Dividends versus Capital Gains Part 1

I was reading Against the Gods by Peter Bernstein again last night, and near the end there's a section about the misperceptions and departures from pure rationality that investors make. I was shocked when I started reading a section that began by saying that there's no rational reason for corporations to pay dividends, or for shareholders to want them to.

As much as I've enjoyed his books up until then, I now have to think that when he wrote that he purely had his head up his rear end. That's a rational academic argument, but it's got no relation to the real world.

The academic argument is that when a corporation pays out dividends, it is losing cash that could be better spent in other ways, such as paying down debt or being invested in some way to make a better return. By being used to improve the company's balance sheet or to make a better business investment, the company's financial position is improved.

This means that the company's stock in theory will be worth more, because the company will be in a better financial situation.

At the time this book was written, capital gains got preferential tax treatment, so an investor receiving dividends paid full tax on them but an investor raising the same money by selling stock paid less in taxes. That's been changed in recent years, but the Democrats plan to go back to socking it to the owners of dividend-paying stocks (anybody who owns dividend-paying stock is obviously rich and evil and needs to have their money taken away from them ((according to class-warfare Democrats)) . . . by I digress.)

(Bernstein didn't mention transaction charges, which favor the dividend receiver over the stock seller who must pay brokerage commissions, but I admit that's minor compared to the tax difference.)

That's a great theory, and a company's stock price does get adjusted for payout of dividends, but that's hardly a major factor in a company's stock price determination. As Bernstein has written about himself, per modern financial theories a company's stock price is mostly determined by the overall market.

How many investors say to themselves, I liked company X at $50 a share but since it just paid out a dividend of 50 cents per share I'm not going to pay over $49.50? Stock buyers that really like that company will buy at market.

Furthermore, it's not real world to say that all cash a company keeps in retained earnings is invested well. Companies can and do waste it. It may just go to give company officers more stock options, which is not a benefit to shareholders. It may go to acquire another company which is a waste of time and effort. Many things can happen to that cash, many of them of no value to shareholders.

The 50 stocks in this Mergent index are not doing poorly in the market place even though they pay dividends.

Not to mention, Enron, Global Crossing and obvious frauds. Most companies and executives are not frauds, but that doesn't mean they're building shareholder value the best way with retained earnings.


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