January 8, 2003
Why Bush’s Plan Will Be Watered Down: Corporate America Loves To Juice Earnings and Wash Away Stock Options Dilution With Buy Back Schemes
Expanding government deficits to let astute shareholders keep more money is not an economy policy, but a desperate attempt to ensure that frightened investors stay in the markets, and scared investors possibly pile more money in.
The fearless U.S. consumer purchased a new automobile to fight terrorism, refinanced his home 3-times to purchase other goods, and is now having to deal with higher energy costs. Does President Bush thank the consumer for helping the U.S. economy avoid a tremendous recession? No. Rather, Bush tells the consumer to wise up and dump some more money into the stock markets; Bush tells consumers to hunt for dividend opportunities which can not be found.
By contrast, some people claim – those individuals living in fantasy land – that if Bush’s proposal passes and dividends are no longer taxed that stocks will become extra attractive. Someone should wake these individuals up and show them the less than 2% yield on the S&P 500 and the shaky 2% yield on the Dow. To be sure, dividend paying stocks are only truly ‘attractive’ when yields escalate near that of bonds. Have the cheerleaders forgotten that stocks are risky while Treasurys are safe?
Suffice it to say, you don’t need to be an economist or politician to know that Bush’s plan could have more of an immediate impact if he gave consumers just itching to spend more money a fat check. By handing consumers all of the expected $50-$75 billion in extra stimulus Bush’s package is expected to generate this year (Goldman Sachs Group Inc.) this would be tantamount to hitting to hitting a solid triple in baseball – this stimulus would make the expected refinancing shortfall in 2003 less burdensome, enabling the U.S. economy to probably (maybe) just ‘muddle along’. Instead Bush is trying to hit a home run: he hopes that his schemes can rekindle stock market euphoria; that stock market gains alone can boost confidence and/or give companies a reason to spend and hire workers.
Another big problem with the Bush plan, especially if the plan aims to rejuvenating capital spending, is that the dividend cuts are aimed at investors not at companies. Bush could have given companies the ability to expense dividends against income. He did not. Consequently, if no new money shows up and propels dividend stocks higher, perhaps also pushing all stocks higher?*, Bush’s home run swing will turn out to be nothing more than a pop fly.
Incidentally, and to reiterate what has been said many times before, companies do not need to spend! If the amount of Lemonade I am mixing beats demand I will not buy another glass jug and wooden spoon. Rather, under Bush’s new plan I, your everyday CEO, may offer preferred shares rather than bonds and I may announce a dividend policy rather than continue buy backs: but this does not mean I will spend…
* It is difficult to figure out why crummy stocks that do not pay dividends should benefit from Bush’s proposal.
From Buy Backs to Dividends
You cannot blame the media and Wall Street for spending a great deal of time covering Bush’s dividend proposal. After all, why talk about the weak U.S. economy when you can latch on to the perception that things may improve because more ‘stimulus’ is set to arrive? However, what is not receiving much attention, make that no attention, is the fact that ending the taxation of dividends could be regarded as an anti-bull market proposal. I’ll explain:
When a company buys back stock they reduce the number of outstanding shares without having to perform a stock split adjustment. As such, this allows a company to buy earnings growth. For example, if company ABC has 10 million outstanding shares and they buyback 1 million shares they would then have 9 million shares outstanding. Simple enough. However, if the company reports the same year-over-year earnings, say $1 million a year, because the company has fewer shares outstanding this would increase the company’s EPS. The company is making the same amount of money but reporting higher EPS.
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The concept of buying EPS growth is not rocket science. Rather, some companies have become quite skilled in the art of manipulating EPS in this manner (along with using related call/put options, and stock option schemes). However, it is important to recognize whereas stock buy backs fuel stock price growth -- both because of the immediate purchase made in the market and because of the reduction of outstanding shares which influence EPS -- dividends do not. In fact, if dividends were to come at the expense of stock buy backs this would hurt the U.S. stock markets: ‘hurt’ meaning stock prices would not rally as much if you assume that prices are hinged to EPS.
This may seem like a trivial point, especially since a stock with a yield doesn’t need to rally as much to provide the same benefit to the shareholder. However, and realizing that the media and Wall Street have been conditioned to judge bear and bull markets based upon percentages, if companies adopt dividend policies at the expense of buy backs it will make stock market rallies appear less explosive. After all, if the Dow loses 10% this year the headlines will not read ‘Dow loses 8% when including dividends’, but ‘Dow loses 10%’.
For an example of this theory in action consider DELL: a company that has repurchased 940 million shares over the last 6 years for an aggregate cost of $9.8 billion and a company that has never paid out a dividend. If DELL had repurchased no stock during the last 6-years (ended 01) the company would be trading at 40 times Jan 2004 earnings estimates instead of 28 times EPS estimates (currently DELL is expected to earn .99 cents/share in 2003. This estimate would drop to 0.72 cents/share if you back out repurchases). Furthermore, if DELL was to take the money it spent on buy backs in 2001 and began paying the same amount out in dividends on an annual basis, the company would currently be trading with a 4% dividend yield.
Point being, and knowing that companies like DELL claim buybacks are for the shareholders benefit, corporate America would not be able to continue enacting huge buy backs if Bush’s proposal is passed. Quite frankly, why would anyone with a clear mind want taxable capital gains rather than non-taxable dividend income? Why would any shareholder want $3 billion in DELL buy backs versus 4% in non-taxable income???
With this in mind, what Bush’s proposal would unwittingly do is make it absurd for shareholders to want their companies to buy back stock. If this happens, and it could take many years for this alternative method of thought to ever come to fruition, what Bush will have done is erased a 20-year EPS influencing trend.
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“Since corporate America was awarded the right to repurchase stock without the threat of being investigated dividend yields have precipitously dropped.”
The Death of Dividends
Conclusions Laced With Optimism
I like dividends, so my conclusions are biased.
Bush’s proposal to end the taxation of dividends, which is part of plan that will add $670 billion to government deficits over the next decade, is wonderful news for shareholders. And while many economists and Democrats are quick to point out that dividends only benefit the wealthy, the fact is that over 50% of Americans are involved in stocks and have always had the option of purchasing dividend paying companies. Quite frankly, ending dividend taxation helps all astute investors, whether they are currently ‘wealthy’ or not. To note: I am not saying 2-3% in dividends make the markets more attractive per se, or that Bush’s plan is a good one for the U.S. economy, only that dividends put money in shareholders pockets and this is a good thing.
If Bush’s plan passes more companies will aim to counteract share price deterioration with the announcement of dividend policies rather than with stock buy backs (There is no ‘debate’ – if shareholders have any common sense they will force companies to give them non-taxable income rather than buy backs that make it possibile for taxable capital gains). This plethora of new dividend policies would temper stock price growth because cash would be siphoned away from buy backs. On this front Bush seems completely out to lunch (he may actually be lengthening the amount of time it takes for the major markets to enter a new bull market). Nevertheless, a slower moving stock market is a more stable stock market, and if dividend yields storm back into the fray and begin being regarded as an important valuation matrix it is less likely that reckless 1990s will ever return…
My prophetic enthusiasm aside, Bush’s proposal is unlikely to pass. In fact, I would wager it has no chance of passing in its current form. What will likely happen is that dividends will be taxed at the same rate as capital gains. When this happens, or when Bush’s plan fails, you will know why: corporate America has a penchant for buy backs not pay outs.
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