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408-The Case for Dividends
  Couse 408:
  The Case for Dividends
  
  If you've made it this far in the Investing Classroom, you can't have escaped
  the following: A stock represents an ownership in a business. So let's say we
  are part owners as well as managers of a business, and when we closed the
  books on the year, our firm made a $10 million profit. Better yet, we
  collected all of it in cash. Now the rub--what to do with that cash?
  
  Assuming we don't simply leave it in the corporate checkbook (though some
  companies certainly do), we've got four choices. We could:
    Reinvest it in the business
    Acquire another company
    Pay down debt
    Return the cash to shareholders
  Real-life boards of directors face this decision in every quarter of every
  year. While the first three options can be productive uses for cash, the
  fourth--a reward to shareholders--is a critical part of the investment
  process. After all, why else would you want to own a stock if you never
  received a payback on your investment? Stocks are perpetual-life
  securities--there's no guaranteed payoff at some maturity date like there is
  with a bond.
  In fact, the grandfather of security valuation (a little-known figure named
  John Burr Williams) defined a stock's value as the present value of future
  dividends. It's pretty easy to see why this is true. Even though capital gains
  loom large in most investors' minds, the ability to sell a stock tomorrow for
  more than was paid today is contingent on that stock eventually returning cash
  to its owner, whoever that owner might be at the time.
  
  Dividends: The New Fad?
  The two components to total return--dividends and capital gains--have two
  totally different tax treatments. Dividends are immediately taxable. Taxes on
  capital gains, on the other hand, aren't due until the stock is sold, creating
  a tax deferral that aids in wealth accumulation. In theory, if the dividend
  hadn't been declared, the value of that payment would have continued to
  compound tax-deferred within the company.
  This natural, if not downright unavoidable, advantage that capital gains held
  over dividends was strengthened further by tax policies that favored capital
  gains over income. For years capital gains had been taxed at only half the
  rate of regular income, which includes wages, bonuses, interest, and (sadly)
  dividends. For example, in a tax cut passed in 1997, the rate levied against
  capital gains was capped at 19.8%, while dividends continued to be taxed at
  rates up to 39.6%. Some wondered why a company would pay dividends at all.
  In time, investors and corporate managers responded to the tax incentives and
  disincentives. With the birth of a new bull market in the early 1980s,
  dividends came to figure less and less in investors' selection of stocks.
  Growth, not stability and income, earned a premium valuation, so corporate
  managers' incentives were to grow earnings (by reinvesting) or, at the very
  least, buy back stock and thereby grow earnings per share. From the bear's
  nadir in August 1982 to the bull's peak in August 2000, the S&P 500 rose at a
  14.7% annual clip, but dividends gained at only 4.6%. The yield of the market
  collapsed from over 5% to just over 1%.
  In pursuit of growth, however, a lot of businesses allocated capital poorly.
  The most profitable--and least risky--growth opportunities are those that are
  well protected by a company's economic moat. Take Hewlett-Packard HPQ, for
  example. For half a century it was absolutely dominant in scientific
  instrumentation and, as an outgrowth of that, computer printers. These markets
  were never going to double the size of the company overnight, but they had the
  potential to grow faster than the economy while throwing off huge profits and
  cash flow.
  But H-P didn't stop with printers. The firm took its excess cash and started a
  consulting business, got into PCs and servers, and bought Compaq (and with
  Compaq inherited the remains of Digital Equipment, essentially picking up two
  of the technology industry's biggest losers with a single stroke). Meanwhile
  it spun off its instrumentation business--the company's heart and soul--as
  Agilent Technologies A. Tens of billions of dollars invested outside its moat
  were eventually destroyed by competitors, not received by its shareholders.
  Lots of companies are capable of investing within their existing moats,
  nurturing their core competencies. But the area (size of the business)
  surrounded by the moat grows only so fast each year, and supporting this
  growth will typically absorb only a modest portion of annual earnings.
  Relatively few managers prove to be as good at handling the cash left over.
  The CEO thinks: "If we're this smart when we invest $100 million a year, think
  how much smarter we'll look if we invest $1 billion!" Earth to CEO: No, you
  won't. The additional cash would be much better off with shareholders, who
  could then allocate their capital among all sorts of different businesses, not
  just whatever the company saw as worthy of investment. But with the tax policy
  stacked against the payment of dividends and investors demanding growth in any
  and all possible forms, earnings that should have been paid out were retained,
  and the money was inevitably wasted.
  After the bubble popped in 2000, however, investors' attention returned to
  capital allocation and the importance of dividends. Plus, today, the perverse
  incentive that double-taxing dividends (first as corporate income taxes, then
  as personal taxes) created for corporate managers is on hiatus due to recent
  tax-relief legislation. Dividend yields--just under 2% in early 2005--are
  still low by historical standards, but dividends seem fated to play a much
  larger role in market returns in the years to come.
  Dividends and Total Returns
  During the bull market, the pursuit of rapidly growing businesses obscured the
  real nature of equity returns. But growth isn't all there is to successful
  investing; it's just one piece of a larger puzzle.

