The recent market sell off has provided investors an opportunity to reconsider a fundamental belief in modern finance and investment. And that is that investors are indifferent between the two forms of return, a harvested capital gain or a cash dividend payment. That notion underpins pretty much all of modern stock market investing, from the calculation of return, to the capital allocation of corporations, to the behavior of investors. In short, it’s a biggie. And in a rising market, it looks like a pretty good assumption, since most of the time the market is up, open and liquid.
The belief is also a central tenet in the academic narrative about, or shall I say, against dividends. Mathematically a dividend payment and capital gain are identical, particularly in academic exercises involving rational actors and “perfect” markets. In making their famous “dividend irrelevancy” argument from 1961, Nobel prize-winners Merton Miller & Franco Modigliani treat the matter casually: “investors always prefer more wealth to less and are indifferent as to whether a given increment to their wealth takes the form of cash payments or an increase in the market value of their holdings of shares.” Almost all subsequent academic writing on the topic agrees with that assertion. Famed financial journalist Peter Bernstein sided with academics when writing that “money is money, whether we dress it up in the costume of income or the costume of principal.”
From a business ownership perspective, however, they are not the same, not even remotely in the same league. The logic of business ownership, particularly for minority shareholders of publicly traded companies, makes a cash distribution from profits—not going into the marketplace to harvest potential capital gains—the natural mechanism for sharing in the success of an enterprise. A dollar may be fungible; how it is generated is not. Let that be considered a maxim of business ownership. It is a matter of philosophy, not mathematical formulas.
Beyond the philosophical differences, there are plenty of real-world ones, such as trading costs, market conditions, and differential tax rates, that may make a dividend or a harvested capital gain more or less preferable than the other for individual and institutional investors. Whether in theory or in practice, these two activities—on one hand, clipping your coupons; on the other hand, going out and selling appreciated securities—are most certainly not the same. Having capital gains depends on market sentiment, on the views of people often far removed from the activities of a company. In contrast dividends are a function of a company’s operations. Drawing this distinction—between a capital markets activity and a business outcome—may be the most important assertion in my upcoming Ownership Dividend.