at the inflated share price while concentrating the burden of future write-downs on long-term, less-informed investors. A dividend, on the other hand, would return cash equitably to all investors, automatically disinvesting slower investors from the overpriced stock, and forcing informed investors to share in losses. Of course, informed investors who know a stock to be overpriced can still sell, but without the support of a buyback program, their selling might inform the market of the firm's poor prospects, and cause the share price to fall before they can exit. (That's how information is supposed to get impounded into markets prices!) With or without the buyback program, investors in an overpriced firm must suffer the cost of a downgrade, but the cash disbursal policy affects the distribution of the losses. Returning cash via buybacks lets the informed shift losses to the uninformed, while the same cash distribution via dividends reduces the eventual cost to slow investors and forces informed investors to share more of the pain.
With an underpriced firm, the difference is less stark. Only ill-informed or liquidity constrained investors sell their shares into a buyback, concentrating future gains in the hands of both informed investors and slow buy-and-hold investors. So although informed investors do gain, the gains are more broadly shared: "slow money" as well as "smart money" benefits, the losers are ill-informed investors or random people who need cash. When an underpriced firm issues dividends, all investors are partially disinvested from a firm whose shares are destined to appreciate. But active, informed investors are likely to reinvest, potentially informing the market and provoking a revaluation towards fair value that benefits all investors. If the market adjusts quickly to the reinvestment flow, informed investors may not be able repurchase very much stock at all from less informed investors before the price adjusts, leaving the revaluation gains broadly shared among all investors rather than captured mostly by the informed.
An easy way to think about all this is just in terms of information: Share buybacks of an overvalued firm create artificial, potentially price-insensitive demand that allows informed investors to exit without suffering adverse price movements from revealing their information. Dividend payouts serve as a shock to investor portfolios that forces informed investors to periodically reveal their information, diminishing their advantage over less informed investors. So uninformed, buy-and-hold investors are less likely to be taken advantage of if they invest in firms that issue frequent, substantial dividends and don't repurchase stock than if they invest in firms that don't pay substantial dividends but use stock buybacks to "return cash".
This line of thinking opens up interesting questions about for whom a firm is to be managed. The party line is that firms should be managed for the benefit of shareholders. Even if that is true, for which shareholders should it be managed? One might conjecture that more active, informed investors have a greater influence than passive buy-and-hold investors, and create incentives for management to buyback overpriced shares even though in some sense this is bad for "the firm". (There are lots of anecdotes about hedge funds and other activist investors lobbying successfully for share repurchases by firms that turned out to be overpriced.)
Even if one imposes a fiduciary obligation on management to treat all shareholders equally, it's not clear that management is betraying its trust by working to inflate share prices and creating opportunities for the savvy to cash out. Even if the strategy harms future earning streams, it creates a valuable option that is ex ante available to all shareholders, and the option value of a firm is a real and often substantial component of its worth. If markets are not efficient, it's quite possible that maximizing current shareholder value is inconsistent with maximizing discounted infinite horizon profit streams, which leads one to question whether current shareholder value is a very useful metric of firm value from a social welfare perspective.
|Steve Randy Waldman — Saturday October 25, 2008 at 8:57pm [ 24 comments | 0 Trackbacks ]||permalink|