Why do companies disregard taxes and their negative effect on compounding value?

[ni-co]

Agreed, Eric. Sorry, obviously I edited while you posted.

 

As long as you assume the market is completely rational. If, for any reason, other market participants prefer dividends over buybacks and the stock price moves up sharply when a company announces a generous dividend policy then I'll happily join the dividend camp (assuming I have a position already).

 

Problem is that this works only short term. In the long run it's like fighting gravity.

 

What I'd love to see is more CEOs who even think about tax as a cost for shareholders. John Malone does this and it pays in spades. He'd never pay you a dividend outright, because he thinks it's stupid. And he is right.

[ERICOPOLY]

You are assuming a sale of stock by an investor, which is irrelevant to management's decision making.

 

I think where you get tripped up is you assume a non-sale of stock by an investor.

 

This too is irrelevant to management's decision.

 

Their decision is merely to return capital to shareholders.  One method has an observable tax advantage over the other.  The people who sell an offsetting amount want the cash, the ones who don't sell an offsetting amount likely prefer the tax-advantaged reinvestment at current prices. 

 

 

[morningstar]

A person who sells an offsetting amount of shares is a "continuing stakeholder".  You claim management's duty is to continuing stakeholders.

 

It's the ownership % that matters.  A person who sells some offsetting amount of stock is not an "exiting shareholder".  He is merely keeping his ownership unchanged and would like management to serve his best long term interests -- distributing capital in the most tax-efficient manner is doing exactly that.

 

You are keeping your personal ownership unchanged, by selling some stock, but those continuing shares represent a higher ownership of the company and there's nothing investors can do about it. The company also has an obligation to the continuing investor underlying the shares you sold - that's what's missing in your account. How did increasing that share's ownership of the company, if at a bad price, aid in maximizing its value?

 

Perhaps my terminology is unclear - the continuing investor isn't the individual, its just the share that's remaining outstanding into the future. A share is issued once by the company and eventually may be bought back - through that lifetime, the company's goal is to maximize the value of that share. It may have one or many investors as it changes hands in the secondary market, but that's irrelevant to the company.

[ERICOPOLY]

the company's goal is to maximize the value of that share. It may have one or many investors as it changes hands in the secondary market, but that's irrelevant to the company.

 

That's absurd.  Any buyback will increase the value of that share.  No dividend ever will.

 

You appear to be saying that the management only cares about the value of the share itself, and not the enrichment of the shareholders.

[ERICOPOLY]

You are keeping your personal ownership unchanged, by selling some stock, but those continuing shares represent a higher ownership of the company and there's nothing investors can do about it.

 

Well of course the shares represent a higher ownership stake.  There is no "but".  That's the whole point -- you can sell some to get the offsetting amount of cash (tax-advantaged "dividend"), and yet maintain the same ownership stake.

 

That's an identical amount of cash as you'd get with a dividend, and an identical remaining ownership stake.  The only difference lies in the taxes you owe.

 

 

The company also has an obligation to the continuing investor underlying the shares you sold

 

Yes of course they do.  There is nothing "missing" in my account.  This new shareholder (if it's not the company itself) will be thrilled to be treated in a more tax-efficient manner. 

 

loop()

{

    company stock buyback

    offsetting share sale by investor  (creating new shareholder potentially)

}

 

The new potential shareholder just lives in this loop like the rest of us.

[Munger_Disciple]

If the company stock is considerably overvalued, they can announce a tax-efficient buyback the following way:

 

If the dividend taxes were zero, we would rather pay out this capital as a dividend. But since the taxes on dividends are not zero, we are announcing a buyback of x% of total shares outstanding at this ridiculously overvalued stock price just so that all of you shareholders can sell x% of your holdings back to the company and create a very tax-efficient dividend for yourselves.

[thepupil]

Not sure if it's been mentioned, but a large % of institutions and individuals money in the market is non taxable or tax defered , so there is little pressure on management to be tax efficient.

[JSArbitrage]

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

 

What? This doesn't make any sense. 

