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 March 2011 The Case For Dividends Miller and Modigliani Revisited
Over forty years ago, Merton Miller and Franco Modigliani postulated investors should be indifferent between dividends and price appreciation. The investor's goal, after all, is simply to make money. He or she shouldn't really care if it was a return of earned income or a jump in share price, all that's important is that they're making money. Of course that's not quite true, when you throw in generally higher taxes on current income (dividends) than capital gains (price appreciation), or when you consider transaction costs involved in buying and selling shares to unlock unrealized gains, there are some additional variables. Messrs. Miller and Modigliani offered further analysis including these factors, and Mr. Modigliani even received a Nobel Prize for his work, yet the issue was never really resolved. Even if statistics can't completely account for it, investors do differentiate profits from dividends from price appreciation. Throughout the rising markets of the past twenty years, dividend-paying stocks have been seen as stodgy and uninteresting. Traditional dividend payers such as Financials and Utilities have been branded (and treated) as "Grandmother Stocks". That's because stocks that pay out their earnings in the form of dividends, don't offer the rapid appreciation of younger, typically smaller companies that reinvest for rapid growth. As stocks have moved up, investors have tended to favor growth of sleepy old dividends. Companies, realizing the investing public currently favors capital appreciation to dividends, have focused on the former at the expense of the latter. When excess cash is available, they've bought back shares (increasing profits per share by reducing the number outstanding) rather than declaring or increasing dividends. This has been true for larger more mature Tech companies who until recently, shunned dividends for fear of being lumped in with Utilities and community banks. That's not the image they want to project. Not surprisingly, dividends have suffered in the process. Equity dividends have steadily declined over the past three decades. After briefly spiking in 2008 (due to significantly lower share prices) they fell back below 2% at the end of 2010. As you'll notice from Chart 1, the current dividend yield on the S&P 500 is near its all-time low -- even after a few recent increases. No wonder investors are looking for gains in other places. Are dividends really dead or is the time ripe for a turnaround?
Their Time Has Come and Gone Fast-forward to today and the landscape is entirely different. The S&P 500 is dominated by Tech and Financial firms, most of which produce services, not tangible products. Analysts correctly point out the U.S. economy has changed from manufacturing to service-oriented. As of last summer, service companies accounted for just under 90% of private sector employment. Quickly growing service companies tend to reinvest in future growth rather than returning cash to investors. Even money-center banks that have traditionally been a source of strong dividend income have had to pull in their horns in the wake of 2008's financial crisis. Stricter regulations are now requiring them to increase their capital, cutting into the cash available for shareholder dividends. Now they're considering reverse stock splits rather than dividend increases.
There's another issue working against dividends and it again is an offshoot from Miller and Modigliani's work: The Dividend Signaling Theory. Although investors shouldn't care where their profits originate, simply declaring or cutting a dividend is interpreted as a strong signal for the stock. Companies that raise dividends -- even if it's just a small percentage or a few pennies -- are usually viewed in favorable light while the opposite holds for any that cut payouts. Again, the actual size of the change doesn't matter nearly as much as the direction. Investors assume companies raising dividends are comfortable with their outlook and wouldn't be increasing their payout if they weren't confident they could cover it. Those cutting dividends are seen as frightened of the coming quarters, so much so they feel compelled to take drastic action. Whether right or wrong, investors trade according to the Dividend Signaling Theory. Knowing this, companies are reluctant to make a foray into dividends for fear that in the near future they may have to retrace their steps. Why take the chance of shooting yourself in the foot when you don't have to? Instead, stock buybacks have all the positive impact of a dividend increase without all the nasty strings. Share buybacks decrease the number of shares outstanding and increase per-share profits because earnings are spread over the lesser number. Tech companies often use this approach -- even when share prices are high. Companies usually make a big splash with their announcement, but they're rarely completed. In other words, when a firm announces a buyback of up to $X, the actual result is generally less than the full $X - $Y where $Y is frequently quite sizeable. Even if fully completed, the process still hasn't increased profits, it's just reduced the number of outstanding shares. Nevertheless, investors continue to respond favorably to buyback announcements. So one could quite reasonably argue that dividends have outlived their welcome. Share buybacks offer firms the same upside without binding them to future performance. Couple this with the shift from manufacturing to service, and there's little reason to expect a dividend comeback in the U.S.
A Different Perspective While it's true that corporate taxes were much higher at various points in the past fifty years, the prospect of higher rates -- or maybe the uncertainty of how high they will be -- is a major factor driving financial decisions. After the last two years' massive federal spending increases and resulting deficits, higher corporate taxes and increased regulation are a virtual certainty. When a company decides to invest its capital, whether physical or human, this is an investment, not just a short term expenditure. It's difficult to confidently commit capital for the long-term when there's so much uncertainty surrounding tax policy. It's even more difficult when the tax rate seems destined for an uptrend. The White House's distinctly anti-business rhetoric of the past two years is also a cause for concern. Under these circumstances, businesses have been reluctant to initiate new investments or hiring.
In the meantime, stocks have staged a powerful recovery from their 2008 lows. Despite the lack of strong economic signals, stocks hit their 2-1/2 year highs in late February. Until the uprisings in the Middle East, the run up had been virtually uninterrupted. With share prices back to 2008 levels and the economy still facing headwinds from the moribund housing market and spiking energy prices, buybacks at this point may be coming at the top of the short-term market cycle. Firms that have recently announced buybacks still enjoyed an immediate bounce in share prices, but not to the usual extent. Arguably, investors may finally be catching on to the fact that the entire buyback may never be completed and/or it is not cost-effective to buy back any shares with prices at current levels. Nevertheless, balance sheets continue to swell with cash. This is particularly true for the larger, better capitalized firms. These include not only the traditional "Grandmother" stocks mentioned above, but now also include the last decade's hot tech stocks. That's right, the Intels, Microsofts, and Apples of the world. Several years ago Microsoft joined the ranks of the dividend payers. After subsequent increases, the stock now yields a respectable 2.4%. Intel yields one percent more at 3.4%. Both are above 1.75% average yield of the S&P 500. At the end of the last quarter, Apple's balance sheet carried just shy of $27 billion in cash. (Under normal circumstances, Apple, too, would have already joined the dividend payers but being a cult stock, it will be late to the game as it tries to preserve its "innovator" image.) In the current political/tax and market environment, dividends offer companies the best alternative to provide value for their shareholders. Even if shares resume their two-year climb, any dividend, no matter how small, will add to total return. When and if stocks experience the long-anticipated bull market correction, dividends, no matter how small, will help cushion the loss. Should stocks stall the the present levels, any yield, no matter how small, will push total returns above those of the pack. As you've probably gathered, the actual size of the dividend payout doesn't really matter as much as the fact that a dividend is being paid. It's the old Dividend Signaling Theory working in favor of today's payers. Not only that, with the average yield so low on the S&P 500, it doesn't take much of a payout to make a company an "above-average" payer; yet another bonus. So let's not declare dividends dead just yet. Savvy investors would do well to seek out shares of firms with growing cash hoards and steady earnings. Like so many other cycles in the financial markets, the time for dividends may just be coming around again. Rather than being indifferent to dividends, now may be the time to seek them. Search this site! Just enter you key word or words:
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courtesy of E-Line Financials:
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OING BACK TO THE 1920s, dividends account for about two-thirds of domestic equity returns. Today the common perception has reversed with most investors believing capital appreciation is the primary source of return. With current dividend yields below 2% for well-established large cap stocks -- the traditional home of dividends -- this assumption would seem correct. In fact, it better be because if it's not, stock returns will be well below historical averages.
Data Source: Standard & Poor's
