Unleash the Dividends!

Here's the good news: There is no question that corporate America is recovered from the recession. Real corporate profits are at an all-time high. Cash flow among S&P 500 companies is at a new record. Nonresidential business investment is inching close to pre-recession levels. Average CEO compensation has zoomed higher, too, lest you worry.

But there's still one part of the corporate kitty that's a fraction of its former self: dividends.

For most of the 20th century, companies paid out the majority of their earnings as dividends to shareholders. That was, after all, the main reason they owned the stocks -- to own a share of the companies' earnings.

Things began to change around the 1960s. Rather than pay dividends, corporate management decided that earnings could be put to better use reinvested back in the company, or to repurchase stock. The dividend payout ratio -- the percentage of net income paid out as dividends -- began sliding from over 60% to around 50%.

The trend sped up over the past two decades. By the late 1980s, just 40% of S&P 500 profits turned into dividends. By 2004, it was 35%. Today, it's a record-low 29%:

Sources: Robert Shiller, Yale, and author's calculations.

The impact this has on yields is obviously huge. The yield on the S&P 500 is now around 1.9%. If the payout ratio reverted to its 20th-century average, the yield would be closer to 4%, or more than double the current yield on 10-year Treasury bonds.

Lower dividends aren't a welcomed development. When payouts go down, companies are retaining more earnings to spend on growth, acquisitions, or buybacks. A few companies are really good at this. Most aren't. One study by Rob Arnott and Cliff Asness actually found that, on average, future earnings growth is the lowest when companies retreat from dividends. "Unlike optimistic new-paradigm advocates, we found that low payout ratios (high retention rates) historically precede low earnings growth," they wrote.

How can that be? The data, the two researchers wrote, "fit a world in which low payout ratios lead to, or come with, inefficient empire building and the funding of less-than-ideal projects and investments, leading to poor subsequent growth, whereas high payout ratios lead to more carefully chosen projects."

My colleague Ilan Moscovitz and I once gave a simple, real-world example. We took two banks, the behemoth JPMorgan Chase (NYSE: JPM  ) and the small Bank of the Ozarks. Ozark's historic return on assets trounced JPMorgan's by two-to-one, yet JPMorgan's CEO earned as much as 50 times more than Ozarks' CEO. It didn't matter if Ozarks was making really good, opportunistic bets. JPMorgan's boss was running a veritable colossus, and so by default was paid orders of magnitude more. When compensation is tied to the size of earnings, the carrot dangled in front of too many CEOs isn't to generate good shareholder returns; it's to build an empire. Retaining earnings to make huge acquisitions is one of the fastest ways to do that.

Now, part of the reason the S&P 500's dividend payout rate is low today is because many large banks are barred from paying meaningful dividends after being bailed out in 2008. Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) , for example, used to distribute a combined $20 billion a year in dividends. Today, the sum rounds to zero because regulators demand the two set aside earnings to rebuild their balance sheets.

But that alone doesn't explain why dividends are so low. Among companies in the S&P Industrials Index, net income has increased 20% since 2007, while dividends have inched up just 4%. Cash held on nonfinancial corporate balance sheets now totals more than $2 trillion, up 40% since 2009. Cash makes up 7.1% of assets, the highest since at least 1963. Corporations can easily afford to crank up their dividend machines.

So why aren't they? Besides the incentives to build empires, a reason CEOs cite is repatriation taxes that are owed when cash held abroad is brought home to pay dividends. This is especially pressing for tech companies like Apple (Nasdaq: AAPL  ) , Microsoft (NYSE: MSFT  ) , and Intel (Nasdaq: INTC  ) that do a large amount of business abroad. Earlier this year, Cisco (Nasdaq: CSCO  ) CEO John Chambers lamented that repatriation taxes effectively dictated his company's dividend policy. The tax code "not only doesn't encourage us to bring [cash] back, but penalizes us with double taxation," he said.

The repatriation tax is a burden virtually unique to America, and it should be repealed, in my opinion. But on average, it isn't a valid excuse to withhold higher dividends. Repatriation taxes or not, S&P 500 companies haven't had any problem finding enough cash domestically to finance share repurchases, which were up 22% in the second quarter to $109 billion. If these companies simply diverted half of the cash now used to repurchase shares into dividends, the S&P's dividend payout ratio would climb back to its historic norm of around 60%, and the dividend yield would jump to nearly 4%. Given how starved investors are for yield with interest rates near 0%, it's hard to see how this wouldn't be enormously bullish for stocks. And in light of corporate managers' dismal track record of repurchasing shares -- buybacks invariably peak when stocks are expensive and plunge when they're cheap -- earnings growth would likely rise.

