Dividends Just Aren't Dazzling Enough

In the rally, investors prefer to chase profits from stock gains

Eight months ago, President George W. Bush got lots of people excited about dividends when he suddenly proposed not taxing them so much. Companies were excited because this might be just the kick in the pants the stock market -- and their own share price -- needed. Investors were eager to collect a greater share of their companies' profits. And good-governance types, after a year of accounting scandals, were heartened at the prospect of companies raising their dividends to prove that their earnings weren't an illusion.

Now, looking back, was it all a big yawn? Sure, Microsoft Corp. paid its first-ever cash dividend in March. And Citigroup (C ) and Wells Fargo & Co. (WFC ) raised their dividends in July by 75% and 50%, respectively. But while Microsoft looked like a leader when it announced in January that it would start paying dividends, fellow tech titans Dell, Cisco Systems, and Oracle have not followed. Overall, companies are boosting their dividends, but not as fast as their earnings are growing. And investors, rather than skipping companies that don't pay dividends, are bidding up their stocks by twice as much as the shares of companies that do pay. No wonder, then, that when Merrill Lynch & Co. analyst John Davi studied this year's dividend payments, he found them "not anything extraordinary when you look at historical trends."

The numbers bear him out. Through August, 365 companies in the Standard & Poor's (MHP ) 500-stock index were paying dividends -- up from 351 at the end of 2002, but still fewer than the 372 in 2000 and the 438 in 1990. Citigroup's 75% increase made big news, but just one-fifth of companies in the S&P 500 have raised their dividends even 10% this year. At the same time, S&P expects earnings from the continuing operations of companies in the index to climb 17% this year. And next year, S&P 500 companies will be paying out only about 30% of their earnings, compared with an average 42% since 1988, S&P estimates. "I don't think there is going to be a structural change in dividend policy," Davi says.

What happened? For one, the levy on dividends wasn't cut as much as Bush proposed. Instead, Congress decided it would charge the 15% capital-gains rate, rather than personal-income rates that now range up to 35%. Congress also didn't make the tax cut permanent; it expires at the end of 2008. Doubtless that has added to investors' ambivalence. Stocks of S&P 500 companies that do not pay dividends have been up 44% this year through August, compared with 18% for dividend payers. So if the tax cut gave any lift to dividend-paying stocks, it has been overwhelmed by the market's rush back to growth stocks, particularly tech stocks, that don't pay dividends. Confronted with the choice of a cash dividend up-front or a chance at bigger gains later, investors are deciding they will do better with companies trying to boost their shares by reinvesting their profits.

Last year was different, though. In a bear market, dividend-paying stocks held their value much better, losing 13%, vs. the 30% drop for stocks without dividends. But now, with stocks going up, investors seem more inclined to let companies hold their profits for them.

At the same time, corporate executives have their own reasons to avoid paying dividends. They can use the money to fund acquisitions, invest in new factories and new markets, and buy back stock, all of which can help consolidate their power and boost their company's share prices -- and the value of their own stock options. What's more, dividends actually hurt the value of stock options (which offer no dividends) because stock prices dip after the payments are made to reflect the money paid out.

The tax cut, such as it is, was certainly still worth doing, experts say. While it hasn't had a big impact on stock prices, it has focused attention on the bias in the tax code against dividends, which occurs because the money is taxed twice -- as corporate profits and then as dividends. It has also encouraged debate about what companies do with shareholders' money and made clearer the difference between a mature, dividend-paying company and a growth company.

And, of course, the much-heralded revival of dividends could still happen. "It takes a long time to change a mindset, particularly when you have a lot of managements that are not used to giving shareholders control of profits," says Joseph Lisanti, editor of The Outlook, a publication of S&P, which, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP ). But as long as investors, often a gambling bunch, are happier chasing faster stock price appreciation than collecting reliable quarterly checks, dividends won't be much to get excited about.

By David Henry in New York

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