Discounting the Dividend Effect

I was recently asked if I was surprised by Microsoft's (MSFT - commentary - Cramer's Take) decision to stop using stock options. After all, I've penned column after column on the abuse of shareholders via profligate stock-option programs, while simultaneously advocating restricted stock as a better compensation tool. It was a surprise, to be sure, but it hasn't been the biggest one.

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Easily, my biggest surprise is an event that is indirectly related to the Microsoft announcement: the change in taxation of dividends, which the market has not yet fully discounted. That change has far-reaching implications, even for the Nasdaq Composite index.

In Part 2 of this column, I'll offer a different angle on Microsoft and its dividend policy, and how it affects the risk/reward for investors in leading technology stocks such as Cisco (CSCO - commentary - Cramer's Take), Dell (DELL - commentary - Cramer's Take), IBM (IBM - commentary - Cramer's Take) and Intel (INTC - commentary - Cramer's Take).

First, though, let's go back to a column I wrote last August:

Many economic Band-Aids will be proffered by the policy wonks at President Bush's confab in Waco Tuesday. One issue that isn't front and center -- but should be -- is the double taxation of dividends. Corporations pay taxes on profits, then, to the extent that those profits are paid to shareholders in the form of dividends, they're taxed again.

My understanding is that the double-taxation issue wasn't on the table at Waco until a participant mentioned it, almost in passing. After further discussion, President Bush ultimately embraced it as a key provision in his economic plan.

The exact causal chain of events here is unimportant. What is hugely significant to individual investors -- and what isn't now priced into the market -- is not how it happened, but that it did happen -- at least, in part. According to the plan, dividends are taxable at a maximum 15% rate.

Equities' Appeal as an Asset Class

Again, from my August column:

Lots of companies are selling at 10 times earnings today, but many don't pay a dividend. That's partly because of double taxation of dividends. If those same companies paid out 30% to 50% of profits to shareholders, the appeal of equities as an asset class would grow considerably...

From 1900 to 1980, companies paid out roughly 45% of earnings (depending on how you calculate earnings) in dividends. Dividend payouts, as a percentage of earnings, dropped dramatically in the '80s and '90s, coinciding with the advent of the bull market in 1982, when the Dow Jones Industrial Average launched an 18-year run-up from an August 1982 level of 777.

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. At time of publication, neither Alsin nor ACM held a position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.