Just a few short years ago, corporate cash dividends just didn't "get no respect." In the second half of the 1990s, investors shunned the stocks of dividend-paying companies in favor of those that were believed to be able to deliver rapid earnings growth as part of the growth miracle of the booming economy.
Professors Eugene F. Fama of the Graduate School of Business, University of Chicago, and Kenneth R. French of the Sloan School of Management, Massachusetts Institute of Technology, wrote an academic paper studying dividend payments. Their report, "Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?" was published in the Journal of Financial Economics in 2001 and concluded that firms had become more reluctant to pay dividends.
But using Fama and French data, the case for investing in dividend-paying companies appears quite positive. Companies that do or can generate positive earnings over an economic cycle are likely to initiate and pay dividends; firms facing high business risks are not. Well-established firms (as measured by age as a public company, revenue size and profit levels) tend to establish and maintain dividends; young, immature companies do not. Messrs. Fama and French identify that on average over the 1993-'98 period, payers had 13 times the assets as non-payers.
According to the Fama-French study, dividend payers have had consistently higher levels of profitability than non-payers since 1963 (e.g. with returns on equity of 13.4% vs. 4.1% for the 1993-'98 period, and returns on assets of 6.9% vs. 4.3%, respectively).
Furthermore, Messrs. Fama and French discovered that dividend payers accounted for nearly all of the net share repurchase activity of corporations as in the 1993-'98 period, as they represented 87% of stock purchase activity of corporations but only 36% of the stock issuance. As a result, dividend-payers generally are the companies with sufficiently high profitability and free cash flow that they can both afford to pay dividends and to make a net reduction in shares outstanding.
Beyond the financial ability to pay and sustain a dividend, dividend payers view the dividend as a signaling mechanism on the part of a company's management and board of directors stating that its earning power will be sustained in the future. This observation was confirmed by SKBA's own survey of the dividend policies of S&P 500 companies conducted in October and November 1998. Of the 100 dividend-paying S&P 500 companies that participated in the study, 87% said they viewed raising annual dividend rates as sending a signal to investors that future earning power would be higher.
This signaling mechanism is one key to why dividend-paying companies are now in favor and likely to remain so. Cash dividends are real money and cut through all the noise about the quality of a company's reported earnings. For companies that can sustain dividends through tough times and raise them in good times, it is prima facie evidence that such companies are managing their businesses reasonably well. Dividends don't lie. We've all painfully learned that, sometimes, reported earnings do. Corporate dividends and dividend policies remain an enormously useful source of valuation information.
But now it's "payback time." Or perhaps I should say it's "payout time." In my 26 years in the investment management business, there are only a handful of events that could have as significant an impact on the economy and stock market as would the reduction in the double-taxation of dividends. The just-passed cut in the tax rates on dividend income to 15% from 38.6% and on capital gains to 15% from 20% will undoubtedly be the most significant economic event of 2003.
And changes in tax policy and tax rates were (and still are) one of the major causes of this shift in investor preferences among asset classes. Cuts in tax rates nearly always lead to improvements in the real economy and financial market returns. Such changes as the Kennedy and Reagan cuts in tax rates and the Clinton reduction in the capital gains rate in 1997 triggered major positive changes in both the pace of growth in the economy and stock market returns.
Relative to the tax regime of the 1997-2000 period, the after-tax return (after paying federal corporate and personal income taxes) from receiving dividend income has just taken up to a 40.7% boost, compared to only a 6.3% increase in after-tax returns for owning a company that can only produce returns from capital gains. Now that's a real incentive shift. So the reduction in the tax rates on dividend income and capital gains is the entire reason we experienced the sharp advance in the stock market during the second quarter of 2003 (we attribute only five percentage points of the rally to winning the war in Iraq). Dividend payments are no longer tax inefficient. As taxable and non-taxable investors show an increased preference for owning dividend-paying companies, the valuations (p/es) and returns of such companies should shift upward.
So while dividend-paying companies "didn't get no respect," they certainly should and finally are. Dividend payments are once again viewed by investors as virtuous behavior on the part of companies. For they embody a promise to shareholders that management will produce sufficient profitability to pay the promised dividend into perpetuity.
Now that the speculative environment of the late 1990s is gone and today's tax rates on dividends are the lowest in the last 45 years, solid dividend-paying companies are the ones likely to get the premium valuations.
Andrew W. Bishcel is president and chief investment officer of SKBA Capital zmanagement, San Fyancisco