The central focuses of Third Avenue Value Fund (TAVF) in making investment decisions revolve around understanding the characteristics of securities and how corporations function: why they do what they do. This entails a concentration on corporate finance, strictly from the bottom up.
In contrast, economists such as R. Glenn Hubbard, Chairman of the Council of Economic Advisers and the principal proponent of dividend tax relief, and Alan Greenspan, Chairman of the Federal Reserve Board, are essentially top-down economists. Their concentrations are on factors such as the general economy, the behavior of markets, and the general level of prices.
It seems to me that a lack of concentration on bottom-up corporate fundamentals, and probably a lack of training in corporate finance, can lead Professor Hubbard and others like him to recommend courses of action that can be quite harmful to the country (even when the proposals might result in net benefits to the stockholders of the Third Avenue portfolio companies over the long term).
One such proposed action is President Bush’s proposal to amend the Internal Revenue Code so that corporate dividends derived from corporate earnings on which taxes have been paid by the corporation would be non-taxable to the recipient shareholder-taxpayer. Further, a shareholder would increase his cost basis for common stock held insofar as a corporation retains earnings on which corporate taxes have been paid.
Three results seem sure to follow if the Bush proposal is ever adopted:
- Businesses will not receive any material incentives to increase their investments in productive assets.
- Governments, both Federal and State, will be deprived of much needed revenues.
- The Internal Revenue Code will become materially more complicated than it already is at a time when strong arguments ought to be made for tax code simplification.
Third Avenue analyzes any company as a stand-alone, not substantively consolidated with its shareholders. This idea of the company as a stand-alone used to be, but no longer is, a “pervasive principle” governing Generally Accepted Accounting Principles (GAAP). The stand-alone concept, however, pervades almost all credit analysis. If each entity filing a tax return is viewed as substantively consolidated with another taxpaying entity, then every taxpayer is subject to double taxation, triple taxation, quadruple taxation, or n times taxation. This “extra” taxation phenomenon is hardly limited to shareholder recipients of certain corporate dividends. A wage earner, for example, pays income tax on the earnings received. This after-tax income is again subject to sales taxes, real estate property taxes, state income taxes, and city personal property taxes. Indeed, if the wage earner purchases an automobile, the price paid by the wage earner-taxpayer includes the cost of taxes paid by the automobile dealer, the automobile transporter and the automobile manufacturer.
Insofar as one desires a fair tax system, each taxpayer ought to be viewed as a stand-alone, filing his, her, its, or a joint return. The tax rate applicable to that taxpayer ought to reflect the appropriate rates relevant to that taxpayer’s circumstances. There seems to be no way in the U.S. economy that double, triple or quadruple taxation can ever be eliminated. There does not appear to be any reasonable basis for picking out corporate dividends for such tax-exempt largesse.
Corporations that generate cash, or taxable earnings, can use the amounts so generated in only three ways:
- Expand the asset base.
- Pay creditors.
- Make distributions to shareholders either via dividend payments or repurchasing shares.
With one exception, and I believe the exception is a minor one, making cash distributions to shareholders has to be a residual use of cash. Meeting the needs of the business to maintain or increase the asset base and servicing creditors has to take priority over paying out cash to shareholders. The one exception to this exists insofar as making distributions to shareholders might give the company better access to capital markets, especially equity markets, than would otherwise be the case.
The vast majority of equity financing for American industry is done by having companies retain earnings, not by marketing add-on issues of common and preferred stocks, either publicly or privately. We examined the changes in Net Worth Statements for each of the 30 companies whose common stocks made up the Dow Jones Industrial Average for 2000 and 2001. Except for the exercise of stock options, in each case the increases in net worth were attributable to increases in retained earnings, i.e., net income minus cash distributed to shareholders via dividends and share repurchases. The sale of add-on issues of common stocks was a non-factor.
The best way, and frequently the only practical way, for a company to reduce its debt load is to increase net worth through retaining earnings at a time increases in assets are minimal. Cash payments to shareholders reduce net worth. It is common, indeed, for loan indentures and bank loan agreements to contain provisions forbidding, or restricting, cash payment to shareholders.
The principal reason companies do equity financing by retaining earnings is that public markets are so capricious; and it tends to be difficult to market equity privately if the purchasers of such equity do not receive elements of control over the corporation. Sound managements would not be very sound if they managed as if they could control the timing of the sale of add-on issues of common stock publicly and if they managed in the belief that they could predict future stock market prices. Selling add-on issues of common stock is a very dicey game for most managements whose companies are not benefiting from the presence of speculative bubbles such as existed in 1998 and 1999. Selling add-on issues of common stock is also quite expensive for most companies and/or their shareholders. Access to capital markets tends to be a lot more rational for credit markets than it is for equity markets, even though there can be times when credit markets are completely closed as, for example, when commercial banks won’t lend.
