The Future for Investors

by Jeremy J Siegel

  On May 27, 2003, President Bush signed into law his “Jobs and Growth Reconciliation Act of 2003,” central to which was a decrease in the dividend tax rate and capital gains tax rate to 15 percent. Although I preferred the deductibility at the corporate level instead of the personal level, the dividend tax relief was much needed and welcomed.

  Responding in kind, many companies increased their dividends substantially, and dividend growth surged to levels not seen in more than forty years. Clearly, the dividend tax cut worked its magic.9

  Stock Options and Dividends

  Taxation was not the only factor restraining dividends. The role of employee stock options in discouraging dividends is more indirect than taxes, but just as important.

  Microsoft provides the perfect illustration.

  On January 16, 2003, a week after President Bush announced his plans to reduce the tax rate on dividends, Microsoft announced its first ever dividend: 8 cents a share. While the yield was small (less than one third of 1 percent), it was a giant step forward.

  But an equally important decision was made at that time. No longer was Microsoft going to issue its employees options; the firm announced that its incentive compensation would consist of common stock instead of stock options.

  Dropping stock options at Microsoft was a dramatic change, since the technology giant pioneered using stock options to attract its employees. Some claim that Microsoft created as many as 10,000 millionaires from generously doling out these options.10 Everybody from programmers to “gofers” who fetched laundry was rewarded with stock options. Stories of staffers and secretaries who retired in their thirties from their millions cashed in on Microsoft options created a culture where stock options were the primary vehicle that technology firms used to recruit and motivate the best talent.

  Now, instead of motivating its employees with options, Microsoft issues its employees shares that receive dividends. You can be certain that had Microsoft not canceled its stock option plan a year earlier, it would have never paid a one-time dividend of $3 per share as it did in 2004, since option holders do not benefit from dividends. This is because options pay off on the price of the stock, not the dividend. Paying dividends, although enhancing the returns of shareholders, does nothing for option holders.

  Option Reform

  To understand what must be done to curtail stock-option compensation, it’s instructive to understand why it blossomed in the first place. Management stock options surged in the mid 1990s after Congress passed a law in 1993 that prohibited firms from deducting a manager’s compensation above $1 million from taxes. This law, which is now part of Section 162 (m) of the Internal Revenue Code, was enacted in response to the public uproar over the ever-rising compensation paid to top executives.

  But businesses argued that top managers needed incentive-based pay to boost firm profits. So at the same time this law was passed, Congress exempted incentive-based forms of compensation from the salary cap. Shortly thereafter, the IRS ruled that option grants qualified as incentive-based compensation. This opened the floodgates.

  This legislation is a perfect example of the Law of Unintended Consequences. The proliferation of option grants gave CEOs strong incentives to cut dividends and do everything they could to hype the price of their stocks. What started out as well-intended legislation designed to curb excessive management pay instead contributed to massive executive option packages built around the short-term price performance of the stock and not the long-term interests of the shareholders. To reduce the incentives to issue options, I advocated that firms be required to expense these options, and I recommended that Congress repeal the 1993 law that restricted the tax deductions for cash compensation.11

  In contrast to the taxation of dividends, we have made less progress when it comes to option reform. Although an increasing number of firms are expensing options, there is still fierce political opposition to proposals recommended by the Financial Accounting Standard Board that would make expensing options mandatory. These issues will be more thoroughly discussed in Chapter 11.

  Wrapping It Up

  The fundamental importance of dividends in delivering superior stock returns rests on credibility. Dividends are the way investors know that the earnings are real. If management says that the firm has a profit, stockholders have the perfect right to say: “Show me the money!” Those firms that do have delivered the best returns.

  After two decades of decline, dividends and dividend-paying stocks are coming back. President Bush’s dividend tax cut was effective at mitigating the double taxation of dividends. Further reform should be aimed at exempting reinvested dividends from the income tax.

