The return on investment you deserve

Shareholders earn more if their company pays a dividend. And they deserve one: They own the company.

from the December 12, 2007 edition

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Companies help themselves

It is true that US companies have raised payout rates at a double-digit pace in recent years. But corporate earnings are rising even faster. Yet companies are demonstrating a stubborn reluctance to pass on the benefit in the form of a dividend commitment.

Instead, company boards and managements have increasingly favored stock buybacks as a way to buoy their companies' share prices. In 2006, stock buybacks trumped dividends by nearly $260 billion and by more than a 2:1 ratio.

In buybacks, companies purchase shares of their own stock, thereby reducing the number of shares in circulation and increasing the value of those still outstanding.

Unlike dividends, stock repurchases do not have to appear on a company's balance sheet as a liability. They do not expire, and they can be executed at management's discretion. Thus, a company can buy back as many or as few as it wants, whenever it wants – or not at all.

A dividend promise, on the other hand, is more formal and less flexible. It is, essentially, an obligation.

The decline of dividends' popularity in the US can be attributed to several factors. Perhaps the most recent reason has been the rise over the past two decades of institutional investors, such as banks and pension and hedge funds, which view stocks as vehicles for capital gains (price appreciation) rather than income.

Another factor is that at one time US corporations were not allowed to repurchase their own stock. The practice was considered stock manipulation and was prohibited by securities regulators.

But that situation ended in 1982, when the Securities and Exchange Commission altered its policy in order to allow American companies to buy back their own shares.

Dividends took a hit when the 1986 Tax Reform Act revoked a law that had allowed individuals to receive dividends tax-free.

But even though in 2003 Congress cut the top federal tax rate on dividends to 15 percent – on par with the top rate on capital gains – companies continue to favor stock buybacks as a way to boost their share prices.

Many companies persist in the argument that buybacks are preferential to investors from a tax perspective. And they suggest there is no guarantee that the current favorable treatment of dividends will be maintained by the government in the future.

Regardless, the tax status of investors should not be the concern of companies' directors. Investors are capable of managing their own tax liabilities, and there are multiple options for reducing taxes.

The preference for stock repurchases probably has more to do with executive compensation than with concerns for investors.

Boosting a company's share price by reducing the number of shares in circulation is appealing to corporate executives who own stock options: The fewer shares on the market, the higher each share's price, and the greater the value of the executives' stock options. Dividends, on the other hand, profit them little.

Stock repurchases also may be preferable to dividends because they are easier to eliminate in the event that earnings turn south. Even though dividends are not guaranteed – and can be initiated, suspended, raised, or lowered at the discretion of company directors – such measures are taken with caution. Once a company issues a dividend, it becomes very difficult to cut or suspend it without investors at least noticing.

Nonetheless, there is a case to be made for companies paying dividends, out of principle: Shareholders, as owners of the company, deserve a slice of the earnings pie.

Give shareholders a cut of the profit

Ultimately, dividends let shareholders decide how they want excess cash deployed. If shareholders favor a share repurchase, they can use the dividend to purchase stock, which would put them in essentially the same position as if the company bought the shares. On the other hand, if shareholders prefer cash, they can simply bank the dividend. With dividends, investors actually can have their pie and eat it, too.

Dividends are likely to come back into fashion for several reasons: investors' growing demand for income, the need for companies to deploy excess cash, and management's desire to boost stagnant stock prices.

With stock prices peaking and large, mature companies having fewer opportunities to reinvest cash, dividends should regain their popularity as a way to distribute excess cash to shareholders. As stock prices rise more slowly, dividends are a way to return value to shareholders in lieu of capital appreciation.

There are some indications that companies are rediscovering the dividend as a way to engender goodwill among shareholders, even as their earnings growth slows. While the number of S&P 500 companies paying dividends is well below historical levels, it is still higher than in 2000, when just 317 companies paid dividends.

Another sign of the reversing trend is among technology companies, which are notorious for not paying dividends. In 2003, one of the granddaddies of them all, Microsoft, instituted a dividend.

The company's stock had been the fastest-growing stock on the market for 20 years, until 2000. At that point, growth slowed, and the company's stock price languished. Investors were not pleased and, consequently, Microsoft issued a dividend.

In general, companies that generate excess earnings have an obligation to give their investors a direct cut of the profit. Dividends should regain their footing as the primary way companies share the wealth with shareholders.

Edward von der Linde is a partner and portfolio manager of Lord Abbett Mid Cap Value Fund and America's Value Fund for Lord Abbett & Co. LLC in Jersey City, N.J. A longer version of this article first appeared in the Summer 2007 edition of The Lord Abbett Review.

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