The exception I refer to above is what I call the “electric utility exception.” This exception, while still present, seems to have become less the rule even for electric utilities. Integrated electric utilities were an extremely capital intensive industry (before the 1990’s growth of Independent Power Producers), where a company had to incur capital expenditures of $5 to $7 to produce $1 of annual revenue. Operating income was relatively stable and predictable, tending to grow modestly year-by-year. And the industry was a real growth industry with demand increasing in each year after World War II at rates of 2% to 7% per annum. Against this background, companies followed a policy of paying 70% to 80% of earnings as dividends; and then marketed add-on issues of common stock every 18 months to 2 years. The high dividends attracted investors interested in income and tended to assure companies that they would be able to market add-on issues of common stock at prices above book value. Marketing add-on issues above book value with regularity made it possible for the companies to report modestly increasing earnings per share year by year. This electric utility exception seems to be becoming rarer and rarer. It never was a good example of how most companies in American industry ever financed. It certainly is not a base case today, but rather a relatively rare exception.
Bush Administration officials estimate that the proposed dividend tax relief will boost common stock prices by 5%-10%. But the Bush Administration is, I suspect, just like the rest of us, or at least like me. I really don’t have a clue as to what will happen to general stock market prices. Neither, in my opinion, does anyone else. Market levels will, of course, be determined by myriad factors, a goodly portion of which cannot be foreseen.
There seems little reason to believe that dividend tax relief will give companies better access to capital markets than would otherwise be the case. The relief will have no particular effect on credit markets, other than to discourage lenders from lending if they think that the cash amounts being paid to shareholders is imprudent. The only sure effect it will have on other markets is that there ought to be a switch in mezzanine finance structures. Increasing amounts of Preferred Stocks ought to be marketed and there ought to be a material diminution in the amount of Subordinated Debentures marketed.
Insofar as dividend tax relief results in a revenue shortfall for governments, government deficits will increase. Budget deficits, whether for governments or corporations, mean that cash outflows exceed cash inflows. The shortfall is met by accessing capital markets; governments issue government debt while corporations issue claims and securities, including bank loans and common stocks. There is nothing wrong per se with budget deficits viewed in vacuo. Rather, it is the use of proceeds that counts the most. For example, the U.S. Government incurred deficits in the 1940’s and 1950’s to finance the GI Bill of Rights. A long-term consequence of the GI Bill is that the country ended up with a well-educated populace and a university system that is the envy of the rest of the world. On the other hand, if the deficits are used to finance losses and non-productive activities, the entity incurring the deficits, even the U.S. Government, will, sooner or later, suffer from diminished credit worthiness. I’ll leave it to each TAVF shareholder to decide for himself, or herself, whether the use of proceeds arising out of the expected 2003 government deficits will, on balance, be productive or non-productive.
One thing should be obvious though. There is no a priori reason to assume that expenditures by governments are less productive for society and the economy than expenditures by taxpayers are. Some are; some aren’t. Government expenditures to keep open unnecessary military bases seem a lot less productive than expenditures by private citizens for good housing. Government expenditures for education or airline safety seem a lot more productive than expenditures by private citizens to own, lease, or operate giant SUVs; or to give annual compensations of tens of millions of dollars (and sometimes hundreds of millions of dollars) to well entrenched Chief Executive Officers of underperforming companies.
While final rules have yet to be promulgated, it seems likely that dividend tax relief, if enacted, will result in administrative and enforcement nightmares for the Internal Revenue Service. Every deal person in the U.S. is probably salivating over the resource conversion possibilities inherent in allowing corporations down the road to become involved in things like cash out mergers and management buyouts where a substantial portion of the cash to be paid out would be tax-free to many recipients. For companies managed by their principal owners, there may well be dramatic shifts in whether payouts to owners are structured as compensation or as dividends.
With one exception, I would doubt that there would be any dramatic shifts in corporate capitalizations toward less debt and more equity because of dividend tax relief. For the vast majority of investors, TAVF included, credit worthiness is a far more important consideration than after-tax returns when investing for income. Few senior creditors seem likely to sacrifice safety for enhanced after-tax return. Credit instruments give holders a legally enforceable, contractual right to receive cash in the form of interest, principal and premium, if any. Equities do not give holders any legally enforceable contract rights to receive cash payments except that cash payments cannot be made to common stocks unless required payments are first made to cumulative preferred stocks, or redemption prices when due are paid on redeemable preferred stocks. Banks, insurance companies and finance companies are just not going to switch their portfolios to equities (assuming regulators or rating agencies would permit them to do so). These institutions will continue to be credit quality conscious first and foremost, as will individual holders of investment grade, tax-free, municipal obligations.
