Dividends have been the larger and more stable component of stock market total return through the measurable part of our financial history. That should not come as a surprise to any student of the markets. What happened in the 1990s was an aberration whereby a number of industries and corporations sought with their cash flow to buy back stock as a way to enhance earnings growth. Investors were told that it was more tax efficient to do so. The issuance of stock options in 1994 (although initially opposed by the SEC) simply accelerated the use of corporate cash to buy more shares to offset option dilution. Dividends got pushed into the background.
Dividends and their growth have supplied more than 50% of the total return of the S&P 500 since it began in 1928. From 1928 until 1958, stocks yielded more than fixed income securities. That fact alone is why stocks have outperformed fixed-income instruments over the decades. It is the yield component that has supplied attractive equity returns over the years. Why would anyone own a stock portfolio that is totally dependent on only price movement of the underlying securities? That is speculating, not investing.
Why would any company subject its investors solely to the cyclicality and volatility of earnings, and hence its stock price, if it earned available cash flow after funding its normal expenses, including research and development? The tax laws, that’s why.
With capital-gains tax treatment preferred over ordinary income-tax treatment, many investors sided with share purchases as a way to enhance the return on their investment. And they left it up to the company to buy its own shares and to make other investment choices — that hopefully would be reflected “only”in the share price. Ouch.
A company is owned by its shareholders and that should mean the shareholder should expect a reasonable return on their investment. That return, from an established company, should include a dividend that is tied to the earnings and its growth rate. If a company is “new,” that company should be using all available cash to grow its business. The established company, however, has the ability to leverage with the wise use of a thoughtful capitalized structure. This type of company tends to represent a large component (over 70%) of the S&P 500 index, the highest quality major stock index. On all exchanges, approximately 40% of equities pay dividends.
The consumer/investor/taxpayer has not realized a reasonable “real” return on investible equity assets for three years. And even in the decade of the 1990s, up to the bull market’s peak, it has been reported that the average investor only realized a 5.5% return on their portfolios. So much for the bull market!
President Bush is attempting to reemphasize the importance of the dividend to market stability, the importance of saving in an aging society, the importance of equalizing the capital structure of corporations to both equity and debt financing, and the importance of trustee stewardship to shareholders and debtholders. These are all valid causes. President Bush should fight on.
Corporations received the advantage of accelerated depreciation approximately one year ago, greatly aiding cash flow. Some of that cash flow could now be channeled to the shareholder in a more meaningful way. Dividends, as a percent of cash flow, are near historic lows — approximately 17% versus the more normal 25% of the past two decades. A dividend phase-in plan on the part of corporations should begin along with the issuance of restricted stock versus option grants to better align the interests of management and the shareholders. Let’s start respecting shareholders as shareowners.
The general public, including our corporations, should also be demanding a sane and simplified tax code. Politicians should stop using the ability of adjusting the tax code to further their own agendas and campaign chests. A refocus on dividends and reforming the tax code — including the elimination of double taxation, equal treatment of capital gains and ordinary income, and putting equity and debt financing on an equal footing — would improve long-term returns for the economy, corporations, investors, and taxpayers.
Let’s work toward a revamping and phase-in of a new tax code that favors long-term growth.
Patricia A. Small is a partner with KCM Investment Advisors, and is the former Treasurer, University of California.