Investors Should Not Aid Investment Banks

By: Andrew Smithers | Thu, Nov 21, 2002
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Recently, there have been some calls in the City for companies to pay higher dividends. Under the old system of Advanced Corporation Tax ("ACT") this would have made a lot of sense, because the tax rate fell as pay-outs rose.

Under ACT, a company which distributed all its profits suffered an effective rate of tax of only 14%, compared with just over 30% for those which paid no dividends. When Gordon Brown abolished ACT, however, the tax rate rose to 30% for all companies.

Dividends are no longer tax efficient. They are often inefficient for tax paying investors. This is particularly true when markets have fallen a lot.

Companies can return cash to shareholders in one of two ways. They can pay dividends or they can use "buy-backs". When companies buy their own shares in the stock market there is no tax liability on the sellers, unless they have made a profit on their investments.

Companies might, of course, increase dividends and still buy-back as many shares as before. But this would either mean lower investment or higher borrowing. It is hard to believe that either of these would benefit investors.

Corporate investment in the UK is low by international standards. Fund managers are not to blame for this - the Chancellor is the number one villain, for increasing the effective rate of corporation tax and driving up the exchange rate.

Nonetheless, reducing the amount that companies invest even further will not help the stock market. In the short-term it is more likely to hurt. Lower investment must be matched by a fall in profits, unless some other offsetting change occurs elsewhere in the economy.

In the long run these offsets will happen, but they take time. Fund managers can hardly want profits to fall, even in the short-term.

Companies could still pay out higher dividends by increasing debt. But this doesn't look too smart at the moment either. Some companies are already going bankrupt because of too much debt; others are cutting back on employment and investment, while others are trying to raise new equity.

If companies shouldn't increase their debts, which seems the case today, then higher dividends will either mean less investment or more equity issues.

More equity issues would mean recycling money from one lot of companies to another in a tax and cost inefficient way. The beneficiaries would the Chancellor and the investment banks. Both of them badly need help, but fund managers shouldn't advocate such aid at the expense of investors.


Andrew Smithers

Author: Andrew Smithers

Andrew Smithers
Smithers & Co.

Smithers & Co. Ltd. provides advice on international asset allocation to about 100 clients based mainly in Boston, London, New York and Tokyo. Our work is based on the fundamental belief that no one's judgement is better than their information. We believe that our clients' decisions will be helped if we can provide them with important information that is not otherwise available to them. We therefore concentrate on research which aims either to tackle issues in greater detail and thoroughness than is otherwise available or to tackle issues of importance which seem to have been generally overlooked. Examples of the former include our work on stock market valuation, the profit distortions arising from the use of employee stock options and the underlying secular problems of Japan's economy. Examples of research into areas which have otherwise been largely overlooked include our work on the Japanese life insurance industry.

Our approach to research is also different. The standard approach bases market projections on economic forecasts of major economic aggregates, such as GDP and inflation. Stock market, bond and currency forecasts are then derived from the way these estimates differ from the consensus. We consider this approach to be flawed in two ways. It places excessive reliance on the ability of any particular analyst to produce forecasts which are consistently better than average. It also ignores the evidence that stock markets tend to lead economies, rather than the other way around. In contrast, we put greater emphasis on "information arbitrage", in which we include identifying factors which have been overlooked, drawing on data and academic research which have not yet been exploited and pointing to inconsistencies in the implicit forecasts of different markets.

Andrew Smithers, founder of Smithers & Co., is also columnist for London's Evening Standard and the Tokyo Nikkei Kinnyu Shimbon's Market Eye, and is regularly quoted in the New York Times, Barron's, Forbes, The Economist, The Independent, and the Financial Times.

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