 

First, from a practical perspective, you don't know if Management destroys shareholder value until it does - at which point it's too late to sell your shares.  Secondly, if the stock price appreciates, do shareholders take the credit for that great decision or does Management?  So it's shareholder's fault if the stock goes down but Management's credit if the stock goes up?

 

Secondly, Management is entrusted with the stewardship of a Company's capital.  If I rent your house from you and then I burn it to the ground with a can of gasoline, is that my fault or your fault?  Let me burn down your house and see if you blame yourself.  Something tells me you'd demand I be put in prison and you'd sue the crap out of me.

 

 

[ERICOPOLY]

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

 

What? This doesn't make any sense. 

 

First, from a practical perspective, you don't know if Management destroys shareholder value until it does - at which point it's too late to sell your shares.  Secondly, if the stock price appreciates, do shareholders take the credit for that great decision or does Management?  So it's shareholder's fault if the stock goes down but Management's credit if the stock goes up?

 

Secondly, Management is entrusted with the stewardship of a Company's capital.  If I rent your house from you and then I burn it to the ground with a can of gasoline, is that my fault or your fault?  Let me burn down your house and see if you blame yourself.  Something tells me you'd demand I be put in prison and you'd sue the crap out of me.

 

You make the point that value is not destroyed until it is.  Please stop talking like a fortune cookie and say it in a way that I can respond to.

 

I don't know where you are going with the bit about prices going up and down, and who takes credit for it.

 

Nor do I understand what the burning house is referring to.

[Hielko]

ERICOPOLY: I probably agree with you more than most, but I do think there is a flaw in your thinking in practice.

 

1. As a shareholder you don't know exactly how many shares the company is buying, so it is impossible for you to sell an equal amount of offsetting shares

2. Even if you would know how much shares management is buying back you would be unable to sell the same amount because of transaction costs (minor point)

3. Because of 1. you are more or less forced to sell as soon as shares cross your intrinsic value estimate because if the possibility of share repurchases exist there is an possibility that as a continuing shareholder you see value destruction while in other scenarios a company that is trading above IV might be worth keeping (they could for example use their overvalued stock in an acquisition and actually create value)

4. For some investors a dividend might be a better option compared to a share repurchase because they don't have to pay dividend taxes, but they would have to pay transaction costs to sell shares in lieu of a dividend.

5. If the company is repurchasing shares regardless of valuation it forces the investor to evaluate daily to buy or sell. Not everybody wants to have that on their plate.

[yadayada]

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

 

What? This doesn't make any sense. 

 

First, from a practical perspective, you don't know if Management destroys shareholder value until it does - at which point it's too late to sell your shares.  Secondly, if the stock price appreciates, do shareholders take the credit for that great decision or does Management?  So it's shareholder's fault if the stock goes down but Management's credit if the stock goes up?

 

Secondly, Management is entrusted with the stewardship of a Company's capital.  If I rent your house from you and then I burn it to the ground with a can of gasoline, is that my fault or your fault?  Let me burn down your house and see if you blame yourself.  Something tells me you'd demand I be put in prison and you'd sue the crap out of me.

management destroys value if they buy overvalued stock. So that means that you made a mistake buying overvalued stock. You bought 80 cents for 1 dollar basicly. If you do your job right as a vallueinvestor, you will never have to worry about this. Because the stock is always cheap, as you sell as it starts to be expensive.

 

It would only be a mistake if they should have reinvested it in the business instead. This would be bad. Get a 10% return with buybacks, a 5% return with dividends, but if they would have gotten a 20% return by investing in the business then buying back is a mistake. But vs dividends it never is a mistake if the stock is trading below intrinsic value.

 

For example if a company is fast growing, it could trade on high multiples. But this could still be cheap. BUT it is not cheap if they are using too much capital to buy back. You are basicly buying the stock hoping it will grow earnings and reinvest capital at attractive rates.

 

But if they are matured and trading at depressed valuations, buying back makes lot's of sense. OR if they are growing moderately, and have left over capital and growth, ROIC and competitive advantage (ie: risk) is not properly priced in yet. Or simply if they don't need a lot of capital because ROIC is very high.