As Wharton Professor Jeremy Siegel found, since the 1950s, "the portfolios with higher dividend yields offered investors higher returns." Period. Get with it, CEOs. Shareholders aren't annoyances to be dealt with; they are owners to be served. Your cash-hungry and return-starved investors deserve better.

Interested in more like this? I've just published a collection of short essays exploring the peculiar corners of the economy -- from rich people risking it all to gain money they don't need, to what investors should have learned after 9/11. It's currently one of the best-selling investment books in Amazon's Kindle bookstore. Click here to download it. It's the best $1 you'll spend all year.

Check back every Tuesday and Friday for Morgan Housel columns on finance and economics.

Fool contributor Morgan Housel owns shares of Microsoft and Bank of America preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Microsoft, Apple, Citigroup, Intel, Bank of America, Cisco Systems, and JPMorgan Chase. The Fool owns shares of and has bought calls on Intel. The Fool owns shares of and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended buying shares of Intel, Microsoft, Cisco Systems, and Apple; and creating a bull call spread position in Apple, Intel, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (59)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 15, 2011, at 4:36 PM, DividendsBoom wrote:

    Good article Morgan, I am right there with you on this one. My one question would be whether or not profits from US business is at an all-time high. With companies experiencing strong emerging market growth, I wonder how much of corporate profit growth is really attributable to the US. Not sure if it's possible to break that out or not, God knows I am not going to try and do it manually. Time for repatriation to go/change.

  • Report this Comment On November 15, 2011, at 5:09 PM, Darwood11 wrote:

    I have to wonder if corporate america is doing so well because 1) it pays such lowly dividends and 2) It has done well with the human capital at its disposal.

    I've long suspected that companies that are run by the President and CEO for the primary purpose of achieving certain targets, so as to achieve a wonderful bonus, payout, etc. are not run as well as other companies. This has been alluded to in other articles and studies.

    The fact is, companies are run in a manner consistent with their objectives. At one level, that may be "to produce widgets" or "shareholder value." However, it seems all too often that the real goal is to increase the value to executives.

    It's my understanding that the majority of Apple sales are made in the US. it's unfortunate that the company has decided to keep the money made overseas, and use it to the advantage of others.

  • Report this Comment On November 15, 2011, at 5:37 PM, xetn wrote:

    I believe one of the reasons that dividends have been held down low is that the corps are retaining their cash instead of borrowing. Even though interest rates are very low, it still represents an additional charge against profits. So, is using internal cash better than borrowing? Depends on circumstances.

    I also believe there is another reason, and that is uncertainty. Perhaps a year from now, once the elections are over, some uncertainty will either disappear or become worse.

  • Report this Comment On November 15, 2011, at 5:55 PM, FutureMonkey wrote:

    I loathe share repurchase programs that are used to offset share dilution...which in my opinion is just a way to funnel stock holder cash to the C-level executives that have large share based compensation.

    If stock options dilute shares of the company, then the board authorize use of cash to "buy back" shares -- something often seen as a shareholder friendly move. My benefit as a shareholder is zero.

    I'd prefer a dividend thank you, but if the board restricted share based compensation I'd be happier still.

  • Report this Comment On November 15, 2011, at 6:35 PM, stan8331 wrote:

    Couldn't agree more. Share buybacks are usually an extravagant waste of resources, since companies are almost always afraid to buy back shares when they're cheap (after a major stock price decline).

    Virtually no large company should be incapable of supporting both a dividend and occasional well-targeted acquisitions. Growth in size through large acquisitions that do nothing to improve investment returns is of no benefit to shareholders, but it does often enrich executives.

  • Report this Comment On November 16, 2011, at 12:39 AM, rfaramir wrote:

    "Given how starved investors are for yield with interest rates near 0%"

    This is exactly why companies don't feel a need to offer a significant dividend, there is no competition! With banks offering negative real interest rates, money flees to stocks whether they offer much in the way of dividends or not.

    This is emblematic of the nation's economic sickness. Lower taxes, less regulation, and no subsidies would result in a freer market and a healthier economy, including better jobs, more of them, and better (more sane) dividends.

