The Case of the Disappearing Dividend
By Robert Kuttner
Whatever happened to dividends? A generation ago, shareholders took much of their return as dividends. The capital value of the stock could fluctuate, but at least there would be some yield year in and year out. In the roaring 1990s, dwindling dividends didn't seem to matter. With stocks soaring, some capital gains could always be cashed in for consumption. But in this decade, investors have the comfort of neither rising gains nor dividends.
How large is the decline in the number of companies paying dividends? A study by Eugene F. Fama of the University of Chicago Business School and Kenneth French of Massachusetts Institute of Technology's Sloan School of Management found that paying dividends was the norm among publicly traded profitable companies until the late 1970s. In 1978, 66.5% of companies listed on the major stock exchanges paid dividends. By 1999, however, that percentage had fallen to 20.8%. Fama and French, whose study was published last year in The Journal of Financial Economics, showed that startups, small companies, and high-growth companies were the least likely to pay dividends, but the practice of paying dividends had fallen off across all categories of companies.
Why the change? Some critics of "double taxation" blame the increasing rarity of dividends on the fact that such payouts are taxed as ordinary income, while capital gains enjoy deferred taxation until the stock is sold. Then they are taxed at a much lower rate. But that disparity existed both before and after the late 1970s, when dividends were in vogue, so it doesn't adequately explain the recent decline. Since 1978, tax rates on capital gains and on ordinary income have both dropped and at about the same rate. Moreover, an increasing portion of stock holdings are now in tax-deferred retirement accounts, where tax calculations aren't relevant.
Two other trends that began in the 1970s provide a better explanation for the disappearing dividend: the boom in mergers and acquisitions and the explosion of stock options. Both are the latest variant on the persistent problem brilliantly analyzed in the 1932 book by A. A. Berle and Gardiner C. Means, The Modern Corporation & Private Property: namely, that corporate insiders don't necessarily serve the shareholders who are the company's owners. For all the hullabaloo in the '90s about strategies to align management interests with shareholder interests, not much has really changed since Berle and Means--except for new schemes to help executives profit at the expense of investors.
Stock issued to finance a merger or to pay option benefits means less available money to pay out as dividends to shareholders. The consensus among scholars of the two recent M&A waves is that most big mergers failed to maximize shareholder value. Acquiring companies often paid too much (the so-called winner's curse). Insider executives of the enlarged enterprise, however, commanded heftier compensation, and insider investment bankers often made money both on the merger and the subsequent breakup. Likewise, free cash spent on a stock buyback (which has the convenient effect of pumping up the stock price for a chief executive waiting to exercise an option) is money that can't be spent on dividends.
From the vantage point of many CEOs, paying dividends is about the last thing one would want to do with corporate earnings. In theory, a CEO by definition is carrying out shareholder wishes. In practice, as the spate of recent scandals has demonstrated, the interests of a chief executive and his shareholders can wildly diverge. Meanwhile, some New Economy companies, such as Microsoft Corp., are sitting on tens of billions of dollars of cash, but they don't pay dividends almost as a matter of principle. Microsoft, with its Windows monopoly, is a remarkable company, but its shareholders are beginning to wonder whether it can truly find optimal uses for all that cash, either internally via research and development or through acquisitions. Wouldn't it be more efficient for Microsoft to disgorge some of those earnings to its owners as dividends and let the market allocate that capital?
In theory, too, an investor with a preference for dividends is always free to shift to a portfolio of stocks that still pay dividends. But this is another classic dilemma of the kind outlined in Professor Albert Hirschman's famous formulation of "exit" vs. "voice." Selling the shares (exit) is the only practical option because voice (demanding dividends) is denied. Shareholders of a given company might actually prefer dividends, but in practice they have little influence over company policy.
Ultimately, the vanishing dividend is one more example of the power of insiders over ordinary shareholders. With little faith in accounting or Wall Street analysts, investors today want hard evidence that company earnings are truly what executives claim. What better proof than sharing those earnings with the company's owners? Let's bring back dividends.
Robert Kuttner is co-editor of The American Prospect and author of Everything for Sale.