 

But if you own for example Intel now if it was trading at 40x earnings, then yeah your an idiot. Sure buying back is bad on their side, but not very relevant as the more relevant thing is, why the hell are you owning intel at 40x earnings, it is matured for the most part!

 

So to boil it down, if it is very likely that the stock will have a larger market cap 5-10 years from now, and they don't have cash to invest elsewhere at attractive rates, then buying back is always preferable over dividends.

[ERICOPOLY]

1. As a shareholder you don't know exactly how many shares the company is buying, so it is impossible for you to sell an equal amount of offsetting shares

 

Well, that depends.  Perhaps if the company has a large amount of capital to return, they merely announce a tender offer.  It's pretty straightforward in that case.

 

Or perhaps they regularly pay a dividend every quarter.  They announce that instead they'll purchase an equivalent amount of stock each quarter instead.  Quarter after quarter they buy, and quarter after quarter you sell.  Sometimes you sell higher than they bought, sometimes you sell lower than they bought -- over the long run, this is just a wash.

 

The thing though that I was primarily commenting on (that got the fortune cookie quality response) was the shareholders who say management destroyed their value by purchasing overvalued stock.  Well, was it overvalued only in hindsight?  If not, then why were they still shareholders at the time?  Why didn't they all sell?  For a stock to be overvalued, there must be a lot of shareholders who want to hold onto it at that price -- that's a given.  So are those the people who cry foul later on?  Let's say the stock is worth $10 and trades at $20.  Later it will drop back to $10, so they cost themselves $10 per share of losses by not selling.  Instead of beating themselves up over it, they will blame management for buying $1 of shares back at $20 instead of paying a dividend.  So the scoreboard now reads that they cost themselves $10 but don't blame themselves, and they instead claim that management is a poor capital allocator for having wasted 50 cents.  It's insane.  This is why I'm saying they having nobody to blame but themselves -- the shareholders are the idiots who made the whopper of misallocation decisions by not selling at $20.

 

Who are they to point fingers at management? 

 

 

[JSArbitrage]

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

 

What? This doesn't make any sense. 

 

First, from a practical perspective, you don't know if Management destroys shareholder value until it does - at which point it's too late to sell your shares.  Secondly, if the stock price appreciates, do shareholders take the credit for that great decision or does Management?  So it's shareholder's fault if the stock goes down but Management's credit if the stock goes up?

 

Secondly, Management is entrusted with the stewardship of a Company's capital.  If I rent your house from you and then I burn it to the ground with a can of gasoline, is that my fault or your fault?  Let me burn down your house and see if you blame yourself.  Something tells me you'd demand I be put in prison and you'd sue the crap out of me.

 

You make the point that value is not destroyed until it is.  Please stop talking like a fortune cookie and say it in a way that I can respond to.

 

I don't know where you are going with the bit about prices going up and down, and who takes credit for it.

 

Nor do I understand what the burning house is referring to.

 

Yes, my point is that it's very easy to say, "It's the fault of the investor to own shares of a company when Management is destroying value."  But the problem with that thinking is that, by the time the investor/market realizes that Management is destroying value, you can't sell without a loss.

 

Secondly, your point above seems to indicate that you blame SHAREHOLDERS for owning shares of a company where Management is destroying value (i.e., shareholders need to take responsibility for their own decisions.)  But that's blaming the victim - a shareholder cannot create or destroy business value.  They can only buy, hold or sell.  Only Management can destroy business value.  Don't blame shareholders for which they have no responsibility. 

[ERICOPOLY]

But the problem with that thinking is that, by the time the investor/market realizes that Management is destroying value, you can't sell without a loss.

 

You don't believe a shareholder can assess when shares are overvalued?  And why would they not be selling their shares (perhaps to management's buyback program) when they are known to be trading at overvalued levels?

 

Shares worth $10 are trading for $20.  They know it's only worth $10, they know they could sell and pocket $20 per share, but for some reason they don't and ride it back to $10.

 

They cost themselves $10.  Management bought back $1 of shares at $20 and cost them 50 cents.