  • Report this Comment On November 16, 2011, at 2:57 AM, SnowdriftFool2 wrote:

    Good article Morgan.

    This state of affairs hasn't been missed on all companies ... Lockheed Martin (LMT) hiked dividends by 33% recently.

    For my part, I have shifted to some solid offshore and ADRs that do not suffer from the patriation tax issues (SSW, SDRL and NGG are all interesting in this respect). These pay good dividends and their global exposure and associated risks are similar to low/no-dividends of APPL, MSFT, and CSCO you note.

  • Report this Comment On November 16, 2011, at 6:03 AM, Stonewashed wrote:

    This is somewhat of a back pedal from when most at TMF advocated gorilla tactics as in using their AP for cash flow, instead of paying their bills in a timely manner (simply because they could) and poo pooed stodgy old companies who paid dividends and didn't utilize gorilla tactics to get their money up front, but slow to pay on the backend.

    So, here we are, gorillas who could give a flip about customer service, and laws that protect them, and legal fees prohibitive for some of their vendors to hit them where it hurts.

  • Report this Comment On November 16, 2011, at 9:32 AM, ajfiore wrote:

    Ohmigosh - I just went out to the URL indicated describing where "Real corporate profits are at an all time high." above and I was thunderstruck by 2 questions. I don't mean to politicize but... this shows after tax profits... 1) How much taxes are being paid? and 2) Where are the jobs??? This seems to belie the preaching that lower taxes produces jobs - at least from the corporate level - I don't mean to imply that small companies would not benefit from same but from the chart - Holy Cow!

  • Report this Comment On November 16, 2011, at 11:30 AM, slpmn wrote:

    I think we'll see the dividend yield start to move up again at SP 500 companies if for no other reason than the top executives who now receive massive annual stock grants instead of options will directly benefit from dividends. Though the shares are restricted and may vest over a period of time in some cases, I believe they still receive dividends on the entire grant.

    I did some quick figuring and estimate that the CEO of Wells Fargo earns about $400,000 year from dividends on the stock grants he received in 2009 and 2010. And that's with the pathetic 1.9% yield. One might argue that's chump change for a guy who pulled in $19 million in 2010, but maybe it will cover the light bill at one of his mansions.

  • Report this Comment On November 16, 2011, at 12:53 PM, DJDynamicNC wrote:

    @ajfiore - nothing political about your statement at all. The "cutting taxes creates jobs" canard doesn't really have any empirical evidence going for it (except the current wild boom times we're living in, woohoo!). Facts are not political.

  • Report this Comment On November 16, 2011, at 12:56 PM, DJDynamicNC wrote:

    @Stonewashed - I don't ever remember a time when the Fool was averse to dividends? It's been the most consistent message on this site; that's part of the appeal here, I've absorbed that message and it's stood me in great stead so far.

    I'm not saying it was never the case that things were different, it just strikes me as odd to call this particular article a backpedal when it comes hot on the heels of hundreds, if not thousands, of similar articles.

  • Report this Comment On November 16, 2011, at 1:46 PM, actuary99 wrote:

    Morgan,

    Am I missing something or is impossible to get your book without having/buying a Kindle?

  • Report this Comment On November 16, 2011, at 1:50 PM, TMFHousel wrote:

    ^ Or an iPad (with a Kindle app). The book is in electronic form only -- wave of the future, my friend.

  • Report this Comment On November 18, 2011, at 10:31 AM, DJDynamicNC wrote:

    @Actuary - you can get a Kindle app for your Android device as well.

  • Report this Comment On November 18, 2011, at 10:32 AM, TMFRoyal wrote:

    Nice article, Morgan.

  • Report this Comment On November 18, 2011, at 12:49 PM, sheldonross wrote:

    @actuary99 Or just download the kindle app for your computer.

    http://www.amazon.com/gp/feature.html/ref=kcp_pc_mkt_lnd?doc...

  • Report this Comment On November 21, 2011, at 3:56 AM, lowmaple wrote:

    And why electronic form come on to computers? Your missing out on my buck.

  • Report this Comment On November 21, 2011, at 3:57 AM, lowmaple wrote:

    Please insert can't behind why

  • Report this Comment On November 22, 2011, at 1:05 PM, DJDynamicNC wrote:

    Lowmaple - you can download a kindle app for the computer to read the file format for e-books.

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