  In the next chapter, I shall show that not only do dividends enhance returns but they also protect investors in bear markets.

  CHAPTER TEN

  Reinvested Dividends:

  THE BEAR MARKET PROTECTOR AND RETURN ACCELERATOR

  The importance of dividends for providing wealth to investors is self-evident. Dividends not only dwarf inflation, growth, and changing valuation levels individually, but they also dwarf the combined importance of inflation, growth, and changing valuation levels.

  —Robert Arnott, “Dividends and the Three Dwarfs,” 2003

  Chapter 9 showed us that dividend-paying stocks provide superior returns for investors. But there is another quality of dividend-paying stocks that makes them very attractive. Long-term investors who reinvest their dividends will find that bear markets not only are easier on their portfolio but also can enhance their wealth. If the price of the stock falls more than its dividend—and this almost always happens during market declines—then the dividend yield will rise. And a higher dividend yield is a ticket to higher returns. Let’s see how these phenomena worked during the single worst period in U.S. stock market history.

  The Great Bear Market

  It took more than a quarter of a century, but on November 24, 1954, the Dow Jones Industrial Average finally closed above the level it had reached at the bull market peak on September 3, 1929. This twenty-five-year stretch is the longest time between stock market peaks in the more than one-hundred-year history of the Dow.

  For many, the market had been an unmitigated disaster since 1929. The Great Depression that followed was the greatest economic contraction in U.S. history. Many stocks fell 90 percent and more, and a vast majority of those who invested on margin or with borrowed money were wiped out. Millions vowed never to invest in equities again.

  But for long-term stock investors who declined to buy stocks with borrowed money, those twenty-five years had been far from a disaster. Take a look at Figure 10.1, which shows the total wealth of stock and bondholders during this period.

  Instead of just getting back to even in November 1954, stockholders who reinvested their dividends (indicated as “total return”) realized an annual rate of return of over 6 percent per year, far outstripping those who invested in either long- or short-term government bonds. In fact, $1,000 invested in stocks at the market peak turned into $4,440 when the Dow finally recovered to its old high on that November day a quarter century later. Although the price appreciation was zero, the $4,400 that resulted solely from reinvesting dividends was almost twice the accumulation in bonds and four times the accumulation in short-term treasury bills.

  Stock Returns Without a Great Depression

  The impact of bear markets on long-term investors is far different from what most investors believe. Consider the following hypothetical history.

  Imagine that the Great Depression had never occurred and, in fact, there never was an economic downturn. As a consequence, assume that stock dividends, instead of dropping sharply, made a smooth ascent from 1929 to 1954, and stock prices, instead of plummeting, remained stable.1 Obviously this scenario would have been far better for the country, as the massive unemployment, bankruptcies, and economic hardships that had occurred during the 1930s never would have existed.

  Yet this rosy economic scenario would have been far wors
e for long-term stock investors. Although the market would have reached the same level by November 1954 in either scenario, the returns to shareholders would have been far different. As Figure 10.1 shows, $1,000 invested at the market peak would have turned into only $2,720 in November 1954 had the Great Depression never occurred. This is 60 percent less than what investors actually accumulated as a result of this economic catastrophe.

  How could this happen? Although dividends declined a whopping 55 percent from their peak in 1929 to their trough in 1933, stock prices fell even more. As a result, the dividend yield on stocks, which is critical to an investor’s total return, actually rose. It is true that shorter-term investors were indeed worse off between 1929 and 1949 because of the Depression, and twenty years is not an insignificant period of time. But for those who persevered, the extra shares purchased during the bear market caused their returns to rocket ahead when stock prices finally recovered.

  FIGURE 10.1: ASSET RETURNS BETWEEN SEPTEMBER 1929 AND NOVEMBER 1954

  During the Depression, long-term investors gained at the expense of all those who were forced to sell their stock, either because they had purchased their stocks with borrowed money or, more commonly, because they dumped their shares in a panic, figuring that getting some money from their investment was better than nothing. These sellers turned out to be the big losers.

