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Midwest Investment Management
The Tower at Erieview | 1301 East 9th St | Suite 1110 | Cleveland, OH 44114
Introduction
In this issue...

By Norman F. Klopp, Jr., CFA, Partner

When Congress reduced the tax rate on corporate stock dividends recently, market analysts and media commentators suddenly found a new interest in dividends. There’s nothing like slashing the marginal tax on an income stream from 39.5% to 15% to get attention! We view the new focus on dividend-paying stocks as positive for the market in general; very positive for those stocks in particular; and rewarding for those of us who have always believed (or known) that dividends are, indeed, important. Because dividends are paid in cash, they are a strong indicator of a corporation’s ability to balance and meet the priorities of both the corporation and the shareholders. There are other reasons why we believe dividends are important:

  • • If a corporation can generate a high cash return on invested capital, it can fund growth and share that cash with shareholders;
  • • If corporate growth is at a sustainable rate, the dividend can be increased regularly;
  • • If management has a dedication to paying and increasing the dividend, it creates a discipline that perpetuates a high cash return on its future investments. Let me emphasize: Cash is real, earnings often are not, and dividends are paid in cash!
Benefits to clients We focus on dividend-paying stocks for client portfolios. In the aggregate, holdings in our clients’ managed portfolios show a higher yield; a higher rate of dividend growth; and a greater number of dividend increases, compared to the Standard and Poor’s 500 Index. We are not the only ones who think dividends are important. In the Financial Analyst Journal (March/April 2003), nationally respected analyst Robert Arnott wrote that over the last 200 years of U.S. stock market history, 74.4% of the market’s 7.9% annual compound total return has come from the starting dividend yield and dividend growth.

Research refutes opinion In the January/February 2003 issue of the Financial Analyst Journal, Arnott and Clifford Asness summarize a study which challenges an opinion that companies which have lower or no dividend-payout ratios (the percentage of their earnings they pay in dividends) will grow faster. People with this opinion contend that management can reinvest the cash in the business and drive growth, rather than pay dividends. However, Arnott and Asness suggest that:

  • The relationship of current payout to future earnings growth is strongly positive.
  • The higher the payout ratio, the better the average subsequent 10-year earnings growth.
  • The cash dividend is a discipline that potentially controls speculative “empire building” acquisitions that generate little or no positive return for shareholders.
Our conclusions? We continue to believe that dividends are important — not just as a contributor to overall stock performance, but also as an important indicator of future earnings growth.

New Tax Law Benefits Investors The reduction of the tax on DIVIDENDS to 15% from the previous marginal income rate of 38.6%, along with the new 35% top rate on ordinary income, will have a significant effect on after-tax returns. This is significant because income on INTEREST will continue to be taxed at ordinary income rates. The new lower rate also decreases the after-tax risk premium of owning stocks. In addition, because the 15% tax rate will now apply to both dividends and capital gains, dividends have become as taxefficient as stock buy-backs.

Most analysts believe the reduction of tax rates on dividends is good news for investors – it decreases the after-tax premium of owning stocks and may reduce “speculative empire-building” by corporate managements.