What's Really Driving Dividends?

Jeremy Glaser: From Morningstar.com, I'm Jeremy Glaser. I'm here today with Josh Peters, Editor of Morningstar DividendInvestor to talk about how some of this new certainty we're getting in at least short term tax rates has impacted dividend investing.

Josh, thanks for joining me.

Josh Peters: Good to be here. Not my favorite topic, but its good to be here.

Glaser: Well, we have heard a lot from investors, who have been clamoring for information about exactly what's going to happen to their dividend tax rates. Can you just give us a sketch of what this framework deal will mean for dividend taxation?

Peters: On terms of dividend and long term capital gains taxation, it really just extends the status quo. The entire package that was struck between President Obama and Congressional Republicans was really designed to either extend tax cuts that had been in place for some time, 2003 in the case of dividends and long-term capital gains, as well as adding some additional tax cuts, like the reduction in the social security piece of payroll taxes.

So, it is really just the status quo, which now is good relative to what we were looking at, which was the sunset of these provisions that really all kinds of tax rates where going to go shooting up on the first of the year if Congress didn't act, here we've got hopefully some action taking place.

Glaser: Now, there's been a lot of talk from corporate boards and from CEOs, saying that they were concerned about raising dividends because they didn't know what the tax treatment of them would be in the future. So are we going to see a kind of rash of new dividends or dividend increases now that we know at least for the next two years those rates aren't going up?

Peters: I really don't think so. I think it's going to be pretty much situation as usual and it kind of breaks down like this; for people who are on corporate boards or corporate executives, who are very, very concerned about tax policy when it comes to setting dividend practices, two years tacked on to the existing regime is probably not going to provide them the amount of clarity they want.

If you're going to put a significant regular dividend in place, you've got to be thinking about the next 5 years, next 10 years for your business, maybe even longer because you're going to get your investors hooked on those dividends, it's not going to be easy to yank them back away down the road.

But actually a much more important point to make is, I don't think tax policy is actually the key driver of dividend policy. I think that really in most circumstances, it's just an excuse for companies to not be paying the dividends that I think they should.

And the point of reference I use is that from almost all the post-war period, up until the late 1990s, in fact, American companies that are in the S&P 500 Index paid out a little over 50% of their earnings every year as dividends. Today, that's maybe 25%, 30%. So investors are really getting a lot less dividend income on their investments than they would have in previous eras, and the difference is in that stocks are massively overvalued relative to earnings, it's that those earnings aren't getting back to the investors who deserve them.

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Glaser: So, what's going to convince companies then to start paying out at those historicial levels or are those levels that are never going to be seen again?

Peters: Well, I think that it's going to be a long process, but it also got a relentless aspect to it and it really is driven by demographics. If you look at the changes in the dividend yield of the stock market as a whole over the last 30 years, as well as changes in the dividend payout ratio, even a more important figure perhaps to consider, it overlaps neatly with what the baby boomers want, as they move into their working years and started saving.

Markets are going up and it was more emphasis on capital gains and less on dividends. And by the time you get into the mid-to-late 90s, it's huge emphasis on growth, trying to slow those 401(k) balances in advance of boomers' retiring maybe another 10 or 12 years out.

Now, they are getting to the point where they're on retirement's doorstep and they found that the growth thing really hasn't worked out for the last 10 years. They didn't get the dividends and they didn't get the extra growth that they thought they were going to get in the bargain. So, what's its going to take is, investors literally voting with their feet.

Either people who are retiring, which is a relatively large cohort of the investing population, abnormally large in a historical context, they're going to move either from low and no dividend paying stocks towards higher paying securities within the stock market. That would mean that a company that pays a good dividend is going to probably trade at a premium in terms of PE or other valuation metrics to one that doesn't or pays a small one. And it also means that fixed income is going to be a more formidable competitor for investors' dollars.

It's not just low current interest rates, low yields at for say six months CD or something like that. The investors now need income. Capital gains, they know, aren't going to show up in time to pay the bills on a regular basis. Now, the emphasis has got to shift. So some companies I think are already thinking about this. I mean Microsoft is one case that put a dividend in place back in 2003. They've been growing it. The yield has become more meaningful, in part because the stock price really hasn't gone anywhere, but the dividend has continued to grow.

I think that they're starting to respond to some of these forces in the market, but in their case, I think they could do a lot more. In some other cases like Apple or Google or something like that, I wonder who they think is going to own their stocks 5 or 10 years from now, unless they are prepared to start being mature, profitable, cash cow companies that are going to provide investors with the kind of returns that they want. It can't be about double-digit or triple-digit growth forever.

Glaser: This tax cut deal only lasts for two years though, what are some of your thoughts and the best way to structure a permanent solution that would make sense for dividend paying stocks?

Peters: Well, I think the important thing is that in the long run we want to have made certain and permanent that dividends and long-term capital gains are going to be taxed at the same rate. Now, I don't know what that rate is going to need to be. I don't know what kind of tax reform proposals are going to come down the pike. How much total tax revenues might be needed in order to fund all the obligations of the government going forward.

There is a lot of broader, political and fiscal policy matters that you can get into their, but there is no reason to buy us a tax code in favor of long-term capital gains. Through most of the history of the federal income tax code that's what we had. Dividends where taxed at the investors' top marginal rate, where long-term capital gains were almost always eligible for some kind of a break, and that was essentially penalizing dividends and trying to incentivize companies to go after long-term capital gains, but that didn't really make any sense.

I mean every company, every business really needs to sit down and try to determine what that optimal mix of income versus growth is. If you bias seeing it in favor of too much growth, you're going to have a lot of risky projects, expansion capital that may not payoff or acquisitions or share repurchases at high prices that don't payoff, there is a lot more potential to destroy value for shareholders, and frankly, weaken the economy in the process by destroying capital value that's been created by having that bias in the tax code.

So, I think that a most important takeaway long run is that, since 2003, policymakers had been willing to endorse this principle that dividends and capital gains should be taxed at the same rate. In 2012, who knows what the whole picture will look like, but I think it's pretty good now, a pretty strong case you can make that we are going to have that kind of fair treatment going forward.

Glaser: Josh, I know it's not your favorite topic, but thanks for your interesting thoughts today.

Peters: Well, we will see where this goes, but I'm glad to have another two years of perhaps not having to think about it every day.

Glaser: From Morningstar.com, I'm Jeremy Glaser.