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Wall Street ballyhoo and flim-flam to the contrary, the year 2005 closed-out half a decade of misery and pain for the average investor in US equities according to Federal Reserve flow of funds accounts F102 and L102.
Investors Forsaken by the SEC
During these years, the SEC, the investors’ watchdog, had forsaken investors and averted its gaze from the diversion of shareholder wealth through buyback-option schemes, while appearing to protect shareholders’ interest with the show trial of Martha Stewart, for a matter unrelated to ordinary investors’ well-being.
With January 2000 as a starting point, the Federal Reserve flow of funds accounts show that stock investors were down $4.3 trillion in portfolio value and dividend payouts in 2005 were only running at about the same level as in 2000, five years earlier.
The grim truth
As the graph shows, average cash dividend yields never surpassed 3.8% during the period, and most of this meager dribble, so grudgingly conceded by corporate boards, was consumed by taxes and management expenses of the open-end mutual funds through which most investors held their shares.
Dividends, Non-financial Corporations 2000-2005
The frugal saver who, believing in the Common Stock Legend, had invested $500,000 in the stock market in a widely diversified portfolio of equities in 2000 through a mutual fund, would only have about $360,000 left in 2005. This portfolio would throw off only about $2,000 in cash to the frugal saver, after deducting expenses of fund management and income taxes.
In contrast, a more skeptical investor might have bought a diversified portfolio of tax exempt municipal bonds in 2000, and enjoyed an after-tax income of $30,000 a year through the period, while still keeping his or her $500,000 nest egg intact.
Happy days for corporate executives
All was not gloom, however, in the executive suites of the public corporations, thanks to the diversion of $765 billion in corporate funds through stock buybacks, some of which found its way into executive pockets through the artful use of stock options.
They were able to pull off this marvelous trick by claiming that stock buybacks were just a more ‘tax efficient’ form of dividends, to the cheers of Wall Street brokers and fund managers, with the blessing of Nobel-prize economists.
An article in the Economist magazine (January 9, 2003), entitled ‘The Dividend Puzzle’, explained:
In the past decade, there was also a sharp increase in firms returning surplus cash to shareholders by buying back their shares, instead of through dividends.
The declining role of dividends was encouraged by the theories of academics, many of whom instructed today’s top managers in business school.
One Nobel-prize-winning theory suggested that whether or not a firm paid a dividend should make no difference to the value of a firm to investors.
Is selling stock at a loss a good deal?
Now, even someone without the benefit of a Harvard MBA should be able to figure out that a shareholder doesn’t need to do anything to receive an ordinary dividend, but absolutely must sell stock (which presumably cost something) to get a ‘dividend’ in the form of a stock buyback.
The average investor who bought stock in the year 2000, would have had to sell this stock at a loss to have benefited from the $765 billion in stock buybacks so generously provided by corporate managers during the five year period, 2000-2005.
In selling stock to benefit from the dividend equivalency of a stock buyback, the average investor would simply have locked in his or her loss for all time.
Of course, corporate executives can regard stock buybacks as a true dividend, because, in effect, they pay nothing to get the stock they have to sell.
Since the exercise and sale of stock can occur virtually simultaneously, the executive need never spend cash to receive this form of ‘dividend’.
What might-have-been
Suppose that people were smart enough not to listen to the theories of the Nobel economists and that boards of directors, instead of authorizing buybacks, had approved an equivalent amount to be distributed as regular cash dividends to all shareholders fairly.
Might-Have-Been Dividends Plus Buybacks
The graph (adding dividends with buybacks) shows that dividend yields would have risen nicely over the years 2000-2005 and investors would not have had to lock-in losses to reap this benefit.
At these higher yields, more cash would have filtered down to investors after management fees and taxes and everyone would generally be better off — except, of course, corporate management who would be deprived of the rich bonanza of stock buybacks.
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