It might seem somewhat pessimistic to start the new year on a downbeat note, but as the euphoria of Christmas fades, there is an area of equity investing that is overdue some criticism: dividends.
Now, I am not about to argue that income investing is, in itself, a bad thing. But what I am going to advocate is that a focus on this rather than on a balance between income and growth is a bad thing both for companies individually and, perhaps more importantly, for economic growth in aggregate.
We live in an unusual era: wealth is highly concentrated in the baby boomer generation, who are either already retired, or are close to retirement. The skew in wealth towards this demographic has a series of implications and while the populist media like to focus on the social implications of growing inequality and the rich-poor divide, I will focus on something with a potentially greater impact on Western markets and economies: the impact of an ageing and retiring investor base.
The problem as I see it is that as individuals move towards retirement, two things change in their investment requirements: firstly, they require income from their investments to replace the previous income from work, and secondly, but probably equally importantly, their time horizon progressively shrinks: an increasing awareness of their own mortality and consideration of the average life expectancy means that what happens 20 years from now seems broadly irrelevant. In economic terminology, their discount rate increases – they put less value on the future value of their investments and more on the current (realisable) value.
On a personal level these changes simply alter the types of investment that the individual is likely to select – probably lower-risk assets in general, but within equities, a clear preference for higher dividend paying, quality businesses. The problem, however, comes when a large proportion of the investor base (by assets, not number of people) shift to these preferences at a similar time.
The result, as we have seen in the investment industry, is a proliferation of income-generating products – a quick look at the top selling funds in 2012 shows a strong preference by investors for income. But as more and more fund managers build equity products seeking income, and as more and more investors shift into these products, the proportion of the stock market owned by investors seeking income increases. The result is that company chief executives become progressively more incentivised to pay (and increase) dividends – both implicitly (because higher dividends are likely to encourage more fund managers to invest and so push up the share price of their company) but also explicitly (as fund managers demand increase dividends funded by profits).
But if the money is there, why does this matter? Simply, because there are a series of options for chief executives regarding how to “spend” free cashflow produced by the business. Dividends and share buy backs are options, but so too are investments in future growth (whether this be R&D, expansion into different markets, or even acquisitions).