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.
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