 

You are saying that by the time they discover management's value destruction it's too late.  That claim of yours makes no sense, because they've been staring at the overvalued $20 ticker for days/weeks/months/years before it collapsed.  Quarter after quarter they could sell after learning of the buyback.  Not much stock gets bought back in any one quarter if you are talking about a regular and habitual buyback program, so very little is on the line in any one quarter exposed to a plunge in price after purchase.  Truly, it's picking nits there to complain about a small amount from one quarter -- easily smoothed over by the regular tax savings over time.  And if it's a big amount in one quarter, it can certainly be neatly handled by a tender offer.

 

There will also be times when they buy and you didn't know about it, but you luckily sell at a higher price the next quarter after reading the news of the buyback. It all balances out over time.

 

[JSArbitrage]

The person who destroys value by holding overpriced shares is... YOU!!!!!!  Don't blame the management, take responsibility for your own boneheaded decisions.  They buy some shares that you decide not to sell... you blame them.  Hmm... why is it again that you are still holding the shares anyhow?

 

What? This doesn't make any sense. 

 

First, from a practical perspective, you don't know if Management destroys shareholder value until it does - at which point it's too late to sell your shares.  Secondly, if the stock price appreciates, do shareholders take the credit for that great decision or does Management?  So it's shareholder's fault if the stock goes down but Management's credit if the stock goes up?

 

Secondly, Management is entrusted with the stewardship of a Company's capital.  If I rent your house from you and then I burn it to the ground with a can of gasoline, is that my fault or your fault?  Let me burn down your house and see if you blame yourself.  Something tells me you'd demand I be put in prison and you'd sue the crap out of me.

management destroys value if they buy overvalued stock. So that means that you made a mistake buying overvalued stock. You bought 80 cents for 1 dollar basicly. If you do your job right as a vallueinvestor, you will never have to worry about this. Because the stock is always cheap, as you sell as it starts to be expensive.

 

It would only be a mistake if they should have reinvested it in the business instead. This would be bad. Get a 10% return with buybacks, a 5% return with dividends, but if they would have gotten a 20% return by investing in the business then buying back is a mistake. But vs dividends it never is a mistake if the stock is trading below intrinsic value.

 

For example if a company is fast growing, it could trade on high multiples. But this could still be cheap. BUT it is not cheap if they are using too much capital to buy back. You are basicly buying the stock hoping it will grow earnings and reinvest capital at attractive rates.

 

But if they are matured and trading at depressed valuations, buying back makes lot's of sense. OR if they are growing moderately, and have left over capital and growth, ROIC and competitive advantage (ie: risk) is not properly priced in yet. Or simply if they don't need a lot of capital because ROIC is very high.

 

But if you own for example Intel now if it was trading at 40x earnings, then yeah your an idiot. Sure buying back is bad on their side, but not very relevant as the more relevant thing is, why the hell are you owning intel at 40x earnings, it is matured for the most part!

 

So to boil it down, if it is very likely that the stock will have a larger market cap 5-10 years from now, and they don't have cash to invest elsewhere at attractive rates, then buying back is always preferable over dividends.

 

Let me first say that I think Eric is correct in theory - buybacks and dividends are essentially a functional equivalent in liquid public stocks because you can always create your own dividend by selling your pro-rata share of ownership.

 

But my issue is that I think value investors tend to (a) overestimate the number of securities that are undervalued at any one time and (b) overestimate the ability of Management to counter-cyclically react to the market (i.e., buy when the stock is low and sell when the stock is high.)  I can probably count on one hand the number of CEOs that did it successfully (think of all those SHLD buy-backs at $160/share).

 

I would also like to note that as a smaller investor (a) my required return is probably much higher than that of a public company so I'd rather have the cash in most situations and (b) transaction fees are a real issue so continually selling stock to create functional dividends is difficult. 

 

But Eric is correct - it's basically a Miller/Modigliani argument.  Absent taxes/transactions costs, dividends and pro-rata stock sales are the same.

[JSArbitrage]

But the problem with that thinking is that, by the time the investor/market realizes that Management is destroying value, you can't sell without a loss.

