July 1, 2005

Notes to article in most recent Financial Analysts Journal called “Dividends and the Frozen Orange Juice Syndrome,” by Peter L. Bernstein. I bolded my comments.

I was at a closed end fund meeting, where a manager of a utility fund (i forget who) suggested this article. Here are the
notes I took, which is relevant to my work. We have been focusing on dividends for a long time. Our focus became greater just prior to the beneficial tax change in 2003.

1. Corporate payout ratios for 2004 in terms of reported and operating earnings are down to close to 30%.

2. From 1950 – 1989 the payout ratio on the S&P500 averaged 50%, and only fell below 38% once in 1979 (due to surge in oil


3. Payout rates are approaching the record lows of second half of 1990’s.

4. His old favorite ratio of “dividends/book value” is about 4.5%, a full 100bps below 1999. This is happening at a time
when profit margins are historically high and borrowed money is cheap. All this tells him that the demand for dividends is nil. He says it makes no sense, especially since taxability of dividends is very low. Of course one could argue that much of invested assets are in tax deferred plans.

5. Dividends matter.

6. Says dividends are real, whereas earnings can be and are manipulated. earnings are accrual estimates, even with the
best of intentions. If you search “dividends matter fischer black” you will find lots of good stuff on this topic.

7. Jeremy Siegel on dividends. Bernstein differs and cites the analysis of Karl Marx in “Capital,” 1867. I took another look at the article, and cut and pasted below:

“More recently, Jeremy Siegel (2002)—one of the most enthusiastic of the bulls on the stock market— pointed out that “the old-fashioned way” of estimating earning power always depended on dividends: Dividends are crucial for pricing a firm, since
finance theory states emphatically that the price of a stock is not the discounted value of future earnings, but the discounted value of future dividends and cash distributions.”

” What Are Capital Gains Worth? Siegel was convinced that taxes explain the shrinking shareholder demand for dividends. “Shareholders prefer that companies use earnings to lift the price of their shares rather than pay taxes on dividends” (p.9) was how he put it. He was in good company. Such leading theoreticians as Franco Modigliani, Merton Miller, and Fischer Black went even farther; they argued that—taxes aside—investors should be indifferent between dividends and capital gains. They had no doubt that “dividends don’t matter.” I beg to differ. My position on this controversy derives from the analysis provided by Karl Marx in Capital (1867). Marx proposed a handy little equation to explain the workings of the capitalist system: M-C-M′. In words, the capitalist begins by investing Money, M, into Capital goods, C, which the capitalist expects to return more money, M′, than the M the capitalist started out with. Most of Capital is concerned with the sources of M′, but my interest here is in what this equation can tell us about the importance of dividends.”
He says that Marx proposed an equation explaining the workings of the capitalistic system. “M-C-M”

M= Money invested in
C= Capital Goods
M= expected return more money than capitalist started out with.

He stresses cash, and not appreciation, since cash is what is needed to pay your bills.

8. Claims that for a rational investor, investments that never yield cash are extremely risky. At the same time, he discusses how he owns Berkshire Hathaway. He claims that even this investment is based on greater fool theory and has no intrinsic value, unless the odds are positive on a cash payout somewhere or sometime in the future.

9. earnings fell 12% between 1955 and 1961, while stocks rose 59%.

10. earnings rose 54% between 1969 and 1974, while stocks fell 26%.

11. GE has paid out 40% of earnings for many years, yet he claims their growth rate is envied.

12. Payout ratio exceeded 50% in every year of the 1960’s.

13. Tax differentials seem to have been “no obstacle.” From 1953 – early 80’s, top federal tax rate was 70%, vs. long term capital gains rate of 25%.

14. Why is demand for dividends so small? For the record, I do believe that Berkshire will pay a material dividend in the near future.

a. It’s a puzzlement, he says.

b. frozen orange juice syndrome. A generation has grown up drinking frozen orange juice and believes that orange juice
only exists in this frozen format. They never indulged in the real thing, so they don’t know what they are missing. Low
payouts and low yields are the frozen orange juice that today’s investors consider to be normal.

15. History lesson:

a. From 1871 – 1950’s, investors set dividends at 4% – 6% range. Payouts were in 50% area. He said that dividends were
higher then, because of lack of corporate credibility and corporate reporting was far less extensive.

b. By 1960’s veterans of the crash had died or retired. Pension funds became increasingly important.

c. credibility has been shattered in the 2000’s. Dividends are not remembered, and he compares new investor to that of Pension funds in the 1960’s.

16. He thinks the orange juice is still Well-frozen, except in high yield bond area, where current yield usually suffices to
offset default losses. Maybe one day soon, the world will see the value of dividends, especially with the 15% tax rate. If
that day arrives, the new generation will disdain frozen orange juice.