  There is an important lesson to be taken from this analysis. Market cycles, although difficult on investors’ psyches, generate wealth for long-term stockholders. These gains come not through timing the market but through the reinvestment of dividends.

  Bear markets are not only painful episodes that investors must endure; they are also an integral reason why investors who reinvest dividends experience sharply higher returns. Stock returns are generated not by earnings and dividends alone but by the prices that investors pay for these cash flows. When pessimism grips shareholders, those who stay with dividend-paying stocks are the big winners.

  The Bear Market Protector and Return Accelerator

  There are two important ways that dividends help investors in bear markets. The greater number of shares accumulated through reinvested dividends cushions the decline in the value of the investor’s portfolio. It is because of the additional shares repurchased in down markets that I call reinvested dividends the “bear market protector.”

  But these extra shares do even more than cushion the decline when the market recovers. Those extra shares will greatly enhance future returns. So in addition to being a bear market protector, reinvesting dividends turns into a “return accelerator” once stock prices turn up. This is why dividend-paying stocks provide the highest return over stock market cycles.

  The Bear Market Protector: The Case of Philip Morris

  The theory that dividends are a bear market protector is equally as valid for individual stocks as it is for the market. In Chapter 4 we saw that Philip Morris had the best return of all the original S&P 500 stocks over the last half century. There is no better example of a company that proves bad news causing its price to go down could actually turn into good news for long-term shareholders.

  In the early 1960s, Philip Morris was dead last in sales among the six major American cigarette producers. But the development and promotion of Marlboro cigarettes was a marketing coup that propelled the brand to be the world’s best-selling cigarette in 1972. In 1983 the firm overtook R.J. Reynolds Tobacco, which had been the leading cigarette producer for a quarter century.

  With rising health concerns about tobacco and increasing cash flowing in from cigarette sales, Philip Morris decided to diversify its operations. The company purchased General Foods in 1985 and Kraft in 1988, successfully integrating food products into its other lines of business. From 1957 through 1992, investors in Philip Morris achieved an astounding annualized return of 22 percent.

  But the future was not as bright as the past. Figure 10.2 shows the ups and downs of Philip Morris stock from 1992 through 2003.

  The first bombshell for Philip Morris shareholders occurred on April 2, 1993. Smokers had begun to rebel against the steady rise in the price of premium brands by opting to buy generic cigarettes whose prices were half that of Philip Morris’s brands.

  But Philip Morris decided to fight fire with fire: it slashed its prices 40 cents a pack. The New York Times described this as a “crash campaign to keep smokers loyal.” Yet crash is exactly what happened to its stock price. The stock fell 23 percent on the news that generics were finally making headway, cutting into brand loyalty critical for Philip Morris’s success.2 April 2, 1993, became known as “Marlboro Friday.”

  But tougher competition from the cheaper generics and newly imposed cigarette taxes were by no means the toughest test for Philip Morris. A wave of tobacco litigation threatened to bankrupt the entire industry.

  Litigation worries always existed, but in the early 1990s tobacco companies were proud of the fact that they had never lost a single case.3 However, a Pandora’s box was opened on March 13, 1996, when Bennett LeBow, the financier who in 1986 had taken over the Liggett Group (maker of Chesterfield and L&M cigarettes), announced a settlement with five states that had sued the industry. This was the first time a cigarette company dissented from the industry’s standard defense that tobacco products were not addictive. The Liggett group agreed to give up 5 percent of its pretax income for the next twenty-five years to settle the class action lawsuits against it. But, instead of making problems go away, the lawsuits intensified. One by one, additional states started suing the tobacco companies to recoup money they paid out through Medicaid and Medicare to treat smoking-related illnesses.

