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Australian market participants’ views about dividends (the payments which are derived from a company’s present or retained earnings and remitted to its shareholders in the form of cash or shares), despite their variety, tend to be lukewarm and are sometimes dismissive. These views also ebb and flow. On 24 August 2001, for example, a report in The Australian Financial Review stated “the recent squeeze on corporate profits has driven companies to pare back dividend payouts, a move which is part of a trend on the part of companies harbouring cash to fund growth-oriented opportunities. Whilst the tough operating environment for Australian corporations can be held partly responsible for the change, alterations to taxation legislation and a need for companies to fund growth opportunities to remain globally competitive are the main drivers.” Less than two months later, on 15 October, came an interpretation from a shareholder’s (as opposed to an executive’s) point of view: “with earnings forecasts falling and share prices down, dividends are enjoying renewed popularity as investors seek out defensive stocks and reliable returns.
Investors who have been preoccupied with capital growth over the past two years are once again looking at dividend yields and payout ratios in the belief that capital gains are going to be scarce for the foreseeable future.” And another month later, on 29 November, came yet another contention: “the prospect of a swift economic world recovery and an increased appetite for risk has steered investors away from the safety of dividends towards stocks with the potential for capital growth. Strategists are expecting the flight away from dividends to accelerate as investors’ willingness to invest in less secure stocks increases, alongside confidence in a global economic recovery.” Given this heterogeneity and fickleness of views, it is not surprising that Australian companies’ policies with respect to dividends vary. But this heterogeneity has well-defined limits: although policies differ from company to company, the average company’s policy tends to change slowly over time. A few companies retain most or all of their earnings; a further few retain little and remit most to their shareholders; and most retain some and return the bulk to their owners. As a rough rule of thumb, in recent years the average Australian company’s payout ratio (i.e., the percentage of earnings paid as dividends) has averaged 68% and has been as high as 75%. On 15 February the average company’s earnings yield (i.e., its earnings during the past year expressed as a percentage of the market price of its shares) was approximately 5.1%; and its dividend yield (i.e., its annualised dividend expressed as a percentage of the market price of its shares) was approximately 3.5%. These figures imply that the average company currently remits 69% (i.e., 3.5 ÷ 5.1) of its earnings as a dividend. In the next several years, according to CSFB Australia and others, this payout ratio is expected to decrease steadily.
In the U.S. the picture is vastly different. During the 1950s, 90% of American companies paid dividends, but today fewer than one in five does. Further, between 1925 and 2000 dividend-payers in the Standard & Poor’s 500 index remitted to their owners an average of 57% of their reported earnings. But in recent years the average payout ratio has fallen substantially and in 2000 it stood at just 33%. Accordingly, and also given the drastic rise of stock prices during the 1980s and 1990s, the average dividend yield (which fluctuated between 3% and 6% for most of the twentieth century) fell below 3% in 1994 and at the apex of the craze in 2000 collapsed to little more than 1.0%. On 15 February it stood at approximately 1.4%. Not only are American companies loath to commence the payment of dividends: they are increasingly prepared to cut established levels of dividends. In 2001 the dividends paid by the companies comprising the S&P 500 dropped by the greatest amount (3.3%) since 1951. That decrease, together with the cut of 2.5% recorded in 2000, represented the first back-to-back declines in dividends since 1970-1971. (Dividends have not fallen for three years in succession since 1931-33). Historically, then, directors of American companies have retained far higher percentages of earnings than have their Australian counterparts. This tendency has grown during the past ten years and became extreme during the mania of the late 1990s. As a result, by historical and Australian standards American companies today pay (and their owners receive) very meagre dividends.
Denigrating Dividends
This development is associated with, and may be caused partly by, the Internet craze of the late 1990s. During the mania, dividends were regarded in America as an outmoded inheritance from the “Old Economy.” Many companies, generally “technology” outfits and particularly newly-floated enterprises, denigrated them and declined to pay them; further, in order to establish their New Economy credentials some prominent and well-established corporations terminated decades-long track records of making steadily-higher dividend payments. Indeed, a few scrapped these payments altogether. According to Eugene Fama and Kenneth French, between 1973 and 1977 33% of newly-listed companies paid dividends during their first year on the exchange. By 1999, fewer than 4% of such companies did so. Perhaps most notably, Microsoft CEO Steve Ballmer “historically has said no way to the idea of a dividend.” Once asked why Microsoft did not pay some of its mammoth cash flow to shareholders, Bill Gates stated “the share price is the dividend, stupid.”
Similarly, Oracle believes “it to be in the best interests of stockholders to reinvest our earnings into the future of the company” (The Wall Street Journal 2 January 2002). During the mania, American owners of stock also denigrated dividends. One was quoted in The Wall Street Journal (29 January 2001): “when I buy a stock, I don’t even ask what the dividend is. If they pay something, great, but it’s not in my decision-making process.” According to the Journal, this stockholder “isn’t alone in his thinking. For the generation of investors that came of age in the 1990s, the watchword is growth. And a new breed of corporate officer is prepared to supply it, dumping dividends in favour of value-enhancing moves such as stock buybacks….”
