The end of business ownership?

Recently, the Trump administration called for defense contractors to suspend dividend payments in favor of increased expenditure on research and development. This isn’t the first time the federal government has involved itself in dividend policy—consider the limitations placed on banks, most notably after the 2008 crisis. Nonetheless, and without getting into the merits of the case at hand, this seems a moment to revisit the question of what dividends are even for.

Throughout the history of commerce—from the Dutch East India Company in 1602 through the American Industrial Age and well into the 1980s—the relationship between a business and its owners rested on a simple proposition: successful enterprises paid their owners a share of the profits. This didn’t mean dividends were always paid. As a practical matter, for instance, startups, turn arounds, and failing businesses generally can’t afford to pay dividends. 

Dividends and volatility

Mandated nonpayment of dividends, however, would transform stock market investing from a standard if attenuated form of business ownership into something quite different, rendering investors solely dependent on price gains (or losses). While that has, frankly, become the dominant approach in the US stock market over the past four decades, it’s still a strange form of business investment. Without current or prospective dividends, the investor’s return is a market outcome—determined by other market participants—rather than a business outcome reflecting the company’s operations.

The owner of rental real estate does not check Zillow between 9:30 and 4:00 every day to determine building values. Instead, the point of the exercise comes in the form of monthly rent checks. Yes, the market price matters when the owner buys and eventually sells, but in the interim, the distributable cash flow, less expenses, defines the investment’s success.

Similarly, for some dividend investors, a certain amount of share price volatility may be tolerable because of the income they receive from the dividend stream. But without dividends, volatility is all that matters. A 20% drawdown cannot be ignored; it’s a destruction of wealth that can only be repaired by a subsequent 25% gain, which itself depends entirely on market sentiment reversing. The standard deviation of returns—that academic measure of risk that has not been as relevant to dividend investors—suddenly becomes the central fact of investment life. ​

Furthermore, in a dividend-paying regime, successful enterprises face discipline: they must generate sufficient cash to meet their dividend obligations while also funding necessary investments. This creates a healthy tension that helps address the core agency cost of investing in modern, large-scale enterprises. Management cannot hoard cash indefinitely or squander it on empire-building acquisitions. But in an environment in which dividends are shunned, this discipline evaporates. Management has the ability to sit atop a pile of cash and do with it as it pleases.

How we got here

It’s worth noting that we’re already quite far down this road, even without a formal prohibition on dividends. The S&P 500 yields less than 1.2%. Why? The answer lies in the 40-year decline in interest rates from 1982 through 2020. As rates fell, the cash hurdle that stocks needed to clear fell with them. Investors grew accustomed to lower yields, then minimal yields, then no yields at all. In a world of perpetually declining rates, anything was possible: growth stocks with no earnings, mature companies with no dividends, valuations detached from any discounted cash flow logic.

As things stand, one-fourth of the index by market capitalization pays no dividend at all, and another fourth yields less than one percent. These aren’t distressed companies or early-stage ventures; they are the largest and most successful corporations in America. That they maintain a dividend-free or dividend-light relationship with their owners is, from a historical perspective, highly anomalous. A government prohibition on dividends would simply codify and universalize the arrangement.

Conclusion

All this being said, the administration has a point. The US has underspent on its infrastructure for decades. We’ve outsourced too much, and now the pendulum is rightly swinging back to greater corporate investment.

Would the resulting substantial increase in investment spending by US corporations potentially pressure dividend payments? Quite possibly, although there’s nothing inherently wrong with the capital allocation pendulum swinging back toward greater investment.

But having the government set the specific terms of capital allocation and disposition is another matter entirely. Hopefully, cooler heads will prevail and it will not come to that extreme a stance.