We own a lot of European-headquartered companies (mainly British and Swiss) and a lot of companies that pay dividends. In U.S. business schools, students learn that a portfolio like this is frowned upon for a few explicitly stated reasons and some that are more subtly implied.
The So-Called Problem with Dividends
Dividends are the most explicitly hated thing in business school. Since dividends are taxed twice, once as corporate profits and again at the level of the shareholder who receives them, students learn that paying dividends should be the last resort of any company. Students are taught that it is better for the company to find (profitable) projects to invest in, to buy other companies (mergers and acquisitions), and to buy back its own stock. All fine ideas in the academic world, but let’s look at what happens in the real world.
The most popular thing for a company to do with excess cash is to buy back its own stock. This is frequently touted as “just as good as a dividend” or better because you don’t have to pay tax on it. What could go wrong?
Apparently, a lot. A June 2012 study by Credit Suisse analyzed the $2.7T in stock buybacks by S&P 500 companies from 2004 to 2011. They found that only 61 percent actually made money; that is, the company bought back stock and the share price rose above the buyback price. Not too bad. But only 36 percent of companies actually managed annual returns of 7 percent or more to their shareholders with their buyback programs.
The problem is nicely illustrated by the graph below. The blue line is the value of the S&P 500 (INDEXSP:.INX), and the black bars are the value of the stock buybacks companies are doing each month.
(Source: Credit Suisse [red highlights mine])
As you can see, companies bought back the most shares when their share price was high. When the market collapsed in 2008/2009 and share prices were low, stock buybacks almost ceased. Companies did the exact opposite of what they should have done!
If companies aren’t buying back their own stock, they are usually buying other companies. Studies have shown this doesn’t work out any better. (In fact, it’s worse.)
A 1999 KPMG study found that “83 percent of mergers were unsuccessful in producing any business benefits regarding shareholder value.” A McKinsey & Company study (no date given) found that 61 percent of all acquisition programs were failures because the acquisition strategies did not earn a sufficient return on funds invested. Here are some other quotes about the dismal rate of success when it comes to mergers and acquisitions: “70 percent of mergers fail to achieve their anticipated value…” from Weekly Corporate Growth Report. “Most [mergers] fail to add shareholder value…“ from Harvard Management Update.
In the real world, letting company management spend shareholders’ hard-earned money on stock buybacks or acquiring other companies is wasteful.
Several clients have asked me why we are continuing to invest in stocks that pay dividends since taxes on dividends may go up. What I would change if I had a client in the highest income tax bracket (assume tax rates go up to the pre-Bush tax cut rate of 39.6 percent) and dividends were taxed as income? For every $1 in dividends being paid, such clients will receive only 60.4 cents.
That seems bad until you compare it to the alternatives. If the company spent its excess cash on share buybacks, then clients could expect to see only 36 to 61 cents, depending on how you interpret the share buyback study. It’s either a tie or a big win for dividends.
If we compare the higher potential tax bite to the company buying another company, then there is an even wider gulf between getting dividends and paying the taxes and the alternative. If the KPMG study holds true, shareholders would see only 17 cents in value! Even using the most optimistic studies that show merger and acquisition success rates of around 50 percent, dividends still carry the day.
So what would I change? Nothing. If top tax rates for dividends start approaching 70 to 80 percent, then it’s time to rethink our dividend strategy for high income clients. At 70 to 80 percent, taxes on dividends would be about equal to the failure rates for the alternatives (stock buybacks and acquisitions).
The So-Called Problem with European Companies
We own BAE Systems PLC (PINK:BAESY), British American Tobacco PLC (NYSEAMEX:BTI) (LON:BATS), BP plc (NYSE:BP) (LON:BP), GlaxoSmithKline plc (NYSE:GSK), Imperial Tobacco Group PLC (PINK:ITYBY) (LON:IMT), Nestle SA (ETR:NESR), Novartis AG (NYSE:NVS), Pearson PLC (NYSE:PSO), Philip Morris International Inc. (NYSE:PM), Roche, Royal Dutch Shell plc (NYSE:RDS.A) (NYSE:RDS.B), Unilever plc (NYSE:UL), and Vodafone Group Plc (NASDAQ:VOD). More than half the holdings in our dividend portfolio are European-headquartered companies.
In my experience, schools subtly imply that U.S. based or American run firms are the archetype of capitalism. Europe is usually implied to be a suboptimal place to invest. It’s communicated (again subtly) as being a continent full of lazy employees unfit for investment. In addition, there are too many rules regarding the hiring and firing of workers and too much vacation time, unions are too strong, and the continent’s workers are coddled by socialist governments. (After all, we all know things like education, healthcare, and robust public infrastructure make for a sickly, untrained workforce and a poor environment for commerce.) Again, some of this is explicitly stated and some is not.
American companies represent the epitome of capitalism, and their CEOs are hardworking, entrepreneurial geniuses, which we are lucky to have running our companies because few people can do as good a job as this elite cadre.
In fact, one of my most vivid memories from business school was a class discussion regarding ever-rising CEO pay. I had been devouring books on Warren Buffett at the time and knew that he paid his managers and executives below market wages, but his companies were still well run and very profitable. I suggested in the class discussion that paying CEOs less money wouldn’t be a problem, because there would be a lot of capable, competent people willing to do the job for $1M instead of $10M and doing so might even be better because you might getting people who care about the company rather than just looking for a huge payday. The professor just laughed at my suggestion. The rest of the class wasn’t too impressed by my line of thinking either. The class continued on its merry way discussing why CEOs deserved their outrageous pay. (No doubt many in the class thought of themselves as future executives.)
Luckily for me I have never been particularly concerned about what everyone else thinks. I went on my merry way believing that the rest of the class and the professor just didn’t get it. I still think they don’t get it, and here’s why.
Here is a graphic from the Washington Post showing the rise in CEO compensation versus the rise in the S&P 500 (INDEXSP:.INX).
(Source: graphic from the Washington Post)
CEO pay has skyrocketed by 726.7 percent from 1978 to 2011 while the S&P 500 (INDEXSP:.INX) gained only 349.1 percent. What did shareholders get for management taking an increasingly larger amount of their profits?