The Wisdom of Marty Whitman

As I noted in my most recent newsletter to clients, Marty Whitman, founder of Third Avenue Funds, is a legendary investor on Wall Street who criticizes indexing and excessive diversification.  His quarterly newsletters are written for investors who are fairly knowledgeable about investing.  In my newsletter, I decided to quote a passage from his Chairman's Letter, and decipher his statements for the average investor.  My plan is to continue excerpting certain parts of his newsletter that provide insight into investing in general, and investing in the current market environment in particular.

Mr. Whitman notes in the Third Avenue Funds Portfolio Manager Commentary and First Quarter Report (2012):

"A primacy of earnings approach clearly is in conflict with the desire of most companies to minimize income tax burdens.  Income from operations are taxed at maximum corporate rates.  Taxation of capital gains is much preferred, because the taxpayer usually can control the timing as to when the tax becomes payable.  And the ultimate corporate tax shelter for businesses which don't need cash return is unrealized appreciation."

Whitman is saying that companies have two options: work to maximize their profits or work to minimize income taxes.  Investors who buy common stock in publicly traded companies face double taxation -- the corporate tax in the year that the income was earned, then again at the investor's level as a tax on dividends paid and capital gains (when the common stock is sold).  Whitman argues that from an investor's standpoint, companies that tend to minimize dividend payments and maximize the amount of capital appreciation are better for investors who like to decide when they pay a tax.  Dividend income is taxed in the year it is distributed.  Capital gains (capital appreciation) is taxed only when the investor decides to sell his common stock.

But more importantly, Whitman is saying that companies that retain their earnings, rather than paying dividends, ultimately have a cheaper source of capital to grow their business, because the government is not taking the tax on dividends in addition to the corporate earnings tax in any given year.  Instead, only the corporate tax is assessed, and the remaining after-tax earnings are free to be invested as the company sees fit.  The company therefore has less need to issue new common stock to investors.

Think about it this way:  If the company paid out a dividend of $100, and the stockholder was taxed at a 15% rate, there would be $85 left to reinvest in another stock.  So if the company decided to sell more common stock, the stockholder would have only $85 to invest.  Yet if the company instead paid no dividend, and retained the $100, there would be more money available to the company for reinvestment in the business.