The Importance of Dividends in a Low-Return Environment

    by John Snare

    Are financial planners and individual investors over-estimating the returns the U.S. stock market will produce over the next decade?

    Warren Buffett and other stock market experts continue to think so, even after 2003’s upsurge. They believe the market will produce returns that are well below the current long-term average return of the S&P 500.

    How should you invest your retirement savings in such a market environment? Examining the last extended low-return market—1965 to 1982—can help individual investors develop investment strategies and return assumptions to use in planning for this type of market environment.

    The Long-Term View

    Warren Buffett’s long-term views have received the most attention.

    In several speeches, first in 1999 and then in 2001, Mr. Buffett pointed out that during the 17 years beginning December 31, 1964, and ending December 31, 1981, the Dow Jones industrial average was almost exactly flat—starting at 874 and ending at 875. Following that 17-year period, the U.S. stock market entered an extended bull market lasting approximately 17 more years, from 1982 through 1999. Mr. Buffett drew parallels to the then-current level of the stock market. In late 2001, it was clear that the technology market bubble had burst and that the stock market was in the midst of a serious correction. Just as the 1965–1982 flat market followed the strong post-World War II returns of 1948–1965, Mr. Buffett argued that the years following the bull market of the 1980s and 1990s would result in much lower returns. Warren Buffett’s main point, supported by many other market professionals, was that investors had developed stock market return expectations that were unrealistic, and that we were most likely entering an extended period of market returns that would be well below the much-quoted long-term average return of 10% to 11%.

    Unfortunately, many investors have chosen to ignore these long-term prognoses because of last year’s strong market comeback. Following the Iraq war in the spring of 2003, stock markets began to rally and produced their best year since 1999. The S&P 500 increased 28.68%, the Nasdaq was up 50.78% and the Morgan Stanley Capital EAFE index, representing the international sector, was up 38.59%. Market performance was impressive across all capitalization and style categories.

    More recently, that performance has flagged. Although 2004 started strong, the markets most recently have given up their early-year gains. None of this recent performance, however, has swayed the longer-term outlook for most market analysts: There is still a consensus that the strong returns of 2003 are borrowing from the future to some degree and returns the rest of the decade will be lower than the historical averages.

    The 1965 to 1982 timeframe provides support for one-year rallies being temporary events within a longer-term flat market. For instance, in 1973 and 1974, large-cap stocks declined 14.7% and 26.5%, respectively. Following these losses, the market then rallied 37% in 1975 and 24% in 1976. However, stocks declined again in 1977 by 7%.

    If lower-than-average stock market returns will be the rule for the next several years, how should investors save for retirement?

    Fortunately, investors saving for retirement generally do not invest all of their funds on a single day, nor do they need to withdraw all of their funds on another single day in the future. Financial planners have been preaching the benefits of dollar-cost averaging on a regular basis for years. Most investors do save on a regular basis, whether by payroll deductions to their 401(k) every month or by making regular contributions to a mutual fund. This strategy, often borne of necessity, is actually a powerful tool that can help investors cope with extended low-return market environments.

    The Importance of Dividends

    Looking back at the period from 1965 to 1982 can provide some other valuable lessons about investing in this type of market environment. Table 1 shows three different investment scenarios over this time period, beginning with the first trading day in January of 1965 and ending on the last trading day in December of 1981:

    • Investing $1,000 each month into the S&P 500 and ignoring dividends. The results from this strategy were far from outstanding—an annual average return of about 3.4%.

    • Investing $1,000 each month but reinvesting dividends on an annual basis. This scenario produced an average annual return of about 7.7%.

    • Investing $1,000 each month but reinvesting the S&P 500 dividends on a quarterly basis, to better reflect how dividends are actually paid. The results were not significantly different than the annual reinvestment assumption, with an annual average return of 7.8%.
    Obviously, the key variable in generating the higher returns was the reinvestment of all dividends. Over the 17-year timeframe, the dividend yield on the S&P 500 ranged from a low of 2.6% in 1973 to a high of 6.7% in 1982.

