When Congress slashed the top federal tax rate on dividend income in May, Wall Street expected that more U.S. companies would be motivated to boost their cash payouts to shareholders.
A summer of fat dividend increases by some of the nation’s biggest companies shows that wasn’t just wishful thinking.
Despite concerns that corporate managers would prefer to hoard cash for stock buybacks, acquisitions or other purposes, a growing number of companies have been choosing to send more of their profits directly to their investors in the form of dividends.
Markets research firm Standard & Poor’s in New York said in late September that 418 companies raised their dividends in the third quarter, a jump of almost 40 percent from the same period in 2002 and up 85 percent from the third quarter of 2001.
“Clearly, companies are responding to the lower tax rate on dividend income,” said Joseph Lisanti, editor of S&P’s Outlook newsletter.
Unclear if investors get it
What isn’t clear, however, is whether investors are showing a new appreciation for dividends.
The stocks that have led the market’s rally this year typically have been highly speculative issues that pay little or no dividend–most technology shares, for example.
That has troubled some Wall Street pros, who fear that investors didn’t learn anything from the collapse of tech shares during 2000-2002.
“It’s a return of wishful thinking” about unending capital gains, said Richard Bernstein, market strategist at Merrill Lynch & Co. in New York.
Yet some well-known companies that have raised their dividends dramatically in recent months also have seen their stock prices rewarded.
On Sept. 24, for example, fast-food titan McDonald’s Corp. boosted its annual dividend payment 70 percent, to 40 cents a share. Last week, the Oak Brook-based company’s stock hit a 52-week intraday high of $24.77.
Homebuilder Lennar Corp., which last month said it would begin paying an annual dividend of $1 a share, an increase from the token 5 cents a share it had been sending shareholders, also saw its stock soar to a 52-week high last week. The shares are up 76 percent this year.
Lowest tax rate in decades
The federal tax cut reduced the top rate on dividends to 15 percent from as high as 38.6 percent as part of a broader economic-stimulus package put forth by the Bush administration. It’s the lowest tax rate on dividends since before World War II.
Many investors had become disinterested in dividends over the last decade, in part because the tax code was biased against such income: Dividends were taxed as ordinary income, while long-term capital gains were taxed at far lower rates.
With the latest tax cut, dividends and capital gains now are taxed at the same rate.
In theory, that is supposed to make dividend income more attractive to investors, because dividends generally represent a return that investors can count on each year. Capital gains, by contrast, can be ephemeral.
Companies tend to decide on dividend payment rates with great care, and are loath to cut their payouts once established.
But even as dividend payments rise this year–companies in the blue-chip S&P 500 index are on track to boost their payments 10.2 percent, on average, the biggest increase in more than a decade–the percentage dividend yield on most stocks is in the low single digits.
That may be one reason why many investors can’t get excited about dividends, experts say.
The annualized dividend yield on the S&P 500 index is 1.6 percent. (The yield is calculated by dividing the dividend by the stock’s price.)
In the 1950s and 1960s, blue-chip yields typically were in the 4 percent to 6 percent range.
Yields top money markets
Still, the dividend yields on many big-name stocks are far above the 0.5 percent or so that investors are earning on money market funds and other short-term accounts.
The dividend yield on shares of financial-services giant Citigroup Inc., which in July raised its annual dividend 75 percent, to $1.40 a share, is 3 percent based on Thursday’s closing stock price. McDonald’s yield is 1.6 percent.
What’s more, even if dividend yields are historically low, they could be critical in providing investors with decent “total” returns on stocks in the next few years if economic growth is moderate and share price gains slow from this year’s pace.
The concept of total return, meaning the combination of dividend income and capital appreciation, was important to investors for most of the last century–until the unprecedented boom in stock prices in the late 1990s.
Some experts say that one long-term benefit of higher dividend payments is that capital should be allocated more efficiently in the economy, because investors would have more say in how profits are put to work.
That would leave less to be “frittered away on dumb ideas” by corporate executives, said Robert Arnott, head of money management firm First Quadrant in Pasadena, Calif.
Trend’s lifespan in doubt
But analysts also note that some investors may be suspicious about whether the lower tax rate on dividend income will be long-lived.
If President Bush is defeated in 2004, a Democratic successor could argue that the dividend tax cut was a sop to the wealthy and take it away, said Don Straszheim, head of economic consulting firm Straszheim Global Advisors Inc. in Santa Monica, Calif.
