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Battered, angry investors are clamoring for dividends. Just like in the good old days. FORTUNE Tuesday, January 21, 2003 By Justin Fox
In the mid-1930s, with the stock market and most of the companies listed on it in utter disrepute, broker-turned-Harvard-doctoral-candidate John Burr Williams set out to rescue investing from the hucksters and quacks and give it a grounding in economic science.
What he came up with in his dissertation, later published as The Theory of Investment Value, was a valuation model that today still provides the theoretical basis for much of what is taught in academic finance and practiced on Wall Street. But hardly anybody actually reads Williams anymore. (The book's Amazon.com sales rank is 63,449, though it is, Amazon reports, "popular in Belgium.") His dividend-discount model is now interpreted to mean estimating a corporation's future earnings or cash flow, and discounting them against interest rates. That is a misinterpretation. When Williams said "dividend," he really meant dividend.
"Earnings are only a means to an end, and the means should not be mistaken for the end," he wrote. "Therefore we must say that a stock derives its value from its dividends, not its earnings. In short, a stock is worth only what you can get out of it." Then, finding prose insufficient to convey the force of his argument, Williams continued in verse:
"A cow for her milk, / A hen for her eggs, And a stock, by heck, / For her dividends. An orchard for fruit, / Bees for their honey, And stocks, besides, / For their dividends."
Today the stock market and corporate America are again in ill repute. And after years of ignoring dividends, a chastened nation is falling in love with them all over again. The clamor began more than a year ago--one of the early clamorers was Ralph Nader, of all people, who berated Microsoft for not sharing some of its $40 billion cash hoard with its owners. The chorus grew during the summer and fall, as market seers argued that dividends were just the ticket to lure Americans back into stocks. President Bush's proposal to (mostly) exempt them from taxation marked a new high point in the dividend resurgence--although it appears to be running into trouble with Congress. (For more on dividend taxation, see Love That Tax Cut.) Then came Microsoft's blockbuster Jan. 16 announcement that it would start paying a dividend.
The resurgence comes after several decades during which dividend yields declined and ever more companies chose to pay no dividend at all. Even now, the market's dividend yield--1.8% for the S&P 500 as of Dec. 31--is at a depth never plumbed before the mid-1990s. Most dividends now stream from a few dozen New York Stock Exchange denizens--with Exxon Mobil, General Electric, and Philip Morris leading the way--that have been paying them since practically the dawn of time. Meanwhile, a new stock market for new companies, Nasdaq, has arisen. Most Nasdaq companies have yet to make enough money to contemplate giving any back to shareholders. But even Nasdaq success stories like Oracle, Cisco, and Dell don't share that success with investors in the form of dividends. And while Intel and now Microsoft do, they pay out only a minuscule share of their earnings.
Whether those companies and their dividend-disdaining ways are the wave of the future or just a bull market aberration is something we'll find out over the coming years. But whatever happens next, their rise has been a striking development in the history of the modern corporation. That history began early in the 17th century with the Dutch East India Co., which made a habit of distributing to its shareholders all the proceeds from its spice convoys--after deducting the cost of maintaining a trading empire and fighting wars, of course. Doling out profits to shareholders was what a corporation was for, and that's how things remained for centuries. From 1871 to 1980 dividends accounted for almost 80% of U.S. stock markets' inflation-adjusted return to investors, according to Wharton School market guru Jeremy Siegel.
The approach to dividends did change over the years, though. By the early 20th century U.S. corporations were no longer paying out whatever they happened to earn each year. Eager to attract investors accustomed to bonds and bank accounts, companies began to make a priority of keeping dividends steady and reliable. The payments could rise as the company grew, but some profits were held back to ensure that there'd be enough cash to maintain the dividend even in down years.
After 1913 came a new twist: the double taxation of dividends at the corporate and personal levels (although for decades this affected only the highest-income taxpayers). During the 1920s boom, dividend yields plunged as stock prices soared and companies held back more and more of their profits. Then came the great crash--and a lot of hard thinking about what makes stocks worth anything in the first place. We've already heard from Williams. Treading similar if less poetic ground were Benjamin Graham and David Dodd. "The prime purpose of a business corporation is to pay dividends to its owners," they wrote in the classic Security Analysis. The 1920s belief that plowing earnings back into a company was usually a good thing rested on the "weak" premise, they said, that "whatever benefits the company benefits the stockholders." In fact, Graham and Dodd argued, "stockholders in general would certainly fare better in dollars and cents if they drew out practically all of these earnings in dividends."
Investors listened. In the early 1950s, despite huge tax disadvantages--dividends no longer received any breaks, and the top marginal income tax rate was 92%--the market's yield topped 7%. But as Americans came around to the idea that another Great Depression wasn't necessarily right around the corner, attitudes about dividends began to relax. And two professors built a new theory of investment and finance that contradicted much of what Wall Street thought it had learned in the 1930s.
"As long as management is presumed to be acting in the best interests of the stockholders," wrote Merton Miller and Franco Modigliani in 1958, "... the division of the [earnings] stream between cash dividends and retained earnings in any period is a mere detail." In a subsequent paper in 1961, M&M--as they came to be known to generations of MBA students--went so far as to argue that, given the tax code's bias against dividends, shareholders were better served by a low dividend payout than a high one.
Over the subsequent decades M&M appeared to win the argument decisively. As mentioned above, some of America's most successful and admired companies now don't pay dividends. One of them even happens to be headed by Graham's most famous student, Warren Buffett, who has run Berkshire Hathaway on the principle that he's able to put extra dollars to better use than his shareholders would. Other dividend deniers make the same argument. Meanwhile, an alternative to the dividend has emerged: the stock buyback. It is a flexible, tax-efficient way of getting money to shareholders, but it forces them to make a call about the future of the company (do I stay or do I sell?). The buyback is, in the charming analogy of Morgan Stanley strategist Steve Galbraith, the equivalent of dating, while the dividend is marriage. More to the point, the dollar volume of buybacks never approached that of dividends--until the late 1990s. And the recent buyback boom had less to do with getting cash to shareholders than with paying employees through the back door.
In the late 1990s corporations gave out billions of stock options to employees and had to buy back stock to keep those options from cutting into earnings per share. This whole exercise put money in the pockets not of shareholders but of employees. What's more, option holders don't get dividends, and at least two studies so far have shown a significant statistical link between compensating top executives with lots of options and not paying any dividends.
For this and many other reasons (Enron, WorldCom, Tyco) it's become harder and harder to make the case that the interests of outside shareholders and corporate management are perfectly aligned. In other words, the Graham and Dodd argument that you can't trust management is more in tune with these times than the Miller and Modigliani assumption that you can. Much of the agitation on behalf of dividends stems from the belief that nothing demonstrates management's good intentions better than cold, hard cash.
Even Franco Modigliani, now an 84-year-old emeritus professor at MIT, acknowledges that corporations haven't seemed all that worthy of trust lately. But he dismisses as "silly" the growing conviction that dividends are the answer to shareholders' ills. "If you don't trust management," he says, "why do you have money in the company?" He has a point. But it's also true that if shareholders have no real prospect of eventually getting their money back--not from some greater fool willing to buy their shares, but from the corporation itself--then the stock market becomes one big Ponzi scheme. The investing theorists of the 1930s tended to divide market participants into investors, who hold stocks for income, and speculators, who buy and sell for profit. John Burr Williams, for one, had nothing against the speculators. But, he warned, "speculators as a class can profit only by trading with investors, to whom they can sell only for income; therefore in the end all prices depend on someone's estimate of future income." These days, we could certainly use a few more investors.