As of this writing, the S&P 500 index is down 45% from its peak close of 1527 in March, 2000. The dividend yield on the S&P at that time was 1.1%. Today, it stands at 1.9% and this is after an approximate decline of 4% in the total dollar value of dividends paid by the companies in the index since then. Furthermore, only 350 of the 500 companies actually pay cash dividends. It used to be that a dividend yield on the S&P below 3% signaled an oncoming bear market. The yield has not been that high since the fourth quarter of 1990.
Indeed, the past two and one-half years have witnessed a market turnaround of historic proportions. With the S&P down approximately 26% just this year, we will likely have a third down year in succession. This last happened in 1941. Add to the mix an economy that is still wobbling, rising consumer debt, the war on terrorism, and numerous corporate accounting scandals, and it's small wonder that many investors seem frozen with fear as to what will happen next.
As growth stocks ruled in the 1990s, dividends appeared to be irrelevant. Indeed, dividends were spurned, denigrated and trashed by many. However, the majority of those who were managing other people's money had never experienced a bear market such as we are in today. Today, getting a better-than-average yield on your stock holdings while awaiting a recovery in the market is a good position to be in. I want to examine some of the arguments against dividends since these have been statistically tested recently. The results will not surprise old hands at investing and will provide a measure of comfort for many investors today.
The question at the heart of the matter is: Are shareholders better off when companies reinvest all their profits in their businesses as opposed to paying a portion out to them as dividends? The answer: The evidence is compelling that a dollar paid out as dividends benefits the investor a good deal more than if it were reinvested in the company.
Does this sound counterintuitive? Perhaps it does in light of the share price gains of the 1980s and 1990s and the fact that dividends are taxable income to the shareholder, in a taxable account anyway. As the argument goes, earnings that are reinvested and shares that are repurchased should lead to higher share prices on which an investor may then defer the tax until the shares are sold, and then pay much lower capital-gains tax rates, instead of ordinary income tax rates.
This appears both logical and sensible. However, a recent study published in the Financial Analysts Journal by Robert Arnott of First Quadrant, L.P., in Pasadena, California, and New York economist Peter Bernstein takes serious issue with this seeming logic. Their study focused on earnings reinvested in the business, rather than paid out as dividends.
They found that, when the payout ratio climbed above 50% in the late 1950s, subsequent inflation-adjusted earnings growth was between 2% and 4% per year. When the payout ratio fell below 50% in the 1970s, subsequent real-earnings growth was negative. In 1991 the payout ratio was 70%, and a bull market raged for nine years. Based on 2002 estimated earnings for the S&P 500, the current payout ratio is approximately 31%. According to Arnott and Bernstein's thesis, the outlook for stock prices warrants caution.
Share repurchases do not appear to be a good substitute for dividend checks, either. According to their findings, these programs in the 1990s simply bought back the shares issued to executives through options. Most investors have tax-sheltered accounts as well as taxable accounts. For these investors and for all tax-sheltered accounts, cash dividends are preferable to share repurchases anytime.
So what happened to all those profits earned in the 1990s? It appears that a lot of those profits went to fund unprofitable projects and acquisitions that actually diluted shareholder value and led to lower returns on assets. I have some experience with capital budgeting. In good times, many projects will get approved which would otherwise be postponed or rejected. It does not help that, for many companies, this process culminates around Christmas time. Companies that maintain a relatively high payout are forced to think hard about funding their less desirable projects with money that is otherwise available to shareholders as dividends.
Smaller growing companies need to retain their cash. Larger, more mature companies do not have as great a need to retain cash. There are certainly some excellent companies that pay only a modest dividend and still do an excellent job financing growth internally. American International Group and Walgreen Company come to mind.
However, a study in 1999 by University of Oregon finance professor Jarrad Harford found that most cash-rich firms that do not increase their payouts end up spending it in ways that reduce shareholder value. Microsoft presently has a $39 billion cash hoard. The company's growth rate this decade will not come close to what it was in the 1990s. Many investors are calling for Microsoft to begin paying a dividend. Who knows? if Coca-Cola can treat stock options as an expense, Microsoft may yet pay a dividend.
Historically, dividends have accounted for more than 40% of the stock market's total return. From 1925 through 2001, reinvested dividends accounted for 4.6 percentage points of the 10.7% annualized return on the S&P 500 Index. Reinvesting dividends can add significantly to long-term returns. Even during the stagnant market years from 1966 to 1982, reinvested dividends would have enabled an investor to keep pace with - - and beat - - inflation.
As many of us are painfully aware today, reported earnings are not always what they appear to be, even if the numbers adhere religiously to Generally Accepted Accounting Principles. A dividend increase says as much or more about the financial health of a company than an increase in reported earnings. Few companies will venture to raise their dividend if they feel they truly cannot afford it because no company relishes cutting its dividend. On the other hand, many companies actually do not complete their announced share repurchase programs. A dividend increase says that the company has the free cash flow as well as the GAAP earnings to afford the dividend.
The widely followed Dow Jones Industrial Average began 1995 at 3,834. If the Dow ends 2002 at 8000, it will represent a 9.6% average annual growth rate before dividends, slightly above its long term average rate of growth. At its 1999 close of 11,497, the index had grown 24.5% annually, an impossible rate to maintain. As painful as this bear market has been, even if the Dow closes 2004 at 8000, the growth rate for the prior ten years will be 7.6% before dividends, pretty close to its long-term average. Investors who focus on stocks whose yields are above their ten-year averages and faithfully reinvest these payouts stand a much better chance of outperforming their more growth-oriented peers. The upshot? Dividends still matter!
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.