 

You don't believe a shareholder can assess when shares are overvalued?

 

 

No, I think the average retail investor cannot make that assessment.  They are in a position where they must trust Management to make their capital investment decisions for them (that's why CEOs make tens of millions of dollars after all.)  So I do not think it is fair to blame retail shareholders for the actions of multimillionaire Management teams.

[morningstar]

You don't believe a shareholder can assess when shares are overvalued?

 

A shareholder can certainly do this to enhance their returns, but it's not their job in the traditional understanding of the company-investor relationship nor are the majority of shareholders approaching the market in that way. It also doesn't have any impact on the company's responsibility to maximize value for continuing shareholders ... which isn't enhanced by buying back overvalued stock ... any more than it would be enhanced by purchasing overvalued stock of another, different company.

[ERICOPOLY]

But the problem with that thinking is that, by the time the investor/market realizes that Management is destroying value, you can't sell without a loss.

 

You don't believe a shareholder can assess when shares are overvalued?

 

 

No, I think the average retail investor cannot make that assessment.  They are in a position where they must trust Management to make their capital investment decisions for them (that's why CEOs make tens of millions of dollars after all.)  So I do not think it is fair to blame shareholders for the actions of Management.

 

The capital allocator of the average retail investor is a mutual fund manager.

 

And using your term, isn't that a multi-millionaire management team?

 

[JSArbitrage]

But the problem with that thinking is that, by the time the investor/market realizes that Management is destroying value, you can't sell without a loss.

 

You don't believe a shareholder can assess when shares are overvalued?

 

 

No, I think the average retail investor cannot make that assessment.  They are in a position where they must trust Management to make their capital investment decisions for them (that's why CEOs make tens of millions of dollars after all.)  So I do not think it is fair to blame shareholders for the actions of Management.

 

The capital allocator of the average retail investor is a mutual fund manager.

 

I don't think the average mutual fund manager can do it either.  I think being good at spotting overvalued/undervalued stocks is really, really, really hard in truth.  Maybe less than 1 percent of investors have that ability over the long-run. 

[ERICOPOLY]

But the problem with that thinking is that, by the time the investor/market realizes that Management is destroying value, you can't sell without a loss.

 

You don't believe a shareholder can assess when shares are overvalued?

 

 

No, I think the average retail investor cannot make that assessment.  They are in a position where they must trust Management to make their capital investment decisions for them (that's why CEOs make tens of millions of dollars after all.)  So I do not think it is fair to blame shareholders for the actions of Management.

 

The capital allocator of the average retail investor is a mutual fund manager.

 

I don't think the average mutual fund manager can do it either.  I think being good at spotting overvalued/undervalued stocks is really, really, really hard in truth.  Maybe less than 1 percent of investors have that ability over the long-run.

 

The mutual fund managers do however have the ability to sell an offsetting amount of shares each and every quarter if they are capable of reading an earnings release (where they mention the number of shares sold).  They also have the expertise to understand what the phrase "tender offer" means and execute on it -- even if they don't understand the valuations, they could get a hint from management that the tender offer is just the new dividend system.

 

Also, keep in mind that the average retail investor who does it on his own is instructed to "dollar cost average", which means that once he gets his dividend he just buys more shares at the market price anyhow.  Only he can't afford as many after paying his dividend tax.  So he gets hurt -- and in that scenario would be better off if management just bought more share on his behalf.

[ERICOPOLY]

All those bogle-heads just say a person should reinvest his dividends.  That's probably what winds up happening.  Dollar-cost averaging.

 

In an overvalued market, (the one where you want management to pay dividends), that doesn't help your retail investor much.  So he's going to buy those shares with the dividend anyway -- only because of dividend taxes he's really getting screwed... not only buying overvalued shares, but a lot fewer of them.

[ERICOPOLY]

Anyways, I think that's likely the reality of it.  It's not like these fund managers or retail investors are going to patiently let their dividends pile up and then reinvest them once the market drops.

 

After all, you've already argued that they don't even know it's overvalued in the first place.

 

So they'll just reinvest the dividend.  Why would they do otherwise if they can't value the stock?