Sunday, February 6, 2011

The most profound lie in finance and economics

A profound lie is one that affects observable reality.  One that shapes social policy at both individual and collective decision-making levels.

Dividends do not matter is the most profound lie in finance.  From a shareholder perspective, higher dividend payouts are always preferable to lower dividend payouts with the caveat that the solvency of the enterprise is not threatened.  The obvious and simple reason this is true is that one of the choices the shareholder receiving that dividend can make is to reinvest it back into the company.  DRIP programs accomplish this reinvestment with minimal transaction costs.

The bedrock finance principle is that there is shareholder ambivalence between owning a company valued at $100 and owning say a $20 cash dividend and the remaining $80 company value.  The reason that this is false, is the ambivalence only holds if reinvesting the $20 back into the company is in the shareholder's opinion the absolute best use of those funds among the billions of alternatives.  A more detailed criticism previously posted.

The reason that this is a profound and pernicious lie is that the ambivalence of dividends together with small transactions costs and tax implications is used as an argument to not pay dividends by both academics and financial professionals.  Government through tax and other policies is a co-conspirator in creating the lie, which I will explain shortly.  Transaction costs are minimal and have come down significantly since the 1970s when the theory was "proven".  The tax costs of dividends, in Canada anyway, are only an  accelerated timing of tax payments.

For the financial professionals that sell stock offerings to the public, corporate executives are their clients and the confidence/gullibility of shareholders (and their money) are the product.  From an executive's perspective, having spent considerable effort obtaining shareholder money, there is natural acceptance of justifying alternatives to give any of it back, just as there is natural acceptance of receiving Ayn Rand's praise and glorification.  "Dividends don't matter" is the lie executives want to hear and repeat because it it is an excuse to never have to pay shareholders.  The docile, deluded, shareholder class will invoke cult heroes such as Buffett and Jobs as an excuse for the other 15000 US public companies not repaying shareholders.

To some, this might all seem like a very small issue or an irrelevant dispute between capitalists and corporatists.   There are profound social costs too, though.  First, if shareholding is a ponzi scheme that will never see adequate repayments to holding shares then there is an expectation of eventual collapse of financial markets.  Second, capital allocation to the most worthy investments is harmed by corporate hoarding of cash. Innovation and new project funding is less available.  Third, as of June 2010, US non-financial companies have in aggregate cash and liquid assets totalling $1.84 trillion.  Recirculating that cash in the economy would provide needed economic stimulus without indebting us all through government debt.  These are the simpler social value arguments.

A corporation does not have to pay dividends in cash.  A novel way would be to pay them with loans.  Natural finance queued soft loans provide ultimate cashflow flexibility for the corporation.  Beyond cash on hand, corporations could provide soft loans with say 2% accruing interest to shareholders in lieu of cash dividends while through their DRIP programs allow shareholders to trade the loans for more shares if that is what they prefer.  This satisfies the Modigliani–Miller ambivalence of dividends and shareholder fairness principles.  The main reason for using loans instead of or in addition to cash as dividends is the social value of reducing market capitalization of the corporation.  Reducing market capitalization of companies by issuing quickly repaid loans distributes more cash into the economy that can be used to fund the most productive ventures, and it shelters that capitalization from disappearing in the next crash.  This is a similar argument to the 3rd point in the last paragraph.  US market capitalization is approximately $50T.  But the additional argument is that transferring market capitalization to shareholders significantly reduces the risk to shareholders.  All companies eventually go bankrupt, and if a company always double downs instead of distributing profits and accumulated market value to shareholders, then the only hope to profit from shareholding is to find someone else to buy shares from you.  Shares that will eventually be worth 0, and without dividend payments will have returned 0 to the shareholder.

There is an unwritten argument in favour of shareholder acceptance of foregoing corporate repayments to them (while still clinging to delusion of future corporate repayments).  Monopolies and companies with government lobbying or other corporate power can make a case that reinvesting with them is more profitable than what most shareholders could do.  Monopolies or corporate legislative handouts may harm society, but it does not harm shareholders.  Repaying shareholders could also be used to fund competition to the monopoly.  Market and social corruption can thus be to the benefit of shareholders.  Reduction of market capitalization through large dividend distributions can mean less power to abuse the rest of society.  The strong government-corporate alliance which at least used to be considered dangerous and worth resisting, but which we now seem to have moved to dejected resigned acceptance, would be weakened by emptying corporate coffers and increasing corporate accountability to shareholders.  This is an unwritten argument because it is an "evil is good for some of you/us" argument.

While shareholder oppression may not be the greatest social injustice in this world, it is a key to unraveling other oppression.  There are laws protecting shareholder rights which are much stronger than those protecting the people.  If citizens can view themselves as equal shareholders of society's surplus (its tax revenue) then they can demand the same protections.

Government takes on the role of economic stewards with the encouragement and support of many.  A related broad mistaken belief is that companies that pay back investors harm the economy by taking away capital that could increase production (and create jobs).  Tax policies that favour common share investments over loans reinforce the outcome.  The truth is that all restrictions on financial flows harm the economy.  Too much capital tied up in corporations with few attractive projects would be better directed to consumption which can then improve the outlook of future projects.  The investor class receiving the financial flows likely has a propensity for further investments, improving capital allocation to needed projects, but even if they choose to set aside returns from investments for consumption, they can invest it back if offered higher incentives.  Increasing financial flows increases the velocity of money which directly increases the economy. Economic theories (schools) that focus on the primality of capital and investment for economic function are wrong due to false presumption that society operates at maximum investment capacity, and thus that further production depends on further capital, and that money cannot be quickly allocated (or even fabricated) to production.  Faster financial flows not only permits the proper capital levels, it distributes capital where it is needed most.

Tax policies that would encourage distributions to shareholders and promote loan investments include to put a maximum cash salary (or service contract compensation, including transfers to multinational affiliates) of 100k per year but allow compensation in securities above that.  Instead of taxing people's investment gains/losses on sale of securities, they should tax withdrawals from investment accounts.  Increasing corporate and personal tax rates, but making dividends tax deductible to the corporation would ensure that corporations often effectively pay 0 tax, but keep neutral tax revenue by getting more from individuals.  A small tax on market capitalization (or equity) would further encourage distributions to shareholders, as would heavy investment in shares by management.  Taxing dividends and capital gains the same as ordinary income would further balance lower risk loans as investment vehicles.

Public company executives abuse shareholders principally by being able to appoint their own (oversight) loyal board members.  Even if laws and procedures exist for shareholders to receive the payments they deserve (and those that benefit greater society), its simply often easier for shareholders to secede from the corporation (by selling shares) and find a more benevolent dictatorship.  Its easy because there are no other easy choices.

Natural finance provides investors with better, less risky, investment choices.  From corporate perspective, less risky investments means a lower cost of capital, and natural finance soft loans are also more flexible and less risky.  The only corporate downside being the loss in power to corrupt society and delude shareholders with a false hope of repayment.  Arguably, there is upside in affirming social responsibility.  For the social and economic steward role (of government), natural finance should be a national strategic initiative.  An easy alternative to choosing among lesser oppressors is needed for investors.  Natural finance only needs modest funding.

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