  FIGURE 10.2: IMPORTANT DATES FOR PHILIP MORRIS STOCK, 1992–2003

  These lawsuits kept the tobacco stocks under constant pressure. Big Tobacco finally agreed to settle lawsuits in 1998 that would pay the states a cumulative total of more than $206 billion over the next twenty-five years to make up for smoking-related health problems—a gigantic sum that far surpassed any other settlement in legal history. Philip Morris’s share of the settlement was approximately $100 billion.

  But the litigation did not stop there. In 1999 the U.S. government filed a massive lawsuit against the tobacco companies, and on July 14, 2000, Philip Morris was slapped with $74 billion in punitive damages to Florida smokers.4 Then on June 6, 2001, a Los Angeles jury awarded Richard Boeken, a former smoker, $3 billion in punitive damages. Given that almost half a million deaths per year have been attributed to cancer and other smoking-related diseases, this award, if applied to others, would most certainly bankrupt the industry.

  Facing all this bad news, the billions of dollars in lawsuits, rising cigarette taxes, increasing negative publicity about smoking, and share lost to generics, it will come as no surprise that Philip Morris significantly lagged the market in the 1990s.

  In March 2003 Philip Morris, which in January of that year had changed its name to Altria Group, lost an Illinois lawsuit that claimed the company’s use of the word light was misleading. The firm was ordered by a judge to pay $10 billion and post a $12 billion bond. Philip Morris claimed that forcing it to put up $12 billion constituted an unreasonable burden and that it might have to file for bankruptcy if the court insisted on such payment. Philip Morris stock sank to $28 a share, about the same level it had achieved twelve years earlier. During this period, when the S&P 500 Index soared from 380 to 800, Philip Morris’s stock price went nowhere.

  Despite these ups and down, during this twelve-year period Philip Morris never lowered its dividend; in fact, it raised its dividend every year except 1993 and 1997. As a result, from 1992 through April 4, 2003, investors who reinvested their dividends increased their shares by over 100 percent, and their total return was a healthy 7.15 percent per year. This return did trail the market, but investors were perfectly situated to receive sharply higher returns if and when Philip Morris’s price recovered.

  And they didn’t have to wait long. The return accelerator was about to work its magic.
When the Illinois judge relented on the company having to post a $12 billion bond, Philip Morris’s shares jumped. By the end of the year, Philip Morris was selling at $50. Although the appreciation of Philip Morris shares did trail the S&P 500 Index, shareholders who reinvested increased their shares by 100 percent and the total return to Philip Morris’s stockholders actually beat the famous benchmark. It is yet another case where bad news for a dividend-paying stock spelled good returns to long-term investors.

  Dividends and the Top-Performing Stocks

  Table 10.1 reproduces the list of 20 best-performing survivor stocks from the original S&P 500 firms that we examined in Chapter 3. The return of each of these companies beat the S&P 500 over the past forty-seven years by between 2.8 and 8.9 percent per year, and every one of them paid a dividend.

  The basic principle of investor return indicates that returns are magnified when dividends are paid and earnings growth exceeds expectations.

  All of these top twenty firms had their returns boosted by dividend reinvestment. In fact, every stock in Table 10. 1 has raised its dividend continuously over the past twenty years except for Royal Dutch, Schering-Plough, and Kroger. Management’s commitment to return cash to their shareholders propelled the return on these stocks upward.

  The case of Kroger illustrates how reinvested dividends can supercharge returns. In 1988 Kroger borrowed $4.1 billion in order to fend off a corporate takeover from Kohlberg Kravis Roberts. With this money, Kroger paid a $40 one-time special dividend in August of that year as well as a debenture valued at $8.50 in December. Because of the huge indebtedness, Kroger had to use all its earnings to pay interest on these bonds and subsequently stopped paying dividends, but those investors who reinvested the $48.50 distribution increased their shares of Kroger more than sixfold. The dividend accelerator then worked wonders when Kroger continued to grow. If investors did not reinvest their dividends, their accumulation in Kroger stock would have been 60 percent less.