Dividends Riposte

So my post on the tax-related downsides of stock dividends failed to impress Nelson of nocommunism.blogspot.com. The guy, I gather, fancies himself as clown the personal finance blogosphere, and he rips me as a doucher, a shithole, an idiot, fruity, and nutty. The dude even mocks my blog name. Ha! There's nothing I enjoy more than a fight, so bring it on, my fatuous friend.

I'll reiterate my argument for the unacquainted: Absent taxes, dividends neither hurt nor help an investor's return, and should matter not one iota when investing. Dividends are, as I wrote earlier, a neutral mutation. They provide just as shareholder benefit---that is, none---as a mandatory share repurchase. But because of capital gains taxes, dividends actually hurt your bottom line. If you disagree with me, you'll also disagree with many very smart financial people. As Jeremy J. Siegel writes in of Stocks For the Long Run on page 99: "From a tax standpoint, share repurchases are superior to dividends ... share repurchases generate capital gains whose tax can be deferred until the shares are sold."

Many modern firms like Google and Dell, and enlightened older ones like Berkshire Hathaway don't bother paying out dividends. Instead, they re-invest retained into the firm to purchase equipment, human capital, pay down debt, etc---in short, investing in the company to increase shareholder value and future earnings. Yes, one can make pretty solid arguments about why dividends serve as a positive signal for a firm's health: A dividend policy can focus management on delivering profits; and dividends can reduce the chances that earnings will be frittered away.

But Nocommunist Nelson doesn't argue with valid arguments. Instead, demonstrates his failure to grasp basic investing and basic math. His post makes me think of this:



Just how fatuous is Nelson? Let's count the ways!

I. I will acknowledge he is discovered an editing error. My editor (that is, me) should have corrected "stock swap" with "reverse split." That said, he misses the point. I'm pointing out that a reverse split is just as unmeaningful as a dividend. I never said companies nowadays.

II. I wrote that the value of a stock decreases when a stock goes x-dividend. Nelson replies: "A stock doesn't just go down because they've paid a dividend. The way the market performs that day has more of an impact than the dividend going x-dividend ... It means that if we look at 5 companies at random, on the day they went x-dividend, their share price should have decreased by at least the value of their quarterly dividend. (perhaps more if the market was down that day) Do they? Let's check." He then proceeds to list stocks that paid a dividend and their value. "Their share price should have decreased by at least the value of their quarterly dividend," he writes.

Nelson's rabid snark impresses more than his meek investing brainpower. Two reasons:

Income can either be used to pay dividends or be retained. When retained, the earnings become part of the shareholder's equity section of the balance sheet. Retained earnings are but one part of a stock's value. When a firm issues a dividend, shareholder's equity decreases by total value of the issued dividends. The value of each share, therefore, should decline by the amount the firm paid out divided by the number of shares. Not, as Nelson naively says, by the dividend amount.

And two, the price of a stock is set by the market, which is the aggregate of millions of humans. Stock prices fluctuate as investors speculate about future earnings and value. But the fact remains, the when stocks go x-dividend, the fundamental value of the stock decreases---because, again, the entire company value decreased by the total amount of the dividend paid out to all shareholders.

III. I write, "Paying dividends to shareholders, in other words, is the functionally the exact thing as a mandatory buyback of shares." Nelson says: No it isn't. For several reasons: 1) Shares don't always go up. A mandatory share buyback could mean being forced to sell at a loss. 2) It's MUCH more simple to pay out dividends as it is to do a mandatory share buyback. 3) Wouldn't a mandatory share buyback eventually make all of someone's shares go away? 4) You're named after granola. Nice call on that one. We've all had some shitty calls in our day, but that one takes the cake.

My response:

1) Wrong again, buddy. When all firm shareholders are forced to sell back their shares, their ownership stake in the company remains the same.

Say there's 100 stocks evenly distributed to 5 owners (5 shareholders holding 20 shares each, for a total of 100 shares). Say the company announced earnings of $700. $300 will go to the shareholders.

Say the company purchases, for a price of $30, 10% of all shares. After the buyback, there is then 90 outstanding shares, distributed evenly among the 5 owners (5 shareholders each own 19 shares, for a total of 90 shares).

In both before and after the mandatory repurchase, each owner owns 20% of the firm.

Let's say the firm opted for a dividend instead, and each shareholder receives $3 dividend. Each shareholder still has 20 shares, for a 20% ownership stake in the company, but with $30 dividend in their pocket.

In both scenarios, the firm used its equity to purchase the shares, so value of the company just decreased by about $300. (10 purchased stocks times $30; or $3 dividends to 100 shares). In both scenarios, each shareholder owns 20% of the company. And in both scenarios, each shareholder has an extra $30 in their pocket.

Like I said, from a shareholder's point of view, absent taxes there is no difference between a mandatory buyback and a dividend! But because of capital gains taxes, each shareholder must pay 15% of their earnings in capital gains taxes, for a total of $4.50.

Say each shareholder purchases more stock with the dividend cash. It can be the same company or a new one; but when he or she sells the "new" stocks at a future date, they pay capital gains again.

If the company retained its earnings and re-invested all the earnings, the value of each stock would have retained its post-earnings increase ($3 for each share, in this case)---and the capital gains would only be paid once.

Lest I made this point unclear, I will quote Yale finance professor Robert Schiller: "It's changing the number of shares outstanding, so the value of the company declines by the same amount; it has to, as if they had just paid a dividend. If they're sending out money, the value of the company has to go down by whatever they sent out. With share repurchase, the number of shares goes down, and if they don't do share repurchase the number of shares doesn't go down. So in a sense, it's all the same to me as a shareholder whether they pay dividends or they repurchase shares." Read that last sentence again, buddy.

2) Yes, it's easier to pay dividends than do a mandatory share buyback, but so what? I said "functionally," with apologies for my typo. Oh, and, Nelson, why didn't you mock my editing? It would've been so easy!

3) If a firm opted to purchase literally every single share, then, yes, all shares would go away. But no company could afford to do so. The same ridiculous scenario could be concocted with with dividends. A company could, hypothetically, issue all its capital as a dividend, and make itself go away.

4) Check out that YouTube video again.

IV. At the end of my post, I rhetorically ask why corporations issue them and spend so much time on them. Nelson replies: "Plain and simply because investors put a value on cash. Isn't that the whole fucking point of investing?" His truism so reductive as to be meaningless. Only a simpleton places a premium on simple cash; only a fool thinks "cash is king" (which, I suppose, would render stocks as as the subordinate subjects). Cash loses due to inflation. Investors value maximizing profit overall return. Hence, they invest in stocks. Behavioral economics and investor psychology explain why investors and management spend so much energy over dividends.

There you have it. Human straw men can exist. As Nelson demonstrates, sometimes that straw man can be rabid with a fetid mouth. Thankfully for me, he is devoid financial and investing brainpower. I will admit that I smirked when reading his post mocking Trent of The Simple Dollar for pondering the efficiency of of toilet paper squares. So Nelson, buddy, keep hacking away at posts about toilet paper. It's your niche in the personal finance blogosphere! But leave the deeper, more thoughtful stuff to those with the brainpower. You chump.