Chaos by Incentives – Part 2

Thesis: Corporations would be better managed, have higher and more stable growth, the jobs of employees would be more secure, and overall shareholder returns would be higher if corporate dividends were tax-free and capital gains were taxed at a flat rate of 20% regardless of income.

Organic growth of a company’s base business is clearly a good thing. Modest acquisitions that build on existing strengths or improve a company’s ability to serve its customers can be good things. But the “Peter Principle” is clearly at work when, through acquisition, companies outgrow their management competency; because of the shear size of the merged company or because the acquired companies are so different that management was never competent to manage the acquired companies regardless of size.

Shareholders in search of capital appreciation are of necessity a fickle bunch. They cannot get cash out of their investment unless they sell. So, in the long run, they must sell. Plus, when the earnings per share growth of a company slows or stagnates the capital appreciation shareholder sells and moves on to the “next big thing”. In a desperate and futile effort to forestall the inevitable, management invokes the “Peter Principle” and takes down many unwary shareholders along with the company.

Companies that focus on organic growth with modest acquisitions recognize the inevitability of slower growth and lower P/E multiples and generally start paying or start increasing dividends. MacDonald’s, Intel, and Microsoft are examples.

Dividends provide a second source of value to shareholders that can make up for the reduced share price appreciation. Dividend shareholders are also less fickle than capital appreciation shareholders. Because they don’t need the higher growth rates and because they get dividend checks every quarter just from owning the company’s shares – they are not forced to sell in order to get cash. As long as the company continues to pay ever increasing dividends these shareholders can hold their shares forever.

Links to Other Posts in the Special Report: "Chaos By Incentives"