  Total return includes not only price appreciation, but income as well. And
  what causes price appreciation? In strictly theoretical terms, there's only
  one answer: anticipated dividends. Earnings are just a proxy for
  dividend-paying power. And dividend potential is not solely driven by growth
  of the underlying business--in fact, rapid growth in certain capital-intensive
  businesses can actually be a drag on dividend prospects.
  Investors who focus only on sales or earnings growth--or even just the
  appreciation of the stock price--stand to miss the big picture. In fact, a
  company that isn't paying a healthy dividend may be setting its shareholders
  up for an unfortunate fate.
  In Jeremy Siegel's The Future for Investors, the market's top professor
  analyzed the returns of the original S&P 500 companies from the formation of
  the index in 1957 through the end of 2003. What was the best-performing stock?
  Was it in color televisions (remember Zenith)? Telecommunications (AT&T T)?
  Groundbreaking pharmaceuticals (Syntex/Roche)? Surely, it must have been a
  computer stock (IBM IBM)?
  None of the above. The best of the best hails not from a hot, rapidly growing
  industry, but instead from a field that was actually surrendering customers
  the entire time: cigarette maker Philip Morris, now known as Altria Group MO.
  Over Siegel's 46-year time frame, Philip Morris posted total returns of an
  incredible 19.75% per year.
  What was the secret? Credit a one-two punch of high dividends and profitable,
  moat-protected growth. Philip Morris made some acquisitions over the years,
  which were generally successful--but the overwhelming majority of its free
  cash flow was paid out as dividends or used to repurchase shares. As Marlboro
  gained market share and raised prices, Philip Morris grew the core business at
  a decent (if uninspiring) rate over the years. But what if the
  company--listening to the fans of growth and the foes of taxes--attempted to
  grow the entire business at 19.75% per year? At that rate it would have
  subsumed the entire U.S. economy by now.
  The lesson is that no business can grow faster than the economy indefinitely,
  but that lack of growth doesn't cap investor returns. Amazingly, by maximizing
  boring old dividends and share buybacks, a low-growth business can turn out to
  be the highest total return investment of all time. As Siegel makes abundantly
  clear, "growth does not equal return." Only profitable growth--in businesses
  protected by an economic moat--can do that.
  DRIPs
  If you think dividend-paying stocks might be good for you, you may want to
  consider participating in a DRIP. DRIP is common shorthand for "dividend
  reinvestment plan." Not every investor needs dividends for income, so many
  dividend-paying companies offer the option of automatically reinvesting
  dividends in additional shares.
  Signing up for DRIPs may help you focus on a company's long-term business
  prospects (because you will presumably participate in a DRIP for a long time),
  and it also allows investors to benefit from dollar-cost averaging. Many plans
  even offer a discount to the market price of the shares on the payment date.
  You can find out more about a company's DRIP by visiting the investor
  relations section of its Web site; you can also find out whether a company
  offers a DRIP or not on Morningstar.com. Participating in a company's DRIP
  requires having the shares registered in your name (rather than "street name,"
  where your broker is listed as the owner on your behalf), but before starting
  the paperwork to retitle your stock holdings, you'll want to find out if your
  broker offers a low-cost or free dividend reinvestment option as well--many of
  the larger firms do.
  The Bottom Line
  Traditional-minded investors like us are glad to see dividends making a
  comeback. Compared with retained earnings or buybacks, a solid dividend
  establishes a firm intrinsic value for the stock, helps reduce the stock's
  volatility, and acts as a check on management's capital-allocation practices.
  Simply put, it's the way things were meant to be.