This perception has crossed the Pacific Ocean. According to The Australian (3 March 2000), “Computershare shareholders yesterday called on the board for an increased share of the company’s profits to be paid out as dividends, but [its Managing Director] was unequivocal in his response. ‘Personally I think you should cancel the dividend totally. I’m on record as saying that. I think it’s ridiculous. Microsoft doesn’t pay any dividend. You buy Computershare for capital growth – if you want an income stream you buy other companies that pay a dividend.’ Earlier, [Computershare’s Chairman] told the meeting it was better to receive capital growth than dividends.”
This perception has also extended well beyond the “technology” sector. According to The Weekend Australian (28-29 July 2001), the CEO of the Australian Agricultural Co. Ltd, one of Australia’s largest owners of stations and one of the world’s largest producers of beef, “has caustic views on Australian companies’ dividend policies. He says there is an unhealthy preoccupation with dividends, as distinct from ploughing earnings back into company growth … ‘Australian companies over-dividend compared with their international competitors. Here they pay five or six times [sic] the figure offered in the US, for example, where the emphasis is in ploughing back profits to provide growth and, therefore, capital gain … It is unfortunate that there is a percentage of the Australian investing population which views an investment in blue chip companies as a type of fixed income securities.’ He cited the Australian companies that have foregone high dividends, yet were successful, singling out News Corp.” (This CEO’s assessment of NCP may not be completely up-to-date: on 16 February 2002 it announced capital and other losses totalling $7 billion – more blood than has ever been spilt at once in Australian corporate history).
More generally, and according to The Australian Financial Review (24 August 2001), Australians “are more likely to now choose [sic] capital growth over dividends … Recent changes to personal taxation have accelerated the attraction of capital gains for Australian shareholders, who are not taxed as heavily on share market profits made after they have held stock for more than 12 months. And a wider global investor base for companies such as BHP Billeton, Rio Tinto and National Australia Bank has further diluted investor demand for fully-franked Australian dividends.” One of the AFR’s correspondents (31 July 2000) went further: “what was once a coveted icon of most blue-chip Australian companies, the fully-franked dividend, is fast becoming irrelevant.” To substantiate this general point, the AFR cited a director at one of Australia’s largest brokerage houses: “in terms of shareholder loyalty, companies are now starting to see [that] franking credits are not as important, particularly if you explain to shareholders that expansion is better in the long run … The trend at the top end of the market is to be more orientated [sic] to capital growth stories.” It also cited an analyst’s view that investors’ acceptance of lower dividends is developing, albeit slowly, and that they are recognising that companies must concentrate more and more upon “growth.” “I do believe we are tending to go in that [capital growth] direction but I haven’t seen a lot of evidence we are there yet …Certainly if the company is performing well the dividend becomes less of a necessity as the growth factor is quite a bit more attractive.”
An Underlying Argument
The contention, then (which appears to be long-established and unquestioned in America and developing in Australia), is that in order to maximise “growth” companies should retain as much of their earnings as possible and pay the smallest possible dividend. A related contention is that in order to maximise the returns from their investments shareholders should seek “capital gains” from “growth companies” rather than dividends from “defensive investments.” What is the source of this disparagement of dividends and praise of retained earnings? Although it is never expressed explicitly, it seems to me that these contentions are the conclusions of an informal argument containing two key definitions and three premises:
| Definition 1: |
If the market price of a company’s shares rises above the price paid by a given shareholder, then that shareholder enjoys a capital gain. For example, if one outlays $100 by buying 100 of a company’s shares at a price of $1 per share, and if the market price of the shares increases to $2 per share, then a capital gain of $100 occurs. If the shares are not sold, the capital gain is unrealised; and if they are sold, then the gain is crystallised.
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| Definition 2: |
The total return of an investment in a company’s shares consists in two components. The first is dollar value of any capital gain (whether realised or unrealised); and the second is the dollar value of any dividends received whilst owning the shares.
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| Premise 1: |
If a company invests its retained earnings productively, then its earnings in future periods will increase.
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| Premise 2: |
Whether they do so via increases in working capital, acquisitions of other companies or the purchase of their own shares, companies can invest their retained earnings more productively than shareholders can reinvest the dividends paid to them by the company.
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| Premise 3: |
If a company’s earnings increase, then the price of its shares will rise in a manner that reflects the increase; and if the company is expected to generate higher earnings in the future, then the price will rise in a manner that reflects this expectation.
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| Conclusion 1: |
Ignoring taxes and other complications, the total return to the shareholder generated by companies that retain a large percentage of their earnings will exceed the total return generated by companies that return a large percentage of their earnings to shareholders as dividends.
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| Conclusion 2: |
Companies should retain as much of their earnings as possible and pay as little as possible to their shareholders.
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Does the Argument Hold Water?
Alas, Parts II-III demonstrate that this argument does not emerge unscathed from scrutiny. Its definitions have several weaknesses, Premise 2 is doubtful and hence (at least in their current form) the conclusions are not unambiguously supported. Indeed, diametrically opposite conclusions may be closer to the truth. What Australian companies have done for decades, in other words, continues to serve shareholders well: companies should retain and re-invest only those earnings which (using suitably dour assumptions) are very likely to generate demonstrably better results than can reasonably be expected if invested elsewhere. If they cannot demonstrate a superior ability to re-invest excess capital, then they should return it to its owners.
...continued in Part II
 
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