The paradoxes of shareholder primacy and ‘short-termism’

In a recent speech “Who owns a company?”, Andy Haldane has this to say:

In the earlier period, dividends decreased as often as they increased.  This is as we would expect if profits fluctuate both up and down.  After 1980, however, we see a one-way street. Dividend payout ratios almost never fall.  This is evidence that the short-term quest for smoothing shareholder returns has come to dominate payout behaviour, almost irrespective of profitability.

Is short-termism quite the right expression for this phenomenon? ¹ Even if you could divide a company’s share register into those with short and long-term investment horizons, there’s a paradox. Other things being equal, increasing the steadiness of the dividend stream doesn’t meet short-term shareholder needs. Firstly in a liquid share market, the distinction between income and capital value is pretty artificial. Shareholders generally seek the best return of income plus capital gain they can. And not only would you expect that. In a well-functioning market, the payment of a dividend would be reflected in an equal and opposite movement in the capital value of the companies’ shares, but that’s pretty much what you do see – at least on the day that shares go ex-dividend. ²

So it seems to me that this transition towards more steady payment of dividends can’t be explained by a move towards ‘short-termism’, or if it is, there’s something more to be explained – which is why such behaviour is more consistent with the interests of short-term than long-term investors. So I think we need to go looking for the real phenomenon here in the conditions under which the market might reward this kind of behaviour – which is clearly damaging to the wellbeing of companies in the market. It seems to me that the answer is tied up in the transition from some earlier form of capitalism towards managerial capitalism.  If the capital market acted rationally, then, other things being equal, it would mark down companies that maintained continuity in their dividend payments when profitability fell, because this suggests bad management and increases in the firm’s financial fragility. ³

It’s also consistent with a pattern of managers withholding bad news from their shareholders and the market. The authors of Do Managers withhold bad news find that … they do. They find that, when they occur, dividend cuts are substantially larger than dividend increases which, if one presumes a steady flow of good and bad news suggests that “management waits and allows bad news to accumulate before cutting dividends”.

And – here’s the thing – the market assumes this (bad) behaviour is normal. So when dividends are cut, markets assume that managers have been busy trying to cover up bad news but that things have got sufficiently bad that they’re being forced to ‘fess up. Markets thus punish dividend cuts more heavily than they reward dividend increases. So if you’re a good manager who just wants to cut your dividend because it would be prudent capital management, you’ll think twice about it because the market won’t believe you. Instead, it will mark down your stock. And if you’re a CEO you could get sacked. So the incentives are to do what the bad managers do and not fess up to bad news unless you have to.

This is the bullshit doom loop in which not only do bullshitters find themselves rewarded, but, as bullshitting becomes more prevalent, truth-tellers find their viability further and further eroded. So, like commentators bullshitting on about who won the latest candidates debate, not in terms of who’s arguments were better, but rather in terms of who most successfully put themselves over, it seems ‘the markets’ expect the same.

Thus a kind of rhetorical reflexiveness enters the market. If a company continues to pay steady dividends from continually diminishing profits at some stage a “Wylie B. Coyote” moment ensures that the market reverts to its traditional role of punishing poor performance and rewarding good performance, but it rewards managements that can bullshit their way through a rough patch until things improve.

In what may have been my first Troppo post on bullshit I asked: “Is there more of it about these days?” I was in little doubt that there was. And exhibit A was John Clarke, our poet laureate of bullshit much of who’s schtick would have gone over our heads a generation or two ago. Well, steady dividend payments is a nice quantitative measure of the amount of bullshit about – and it turns out there’s been a regime change.⁴

Most perversely of all the economic drivers of bullshit are the principal/agent problem. The principal-agent problem is bad where it’s difficult for principals to judge the quality of agents’ behaviour from a distance. Thus for instance managers might put too much emphasis on externally visible phenomena – the credentials or reputations of key employees (irrespective of how predictive they are of good performance), the ‘brand’ of major contractor or consultant (No-one ever got fired for buying IBM). Where one could understand if there was more of this about (and I think there is more of that about), here it is quite easy to see that, in principle, managers are managing irresponsibly. And yet somehow the culture of pretend incubates and grows within the market as bullshit and groupthink take over amongst investors take over, and managers respond with gaming and willful blindness.

But smooth dividends is the tip of the iceberg. The same forces lead to the secular over-payment of dividends and share buy-backs. One stylised fact which corroborates this is that the hurdle rates for projects within companies are notoriously higher than the rate of return on the company’s shares suggesting that shareholders money is being left on the table.

Davies et al, 2014 report “significant evidence of myopia, which appears to be increasing over time”:

There is both direct and indirect evidence of investment having been adversely affected by short-termism on the part of either investors or managers or both. …

Based on a survey of over 400 executives, Graham et al. (2005) found over 75% would give up a NPV-positive project to smooth earnings.

Dividends provide a signal about earnings that investors can observe. This means the manager has the incentive to surprise the market with high dividends, even if this means cutting investment. Investors understand this, and discount these inflated dividend signals accordingly. In equilibrium there are no surprises, but dividends are higher and investment lower than with full information.

And the impact of this is possibly huge – worth more than any amount of micro-economic reform.

Studies in the US have found evidence otherwise-identical private companies consistently invest considerably more, for given profits, than public companies (Asker et al (2014)). …

These results suggest, overall, that UK private firms tend to plough back between 4 and 8 times more of their profits into their business over time than publicly held firms. …

1. 1. One preliminary point needs to be got out of the way for the purposes of discussion. There are two sides of the dividend transaction – the company and the shareholder. One possible legitimate reason for companies maintaining a more stable dividend policy is that their shareholders appreciate this and that shares are in competition with other assets like bonds and deposits and that therefore a more stable dividend policy represents a new compromise between the interests of the shareholders and ‘the company’ (ignoring the obvious fallacy of composition in that contrast). So to some extent, this development may not be pathological. I’m proceeding on the assumption that it’s not as simple as this – that this development suggests something fishy is going on.[↩]
2. 2.Indeed, in an efficient capital market, other things being equal, one can think of two reasons those with short-term time horizons might prefer capital gains to income. Dividends generate slow, steady gains whereas capital gains can come quickly as the market reevaluates its view of the long-term potential of a stock. And dividends are usually less tax-efficient than capital gains (though in Australia franking credits complicate this story.)[↩]
3. 3. Again I’m leaving aside the prospect that volatility of profits is likewise suppressed by management’s accounting decisions.[↩]
4. 4. This may not mean that management is worse now than back in the day when companies dividend payout ratios tracked their financial needs more. It may well have been that in those halcyon days, managers simply suited themselves more. They probably got home earlier. How all the costs and benefits of the changes we’ve seen come out in the wash is anyone’s guess. What we can say is that a particular practice which clearly suggests poor management is getting worse and, paradoxically that it’s getting worse in response to increased shareholder scrutiny of management.[↩]