The Investor

The Groucho Marx Theory of Dividends

No, not ''I was only with that girl because she reminded me of you.''

By 1.2.03

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The first big business story of 2003 will be about corporate dividends. Once the inducement to own the dowdiest stocks, dividends are suddenly hot. According to a recent Fortune, stock dividends have risen 20% since last spring, and dividend payouts by S&P 500 companies have grown by half a percentage point in the first nine months of 2002. It's not a surprise, really: after three losing years in the stock market, a cash dividend puts at least some money in your pocket. Dividend-paying companies also have a reputation for being conservative and reliable.

Now, it looks like the government may help pay for the party. Republican victories in the Senate and House in November, plus all this talk about an economic stimulus package, have increased the likelihood that taxpayers will receive some kind of tax break on dividend income.

I hate to spoil the fun, but there is a big ugly downside to all this dividend hype. Except for a small number of investors, dividend yield should be irrelevant in deciding to buy a stock. Furthermore, tax relief in the form of reducing the taxes on dividend income (to, say, 20%, like long-term capital gains) will have a disastrous effect on the economy. Dividends are much more dangerous than they look.

Dividends are an unproductive use of capital. One of the great attributes of our economic system -- maybe its greatest attribute -- is that it gets capital to the places where it can be used most efficiently. (Close behind is the fact that, after providing the greatest rewards to those most responsible, the system generally rewards a relatively large number of people for being part of the process, like investors, customers, and employees.)

Every investor makes this decision without even thinking about it. Who can make better use of $100,000, me or Bill Gates? I was thinking of opening a pizza joint, but I think Microsoft will make better use of the capital than my restaurant fantasy, so I bought 2,000 shares. Imagine my horror if I received this letter:

Dear Mike:
Thanks for investing in Microsoft. We used the money profitably, but ran out of ideas. Enclosed is a check. Let us know how the pizza place turns out.
Bill G.

At first, I'd appreciate the candor. This would be better than Microsoft blowing the money on some product that never had a chance, or on some poorly conceived acquisition. But the day Microsoft says Mike Craig can use money more productively than Bill Gates is the day I get rid of that stock.

The whole economic recovery is up for grabs if Congress and the President allow a portion of the economic stimulus package to be wasted on dividend tax relief. Encouraging companies to pay dividends would lead to economic stagnation, not economic stimulus. The recovery is so shaky because businesses aren't spending. They are cutting inventory, laying off workers, putting off capital improvements, and slowing down research and development. The consumer, in contrast, is generally holding up his end of the bargain, buying things and racking up debt.

If ever there was a time to direct a tax benefit to business, it is now: make it cheaper for businesses to hire more workers, pay them more money, buy new equipment, and increase R&D. Companies usually do these things before they pay dividends because these other things enhance the company. Dividends don't. And the current tax system encourages spending the money productively, and discourages just returning it to investors. Encouraging companies to devote more profits to dividends, and less to more productive uses of capital, will stop the recovery in its tracks.

A lot of dividend-paying companies are getting a free image boost these days. Yes, most dividend-paying companies are conservative. But that's because they don't have much choice. Look, for example, at Philip Morris, which pays a fat dividend. The company would probably rather spend that money on marketing to get more people to smoke, or on blends of tobacco that encourage people to smoke more. Of course, they aren't allowed to do that. AT&T used to pay a big dividend. Once it got the approval to enter other businesses, it took a shot at diversifying out of its dead-end long distance business. It didn't work out, but it was absolutely the right thing to try. Like most companies, AT&T paid a big dividend only when it had no place else to put the money

With more companies offering dividends and the possibility of more still if Congress gets involved, investing for yield will become a dangerous game. After all, dividend yields are not guaranteed. If companies start throwing money at investors to make their stocks attractive, they could be taking money away from other things, and eventually find themselves having to cut those newly-generous payouts. Almost as bad as owning stock in a fraudulent company is owning one that cuts its dividend. Apart from losing that regular payout, investors flee the scene, sending the stock plummeting. (And what if some company tries to get with the program by offering a dividend, then later discovers some other great use for the money -- a great acquisition or vital R&D? To keep investors from jumping ship, it's going to have to pass.)

Finally, most of what I read suggests that Congress will probably cut the taxpayer portion of the tax rather than the corporate portion. After all, the pressure is on Congress to spread the stimulus around. If that happens, it will still be disadvantageous for a corporation to pay a dividend, compared to some other (tax-deductible) use of the money. But now you've got a nation of investors looking for dividend yield. For companies to attract those investors, they will have to spend their money on non-deductible dividends, even though they have previously been spending it on deductible items they thought would help investors more in the long run. Isn't that just as bad as a company, during the late Nineties, making a dramatic acquisition for too much money to impress shareholders?

To paraphrase Groucho Marx, I wouldn't want to own stock in any company that thinks I could outperform it.

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About the Author

Michael Craig is a writer in Scottsdale, Arizona.