Dividends are Back!

Mike Kauffelt, CFA, Chief Investment Officer

For a long time, the financial academics and the momentum of a bull market were working very hard to make the stock dividend irrelevant. The bull market of the eighties and nineties had company managers believing that it was an embarrassment to pay dividends, or to increase them if they were already being paid. The mindset was that paying dividends was a sign that you had no internal growth opportunities within your company. If you could not find a better way to invest your company’s excess cash flow in higher yielding internal investments, then you could admit your failure and return some of that cash flow to the shareholders (pay a dividend). Also, the academics were touting that paying dividends was inherently flawed because the money was being taxed twice. First, the profits were taxed at the corporate level. Secondly, those after-tax profits that were paid out in dividends would be taxed again at the shareholder’s income tax rate. Although the academics were technically correct, the analysis was not necessarily correct at the human level.

What do I mean by the human level? Well, some things that are technically correct do not always feel right. After twenty years of working with individuals and their finances, I am convinced that most investors like dividends. A dividend is a small, immediate and ongoing reward (return) on what they hope is a good long-term investment. Regardless of the tax strategies involved, receiving a check every ninety days from your investment, returning a small portion of your investment, has typically gone a long way towards enhancing the total return earned from stocks. Not to mention, many stock investors can receive their dividends tax-free! If held in a pension fund, a charitable account, an IRA or even inside an individual’s 401(k) plan, that dividend is typically exempt from income tax.

So why are dividends back in vogue with more companies paying them and more companies raising their payout rates? Again, I think there are two primary reasons. The first is that the tax rate on dividends was cut to 15% for most investors, which is the same as the capital gains rate. This makes investors indifferent as to whether they receive a dividend or hold onto a highly appreciated asset and pay a capital gains tax when they sell it at a later date. Also, all those who own a lot of stock in a company they control (like Bill Gates does of Microsoft) can get more net after-tax money from their companies now through dividends. If Mr. Gates gives himself a big pay raise, he is probably paying north of 40% in taxes on his income increase. If he increases the dividend payout on his stock by an equivalent amount to what his raise would have been, he is only taxed at 15%. Secondly, paying and increasing dividends is now becoming a management badge of honor as opposed to the badge of shame that it was in the past. After all the corporate scandals of the past few years, most involving phantom profits and exaggerated cash flows amongst subsidiary companies, investors have realized you can not fake dividends. When that check comes every ninety days and is modestly increasing over time, it is a symbol that your company’s management is being a good steward of your funds.

Dividends are back! They are good for the investor and, once again, good for the manager who distributes them. Financial preferences, like fashion trends, can and do change over time. Let’s hope the current preference for management to reward its shareholders with a constant and growing stream of dividends is a long-term trend that is here to stay for awhile. We certainly think so and will be investing with companies that act accordingly.