The one major change in corporate capitalizations likely to result from the enactment of dividend tax relief is in the area of mezzanine finance, a relatively small component of most corporate balance sheets. Here, there is likely to be a massive switch away from Subordinated Debentures to Preferred Stocks. While holders of Subordinated Debentures do enjoy a legally enforceable contractual right to cash payments, as a practical matter, having that enforceable right usually is akin to having the right to commit suicide because a Subordinate’s rights to cash payments virtually always are subrogated to the senior debts’ rights to priority payments. The vast majority of Subordinates are not very creditworthy to begin with.
Even now, in a going concern context but not a reorganization context, Preferred Stocks tend to have a de facto seniority over Subordinates in many instances. In many cases, holders of Preferreds are better off accumulating dividend arrearages than are holders of Subordinates who will never succeed in exercising their legal rights to cash payments. Preferred Stocks, as a class, would certainly become structurally senior to Subordinates insofar as Preferreds acquired elements of control, e.g., if the Preferreds became entitled to elect a majority of the Board of Directors if four quarterly dividends were passed. To my knowledge, with the exception of closed-end investment companies registered under the Investment Company Act of 1940, as amended, there are no publicly-traded Preferreds which have anywhere near such strong covenants. If dividend tax relief is enacted, smart financiers are likely to try to structure Preferreds where the “dividends” are entitled to an interest deduction at the corporate level but which pay to the security holder a tax exempt dividend. There would be attempts to make these instruments as creditworthy, in form or substance, as a senior loan, or even a secured loan. Perhaps combined tax bills of corporations and their preferred shareholders will be minimized via the issuance of exchangeable securities. Doing these things will, of course, further complicate the Rules and Regulations that are part and parcel of the Internal Revenue Code in that the Internal Revenue Service might have to do something about Senior Loans, masquerading in effect, as Preferred Stocks strictly for tax-shelter purposes.
It seems possible that an attractive business might develop for financial insurers willing to enhance the creditworthiness of Preferred Stocks. If so, the premium charged by the insurers ought to be a lot higher than when insurers credit enhance Senior Loans because the losses seem likely to be manifestly larger in the case of Preferred Stocks. If such a market ever develops, four companies whose equities Third Avenue owns — Ambac, American Capital Access, MBIA, and Radian — ought to benefit.
If a company is viewed as a stand-alone, issuing add-on issues of common stock on which no cash dividend is paid, either in public offerings or mergers, has, for the company, a zero cost of capital. There is, of course, a cost of capital in this instance but the cost belongs to the shareholders, not the company. In that case, shareholders have to either put up new money or see their percentage ownership reduced. Where the company is committed to paying a common stock dividend, the cost of capital for the company when add-on shares are issued is the present value of the future dividend requirements. It is nonsensical to say that making dividends tax-free will reduce the cost of capital for a company. For that minority of companies who finance the way electric utility companies used to finance, there very well could be a reduction in the net cost of equity capital for the company. However, this seems unlikely to hold true for the vast majority of companies.
Individual companies, no doubt, will continue to follow disparate policies in the future just as they have in the past. For example, IBM seems to have been very successful during most of the 1990’s in following the policy of borrowing heavily, i.e., incurring deficits, and using the proceeds to buy-in its own common stock.
If enacted, the dividend tax relief proposal probably will be quite helpful for Third Avenue over the long term. Companies with dividend-paying ability might be worth a premium. First and foremost, companies with dividend paying ability are those with strong financial positions, i.e., cash on the asset side and enjoying substantial “surplus-surplus” (a relative absence of liabilities) on the obligation side. These are the types of common stocks in which the Fund invests. Further, the largest potential beneficiaries from dividend tax relief might be those who own common stocks selling at a discount from, or a small premium over, the amount of tax paid earnings retained after year 2000. It seems as if a major portion of book value for most companies consists of tax paid retained earnings. The TAVF portfolio is currently priced at around 1 times book value while the Standard & Poor’s Industrial Index is priced at around 4.6 times book value. The Fund may not realize on this proximity to book value advantage for several years. Third Avenue, however, remains with the advantage that its portfolio companies’ strong financial positions result in businesses with much above average dividend paying ability.
Regardless of whether or not dividend tax relief is enacted, I remain convinced that the TAVF portfolio is an attractive one.