Prior to the mid 1950s, common stocks usually paid more in dividends than corporate bonds, except during brief periods, such as the late 1920s, when common stock prices were unusually high. The historic rationale for pricing common stocks to provide more dividend income than was available on bonds was that companies are under no obligation to declare dividends on their common stock but they are contractually obligated to pay interest on their bonds. The income from holding common stocks was thus assumed to be less assured and riskier so that investors needed a greater inducement to hold stocks instead of bonds.
By now it has now been nearly 50 years since stock yields exceeded bond yields. Investors became willing to accept a lower current yield on stocks than on bonds for two reasons: government-sponsored inflating and high taxes. It became evident that economic activity was booming and was not going to relapse into the “secular stagnation” of the 1930s and that politicians were more focused on maintaining boom conditions, i.e., on short-term trends of output and employment, than with maintaining the long-term purchasing power of currency. Because common stocks are residual claims against the real assets held by corporations, which appreciate in terms of currency, even as inflating erodes the purchasing power of the debts owed by corporations, the recognition that inflating had become chronic made common stocks attractive as a “hedge against inflation.”
In addition, the high individual and corporate income tax rates that had been imposed as wartime measures were barely reduced. This meant that profits were taxed when they were earned by corporations, and again when paid out as dividend income to stockholders. In addition, capital gains were taxed at a lower rate than dividends, which created even more of an incentive to grow by reinvesting retained earnings, rather than pay dividends. However, the simple fact remains: “dividends seldom lie.”
A company’s earnings, assets and liabilities can be compiled in many ways to show different things to different observers. What it says on a company’s tax return can be very different from what it reports to stockholders, and both sets of books may be very different from what is used by the company’s day-to-day managers. Financial statements can be restated long after the fact, and, as the Enron bankruptcy shows, they may even be fraudulent.
In contrast, the amount of cash dividends that a company has declared and paid is an unambiguous number, not subject to varying interpretations or to revisions. Payment of cash dividends is a tangible indication of that a company is profitable (otherwise the dividends cannot continue for long). Buying a stock paying little or no dividends means hoping that someone else will one day be willing to pay more for it than you did, which may or may not happen. On the other had, cash dividends can be reinvested and compounded no matter what happens to your original outlay.
Also in This Issue:
Saving for College
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
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