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High dividends point to companies set for growth

It may seem too good to be true, but companies that pay the highest dividends are also likely to grow the fastest.

For years, many finance professors have taught just the opposite. Reinvesting current earnings back into a company is supposed to promote earnings growth. Higher payout ratios are supposed to be followed by lower earnings growth.

But research conducted by Robert D. Arnott of First Quadrant and Clifford S. Asness of AQR Capital Management reveals a very different picture. For the overall stock market between 1871 and 2001, corporate profits grew fastest in the 10 years following the calendar years in which companies had the highest average dividend payout ratio. In contrast, the 10-year real earnings growth rate was the lowest following years with the lowest average payout ratios.

Arnott and Asness, who both work for quantitative research firms, began circulating early versions of their study in academic circles earlier this year. In their latest version, which will bepublished in the January/February issue of The Financial Analysts Journal, they respond to several arguments posed by critics.

Critics say that while the researchers' conclusion may accurately describe the behavior of the overall market, it may not apply to individual companies. Arnott and Asness concede that thisis possible.

But based on the preliminary results of additional research being conducted by Arnott, he believes it is likely that the pattern that he and Asness found at the level of the overall market applies to the individual firm as well. He notes in this regard another study that appeared in last December's Journal of Finance by two Columbia Business School accounting professors, Doron Nissim and Amir Ziv ("Dividend Changes and Future Profitability"). This other research found that between 1963 and 1997, earnings per share grew for two years at an above-market rate for the average company that increased its dividends.

Other critics worried that the research by Arnott and Asness may have been skewed by firms' share repurchases. Arnott and Asness reject that objection. They found that the period since 1980 fit the same pattern as did the prior period back to 1871, during which share repurchase programs were relatively rare.

Arnott and Asness believe that the primary cause of their surprising result is the poor job that the average company does when investing the cash that it would pay out as dividends. Therefore it is better for the company to distribute its earnings to shareholders.
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