You hear all kinds of reasons for why stocks should perform badly in the coming years. We'll have another recession. Inflation will take off. There will be a debt crisis. America will fall behind the rest of the world.
All could happen. But there's something simple American corporations could do today that would dramatically boost the appeal of the stock market: increase the dividend payout ratio back to historic averages.
The dividend payout ratio -- dividends as a percentage of earnings -- on the S&P 500 Index has plunged to its lowest level in modern history. The current payout ratio, 29%, is less than half its long-term average:
Source: Robert Shiller, Yale, author's calculations.
The plunge has caused all sorts of confusion and irrationality, namely that low dividend yields are a sign of an overvalued market. Last December, widely followed perma-bear analyst David Rosenberg warned:
From a historical standpoint, the yield on the S&P 500 is very low -- too low, in fact. This smacks of a market top and underscores the point that the market is too optimistic in the sense that investors are willing to forgo yield because they assume that they will get the return via the capital gain.
But this overlooks the collapse of the payout ratio. If today's ratio were at its long-term average, the S&P 500's yield would be nearly 4%, which happens to be the average yield from after World War II until the early 1990s (before the dot-com bubble skewed yields).
Companies could (and do) argue that investing in the business is preferable to paying dividends since it leads to higher earnings growth. While this might be true in some cases for some companies, on average the data doesn't back it up. One 2006 study found that "contrary to popular wisdom, the greater the proportion of earnings paid out as dividends, the greater the subsequent real earnings growth." For every period of strong earnings growth paired with a low payout ratio (late 1990s), one can point to a period of strong earnings growth paired with a high payout ratio (1910s, 1920s). Investor Cliff Asness looked at how current payout ratios relate to future earnings expectations. No luck here, either: "The historical evidence strongly suggests that expected future earnings growth is fastest when current payout ratios are high and slowest when payout ratios are low."
How can this be? It's likely that corporations choosing to invest cash rather than pay higher dividends end up overpaying for assets. Acquisitions are nearly always done at premium valuations, and stock buybacks are well-documented to only become popular at precisely the wrong time: when share prices are at their highest.
In all likelihood, today's market would welcome higher payouts. Last year, renowned value investor Bill Miller noted that telecom is one of the slowest growing industries, yet trades at one of the highest valuations. His explanation for this puzzle was simple: "It has a high dividend payout ratio, which is why it trades where it does." AT&T (NYSE: T ) actually trades at about the same forward earnings multiple as Google (Nasdaq: GOOG ) . Similarly, the snail that is Consolidated Edison (NYSE: ED ) trades at a richer multiple to earnings than the dynamo that is Apple (Nasdaq: AAPL ) . These companies come from vastly different industries, so apples-to-apples comparisons might not be apt. In general, though, it's clear that investors are willing to bid up valuations in exchange for yield. As they should. Have you seen bond yields lately?
So if it's obvious, why don't more companies increase dividends? A tepid economy could promote the desire for businesses to hoard cash. But this is more self-fulfilling than it is rational. A major reason the economy is tepid is because businesses are hoarding. The incentive arrangement between management and shareholders can also be skewed: Empire building through acquisition can increase executive compensation even if it comes at the expense of earnings.
Run through all the excuses, and none stack up to the most powerful argument for higher dividends, outlined by value investing great Ben Graham in his classic book The Intelligent Investor: "The profits 'belong' to the shareholders, and they are entitled to have them paid out within the limits of prudent management."
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