Dividends and the Frozen Orange Juice Syndrome

The bonanza of a 15 percent top-bracket federal income tax on dividends has had little impact on values in the stock market or on management decisions about dividend payout ratios. The question is why. Dividends matter, yet investors have forgotten how to think about such factors. This article explains the phenomenon in the form of “the frozen orange juice syndrome” and describes through four chapters of history how the situation arose. Why has the bonanza of a 15 percent top-bracket federal income tax on dividends had so little impact on values in the stock market or on management decisions about dividend payout ratios? At 15 percent, this tax rate on dividends means that the after-tax income in your pocket from dividends is now worth as much as the after-tax dollars in your pocket from capital gains. This radical change should have ignited a big shift in investor preferences.Why has the response been minimal? To answer this question, I first make the positive case for dividends and then take a trip through history.Dividends matter, first, because earnings data, thus also P/E multiples, are inherently inaccurate—in many cases, purposely inaccurate. Dividends matter, second, because capital gains do not pay your bills. You must have cash to pay your bills. Therefore, for a rational investor, investments that never yield cash are extremely risky. Third, retaining earnings or buying back stock does not magically equal growth. Reliance on companies to use the cash to raise the price of their stock is reliance on the “greater fool" theory of investing. Companies cannot use cash to make the market raise their stock prices; no one can make the market do anything. Finally, the notion that growth companies need or use the money to continue growing and thus cannot afford to pay dividends is not true. For example, in the years before 1990, S&P 500 Index companies as a whole paid out dividends and still recorded high earnings growth rates. The payout ratio exceeded 50 percent in every year of the 1960s, the decade when growth became the dominant theme in equity investing.Yet, investors have forgotten how to think about these matters. I offer the unorthodox explanation of this phenomenon in the form of “the frozen orange juice syndrome." A generation that grows up drinking only frozen orange juice will forget that any other form of orange juice exists. Low payouts and low yields are frozen orange juice.I describe how this situation came about through four chapters of history: (1) From 1871 to the end of the 1950s, investors set dividend yields in a range of 4–6 percent. Payouts were in the 50 percent area. (2) For at least three decades after the market crash of 1929, veterans of that event dominated Wall Street. Most investors were still the wealthy individuals, and they lived off their incomes, not their capital. Institutional investing was in its infancy. (3) A paradigm shift occurred in the early 1960s with the rise of institutional investors, to whom dividends are not important. The miracle of compounding was forgotten; growth was what mattered. (4) By the technology bubble of the 1990s, the new market participants knew little about hard times and had no memory at all of the days when dividends mattered. The bursting of the bubble in 2000–2002 changed perceptions about the credibility of earnings announcements, but because nobody remembered much about dividends, dividends remained in the shadows. The new individual investors were not living off their incomes; moreover, none of the innovations in financial instruments of the 1990s—such as hedge funds—were focusing on income. Today, except in the area of high-yield bonds, income plays no role in portfolio strategy or in the formulation of investment objectives. All have forgotten any form of orange juice but frozen.Maybe one day soon, however, word will reach market participants that dividends have been enriched by an income tax of only 15 percent. If so, they will launch a new generation of investors who, at last, will disdain frozen orange juice.