    Currently, the dividend yield on the S&P 500 is at or near an all-time low, approximately 1.5%. If dividend reinvestment is key to a level of returns that is acceptable for retirement planning, but dividends are at a historically low level, what does this mean for future planning?

    Will Dividend Policies Change?

    There are two potential scenarios when considering the future of dividend policy for U.S. companies. The first scenario is that corporations continue to de-emphasize dividends.

    The second possibility is that dividend policy does matter and companies will once again begin producing higher dividend yields.

    The first possibility is generally the accepted academic approach to dividend policy, based on the theory that dividend policy does not matter because investors are indifferent to the choice between receiving earnings as dividends or in capital appreciation of share price produced by retaining a greater percentage of earnings.

    Financial theory holds that a company’s sustainable growth rate is equal to its earnings retention ratio multiplied by its return on equity. Thus, if a company pays less in dividends and retains more of its earnings for reinvestment in the business, the company will grow faster in the long-run, providing more share price appreciation.

    If this theory holds true and dividends remain at a low level, there should be greater price appreciation that will offset the lower dividends and investors will not, therefore, demand higher dividends.

    The second scenario is that dividend policy does matter and that investors will show a renewed interest in companies that pay higher dividends, thus rewarding those companies in the market. If this were the case, dividend yields would revert to the higher levels common in the 1970s and 1980s.

    This scenario is supported by a more recent academic study that challenges the old theory, in which it is shown that higher dividend payouts historically have been more indicative of future earnings growth than low dividend yields.

    There are several theories to explain why this is the case. One is that high dividends offer a “signal” that managers are confident in the future prospects of their businesses and are comfortable paying out dividends, which coincides with the observation that dividends are “sticky”—that is, managers resist lowering dividends in all but the most extreme cases. A second theory is that low dividends are caused by managers investing earnings in dubious or marginal projects in order to increase the size of the business in an act of “empire building.”

    According to the proponents of this theory, the current low level of dividends yields would predict below-average growth rates for stocks for the next 10 years.

    Under either scenario, dividend policy will be important to the long-run success of investment plans. Companies will either be forced to increase their dividends to satisfy investors, or future share price appreciation will be greater due to higher retention rates.

    New Tax Rates and the Rebirth of Dividends

    Recently, a significant variable has been added to the argument over dividend policy. On May 28, 2003, the Jobs and Growth Tax Relief Reconciliation Act of 2003 was signed into law. The new law lowered the top marginal tax rate on qualifying corporate dividends to 15%, generally the same as the rate for long-term capital gains.

    One of the arguments that proponents of low dividend payout ratios often made was that investors could create their own dividends by selling appreciated shares and be taxed at the preferential long-term capital gain rate. Or, corporations could enter into stock buy-back programs and buy their shares on the open market, thus distributing excess cash through purchases, which would increase the company’s earnings per share by reducing the number of shares outstanding. The new tax rates on dividends eliminate that argument, since investors no longer have an after-tax advantage from capital gains as compared to dividends.

    If U.S. corporations were refraining from paying dividends due to adverse tax consequences to their shareholders, this change in the tax law should encourage them to begin paying dividends or increase their payout ratio.

    Additionally, the corporate accounting scandals of the last two years could serve as an additional motivator for companies to pay out dividends as a way of affirming the strength of their business and the veracity of their income statements.

    Following the enactment of the new law, increased dividend activity by U.S. corporations was significant, according to Standard & Poor’s:

    • Favorable dividend activity by S&P 500 companies increased by 53% in 2003 compared to the prior year.

    • Nineteen more firms paid dividends in 2003 than the previous year, the first year-over-year increase since 1994—and in that year, the net increase was only one.

    • In 2003, 62% of all S&P 500 companies that do pay dividends increased their payouts, and

    • Thirty-nine companies actually increased their dividends more than once during the year.

