The Bear’s Lair: A re-focus on dividends

U.S. corporate earnings and the stock market in general have become divorced from reality, with corporations increasingly ignoring stockholders in favor of a politically correct “woke” agenda. This is dangerous for society and it is not capitalism. The solution is for stockholders, investment analysts and designers of tax codes to focus laser-like on dividends. Actual cash payments to shareholders, generated through earnings, are the best way to keep the system honest and functional.

Traditionally, all investment decisions were based on dividends. Changes in stock prices were treated as random fluctuations, to be ignored as far as possible. Speculative bubbles were recognized for what they were, and sensible investors were advised to avoid them to the extent possible. With money maintaining its value through a Gold Standard, there was really no reason to focus on share trading profits rather than income; a history of steadily rising dividends was a sign that a company’s business was growing and prospering.

With the abandonment of the Gold Standard during World War I, and the burst of inflation that followed, investors’ focus changed. Benjamin Graham and Maynard Keynes both invested on a leveraged basis during the 1929 bubble, looking for capital gain opportunities. Naturally, both lost money in the crash, Graham being almost wiped out. Their response to disaster was similar. Keynes “ceased using his economic understanding for investment purposes” (given Keynes’ bizarre economic beliefs, he would have lost money doing this anyway) and started to search for value stocks with good fundamentals. Benjamin Graham came to the same conclusion, wrote a book about it, and inspired Warren Buffett to become the richest man on earth.

Keynes and the tax system had nevertheless undermined traditional sound investment practice. With Keynesian inflation paramount, looking for a solid dividend was no longer enough, because inflation could erode the value of both your investment and your dividend. With corporate tax being levied on top of individual tax, dividends became the highest taxed form of income on earth, since they suffered both corporate tax and personal tax before the money finally landed in the investor’s pocket. Consequently, the principles of sound investing went out of the window, and investors began searching frantically for capital gains, as Keynes and Graham had done to their cost in the 1920s.

With monetary policy and stock prices increasingly divorced from reality since 1995, this has now become universal. Corporate managements promise capital gains to shareholders by buying back stock, ignoring the fact that by eating away the equity in the company they are making it over-leveraged, even infinitely leveraged as is Boeing (NYSE:BA) and vulnerable to the tiniest setback. (Boeing was bailed out last year by long-suffering U.S. taxpayers, but as a shareholder you cannot rely on that – and as a taxpayer you should fiercely resent it.) Shareholders who benefit from rising share prices really do not care what the company earns, or whether the company indulges in “woke” fantasies of the far left; so long as management and the Fed goose the value of their investments, they are happy.

The solution to this problem is to focus investors’ minds exclusively on dividends, the actual cash received from companies in which they invest. At the government level, this can be expedited by a tax reform I recommended at the time of the 2003 Bush tax package: making dividends tax-deductible at the corporate level.

If this were done, then corporate income tax would be payable only on retained earnings. There would be no benefit to shareholders in management hiding earnings in tax havens, because a zero corporate tax rate could equally be achieved by paying those earnings out to shareholders. There would also not be much benefit to manipulating earnings reports; fictitious retained earnings would be taxable and would have very little value.

Naturally, with such a tax system, some companies might prop themselves up by paying out dividends in excess of their earnings, thereby liquidating themselves. However, once investors had been trained to focus on the flow of dividends, they would discount companies whose dividends appeared to be unsustainable.

President Bush went the other way, reducing dividend tax on individuals. That had the benefit of lowering the ludicrous overall tax rate on dividend income, but it did almost nothing for incentives, since non-taxpaying institutions are far more important shareholders of the big companies than individual investors. Hence managements had no incentive to increase dividends – share repurchases, which specifically benefitted their own stock options, were much more attractive. This choice of policy thus shared the hapless quality of most George W. Bush decisions.

If dividends were tax-deductible at the corporate level, institutions as well as individuals would benefit from higher dividends, thus making the pressure on management to behave itself irresistible. As a further incentive, corporate tax on retained earnings could be raised to say 40%, the equivalent of the top Federal rate on individual earnings, thus ensuring that shareholders would squawk if managements kept pots of money to play games with (or repurchased shares out of highly taxed corporate retained earnings). The higher tax on corporate earnings would then make the social justice warriors happy and balance any revenue losses from the dividend tax-deductibility, a win-win all round.

Without this first step in a return to macro-economic sanity, the other steps I propose would have no effect – returning to sensible monetary policies without reforming dividend taxation would merely cause the mother of all economic slumps. That may be coming anyway but wiping out investors’ speculative gains without showing them a better way to make long-term returns on their money would kill economic confidence, as it did in the U.S. 1930s.

Nevertheless, further steps are necessary to return the process of capital allocation in the U.S. and global economies to sanity. The zero-interest-rate policies must be discarded, once and for all, to remove the dangerous and damaging market skew towards leveraged asset speculation, which then produces “inequality” that leftists can exploit to impose socialism.

The best way for the Fed to do this (absent a return to the Gold Standard) would be to set an inflation target of zero, not 2%, thereby ensuring that interest rates became set at a modest premium over the rate of inflation. A 2% inflation target is itself dangerously inflationary, not because people cannot deal with prices doubling every 35 years, but because a 2% target encourages a long-term monetary sloppiness of permanent negative real interest rates and an economy driven solely by asset-price inflation. President Trump’s candidate for the Fed governing board, Judy Shelton, understood this as do none of the current members of that board, which is why ex-Senator Lamar Alexander (R.TN) should be forever cursed for arbitrarily blocking her appointment. Now it is too late; absent a complete crash (which we may get) there is no chance of even a small Fed voice for monetary sanity for the next 4 years.

Once dividend taxation has been reformed and monetary policy corrected, investors should align fairly naturally with a dividend investment strategy. Asset prices will then be stable, so there will be no temptation to chase them upwards in an ever more insane spiral. Returns on assets will be higher (because prices will be lower and interest rates higher) so the annual yield on an investment will be relatively more important than its chances of capital gain. Dividend payout rates from companies will be higher, because of the tax changes, so investors will be offered dividend yields that are truly attractive.

This will be a world that will be miserable for speculative billionaires, most of whom will lose much of their wealth in the transition from here to there. It will also be unattractive for sponsors of 15-year startups, the type of Silicon Valley company that never makes a profit in the first couple of decades of its existence – the cost of capital for such wayward behemoths will be prohibitively high. However, true innovation will find it easier to get finance because there will be less competition from over-financed rubbish, and small business, able to pay a steady dividend from its sound long-term business, will find it easier to compete with the giants of woke enterprise. With investors looking carefully at cash payouts, there will be no temptation for ESG investing or woke nonsense – any companies indulging in these will find their share prices falling through the floor, as investors see the danger of wokehood to their cash returns.

Above all, it will be a better world for long-term investors, and for everybody else as participants in the economy.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)