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.

Tax policy plays favorites

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 included 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.

Chasing growth has not been an easy thing to do

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. 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 might 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.

Investors still like their dividends

After the tech and housing bubbles, however, investors' attention returned to capital allocation and the importance of dividends. Plus, today, the incentive that double-taxing dividends (first as corporate income taxes, then as personal taxes) created for corporate managers is on hiatus due to tax-relief legislation.