    • Finally, net individual dividend income increased by 50% in 2003 from $32.7 billion to $49.1 billion.
    Despite recent improvements, there is still a long way to go before dividend payouts return to previous levels. In 1980, 469 of the companies in the S&P 500 paid dividends, as compared to 370 at the end of 2003. Additionally, the current low dividend yield for the major market indexes suggests it will be a long time before dividend yields return to a level equivalent to historical averages.

    The change in the income tax rate on dividends will provide an interesting opportunity to test financial theory. Proponents of traditional theory would argue that dividend policy is irrelevant, while the challengers have shown that higher dividend payouts suggest higher future earnings growth.

    If the lower tax rates encourage more companies to increase their dividend payout, which consequently decreases the firm’s retention ratio, the effect on future earnings growth will provide support for one of these two arguments.

    Concentrating on the Fundamentals

    The historical record of stock market returns from 1965 to 1982 shows that a disciplined, patient investor would have generated an annual average total return of between 7% and 8% per year.

    But dividends were an important component of that total return.

    Even during the bull market of 1982 to 1999, dividends were an important component of total return. At the beginning of the bull market, the dividend yield on the S&P 500 was 6.7%. Although it declined through this period, it was still as high as 3.5% in 1995. Not until 1998 did it drop below 2%. The difference between the principal return of the S&P 500 and total return, including dividends, was still noticeable over the 1982 to 1999 time period. The average annual return over those 17 years for principal only was 15.42%. Total return including dividends was 19.08%, a difference of 3.66%.

    Many market analysts, including Warren Buffett, are predicting a rate of return over the next several years that is roughly similar to the rate of return for the 1965 to 1982 period.

    If this is indeed the case, sticking with the fundamentals will reward investors saving for retirement or other long-term goals.

    Investors should focus on the following:

    • Develop systematic investment and savings plans that will take advantage of market volatility,

    • Systematically reinvest all dividends,

    • Concentrate on minimizing fees and income taxes, and

    • Continue to diversify to gain exposure to asset classes that may generate more attractive returns over the next 10 to 15 years.
    Many investors became spoiled by the 20+% returns of the 1990s. Notwithstanding the strong performance of equity markets in 2003, there is a good chance that returns from the stock market will be below average the rest of this decade.

    While 7.5% returns are not nearly as exciting, they can be sufficient for long-term investment success. By using these reduced expectations in your planning, you can develop realistic plans that will still meet your long-term goals.

       Safety First: How to Make Sure Dividends Are Protected
    Dividends are an important part of the total return of stocks, and are enjoying somewhat of a renaissance under the Tax Relief Act of 2003. However, buying stocks simply because they have a high dividend yield can be risky. A stock’s dividend yield is determined by taking its indicated annual dividend and dividing it by its current stock price. An abnormally high dividend yield can be a sign of trouble—investors may have figured out that the current dividend is unsustainable and have sold the stock in anticipation of a decrease in the dividend payout. The lower stock price results in a high dividend yield. Investors can get a nasty surprise if they buy a stock because of the dividend only to have the dividends reduced or eliminated by management a few months later.

    How do investors know which dividends are safe and which ones are at risk of being reduced?

    According to Geraldine Weiss, founder of the highly regarded Investment Quality Trends, a La Jolla, California-based newsletter that tracks and recommends stocks based on her dividend yield approach, useful rules-of-thumb concerning dividend safety include:

    • Payout ratios (dividend as a percent of earnings) of 50% or less, although a rising earnings trend can support rising dividends. Be wary of payout ratios approaching 100%.

    • Indicated dividend should be lower than reported annual earnings; be wary of an indicated dividend higher than reported annual earnings.

    • A ratio of current assets to current liabilities of at least 2.0.

    • A debt-to-equity ratio of no more than 50% debt to equity.

    Jon Snare, CFA and CFP, is a senior manager with Deloitte & Touche Investment Advisors in Seattle, Washington. He can be reached at The views and opinions expressed in this article are Mr. Snare’s and do not necessarily represent those of Deloitte or its partners.

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