Throughout the booming 1990s, dividends fell out of favour as investors turned their focus to rising stock prices and juicy capital gains. Corporate North America convinced investors that profits were best spent expanding businesses rather than paying out fat dividends, leading to stronger growth in years ahead. But new financial research argues the opposite is true; that low dividend payouts lead directly to poor profit growth.
The findings, from work by two top U.S. money managers, suggest investors would do well to once again re-evaluate their priorities. Further, the evidence bodes badly for today's highly valued stock markets, whose lofty levels depend on impressive profit growth.
"Investors should pay more attention to dividends," said Robert Arnott, managing partner of Pasadena, Calif.-based First Quadrant LP. "For companies that don't pay out their profits, the onus is on them to justify to their shareholders why the 10th item on management's priority list is better than the first item on the shareholders' priority list -- seeing a return on their investment. If an investor doesn't ask those questions, then they deserve what they get, which is usually the funding of stupid projects that lose money and lead to slower earnings growth."
Mr. Arnott's research kicks current investing wisdom in the teeth.
"Our findings offer a challenge to optimistic market observers who see recent low dividend payouts as a sign of high future earnings growth to come," wrote Mr. Arnott in a paper co-authored by Clifford Asness, managing principal of New York-based AQR Capital Management LLC.
"These observers may prove to be correct, but history provides scant support for their thesis. This challenge is potentially all the more serious, as recent stock prices, relative to earnings, dividends and book values, rely heavily upon this expectation of superior real earnings growth."
The results surprised both Mr. Arnott and Mr. Asness. The duo stress-tested their findings, to see whether other variables skewed the data. However, they concluded the numbers were "statistically sound."
Beginning in 1950, real corporate profits (adjusted for inflation) among Standard & Poor's 500-stock index companies rose on average 3.2 per cent in 10-year periods following high dividend payouts. When dividend payouts were low, profits in the next 10 years actually fell on average 0.7 per cent. In fact, the best 10-year performance following low dividend payouts was 2.6-per-cent growth, lower than the average growth from a high payout level.
It shows up after the Second World War as well as before the war, Mr. Arnott said. "And it shows up before stock buybacks became a fad and after stock buybacks became a fad. It shows up over the whole span."
According to data prepared for The Globe and Mail by Robert Spector of Merrill Lynch Canada Inc., the Canadian experience is the same. Since the mid-1980s, rising dividend payouts, relative to earnings, clearly precede rising profit growth. Falling dividend payouts precede falling profit growth.
The reasons, though anecdotal, appear clear. Mr. Asness said dividend payouts keep corporate management focused on top-quality projects, rather than chasing more dubious ventures typical of the telecommunications industry -- and others -- in the past couple of years.
"It seems dividends are a disciplining process," he said. "When the market doesn't pay a lot of dividends, we call it 'burning a hole in the corporate pocket.' Management pursues some less-than-optimal projects."
North American tax laws encourage investors to aim for capital gains over dividends. In the United States, capital gains on investments held a year or more are taxed at a maximum rate of 20 per cent -- half the top rate on dividends. In Canada, dividends are treated more favourably. Yet for most domestic investors, a salary higher than $31,700 a year means capital gains are better than dividends from a taxation point of view, according to tax expert Tim Cestnick of Burlington, Ont.-based AIC Ltd.
Some major investors see change coming.
"Dividends will become much more popular," said Morgan McCague, a senior vice-president at the Ontario Teachers Pension Plan Board. "The 1990s was an aberration."
James Paulsen, chief investment officer at Wells Capital Management, agrees.
"Most investors are holding stocks which haven't done anything for four years," Mr. Paulsen said. "The only return they've had is dividends. And they're starting to take note of that. As well, corporations are looking at incredible levels of excess capacity, particularly in the tech sector. They had a plethora of investment opportunities in the 1990s -- and now they have none."
Mr. Paulsen said corporate management will face "increasing pressure" to drive dividend payout ratios higher.
Microsoft Corp., maker of computer software, is an obvious target. It's never paid a dividend. Its stock is at the same level it was 3¼ years ago. However, according to its most recent regulatory filing, it has $38.2-billion (U.S.) in cash and short-term investments. The company should pay a dividend, Merrill Lynch & Co. Inc. technology strategist Steven Milunovich recently suggested. Ralph Nader, the consumer advocate, said the same in an open letter to Bill Gates, Microsoft chairman.
The company has said it has no plans to pay a dividend.
Eventually, most companies age beyond their growth years, said John MacNaughton, chief executive officer of the Canada Pension Plan Investment Board.
"There is a sweet spot on the growth curve for a company where the reinvestment of earnings plus additional capital is the right thing to do," Mr. MacNaughton said. "But there is a stage in the life cycle of a corporation where paying a higher dividend rate is appropriate because it eliminates the temptation to make suboptimal investments -- just to be big."
Gerald Vincent of Davis-Rea Ltd. focuses on the sweet spot.
"I'm perfectly happy to forgo a high dividend," Mr. Vincent said. "We tend to want companies with a very high return on invested capital. Quite often, those businesses make a conscious decision that a dollar of capital in the company's hands to develop the business will pay far greater returns down the road than to diminish that capital through an aggressive dividend payout ratio."
"It is important to realize that we did not start out trying to forecast doom and gloom," the authors wrote. "We started out by looking at the optimists' assertion that low payouts were a strong positive signal for the future. Unfortunately, this view is emphatically inconsistent with the historical evidence."
Should today's low dividend payouts indeed foretell slow profit growth in the coming years, Mr. Arnott and Mr. Asness believe investors face a decade of disappointment.
Why low payouts can slow profit
There could be several reasons why low dividend payouts lead to slow corporate profit growth, two U.S. money managers say.
Clifford Asness, managing principal of New York-based AQR Capital Management LLC, and Robert Arnott, managing partner of Pasadena, Calif.-based First Quadrant LP, advance these theories in their new research on dividends:
"Perhaps," Mr. Asness and Mr. Arnott write in a study, "a high payout ratio indicates management's confidence in the stability and growth of future earnings and a low payout ratio suggests the opposite. This confidence [or lack of same] may be based on public information but may also be based on private information. If the latter, the high payout ratio is a reliable signal from management about their confidence in the sustainability of earnings and low payout ratios signal concern. In this case, the payout ratio would be positively related to future earnings growth."
"Another possible explanation," the managers continued, "would be that, in any year, there are only a few truly compelling internal reinvestment opportunities in most companies." In theory, the first idea a company pursues is its most promising avenue. After that, however, the quality of ideas declines. "In essence, when most of the earnings are retained instead of paid out, resources are available to fund marginally less attractive projects. . . . Low payout ratios, or more specifically the behaviour that accompanies them, can cause poor earnings growth and high payout ratios forecast good earnings to come, as they are associated with times of efficiency and reinvestment selectivity."
A third reason may be "managers' own desires to build 'empires.' " Prior research has argued: "Other things being equal, managers prefer to run large businesses rather than small ones."