Taxes on Dividends: A Very Bad Idea Is in the News Again

Greg,
I just read an article about Obama's new proposed tax rates.  I will be paying 43.4% Federal + 5% State & Local = 48.4% on interest & dividends.  God helps us!


This is just one of scores of emails we have received from clients regarding President Obama's recent announcement of his proposal for new taxes on dividends.  If Obama's plan comes to pass, it would mean taxes would rise by 2.5 times their current level. (From about 20% for Indiana residents to nearly 50%).


The above email was short and to the point.  Here was my answer: "Fear not. This does not have a chance of passing the present Congress. It's pure politics."  My reason for such a short response was not as a time saver or to be flip, it was to state the obvious.  We already have ample evidence of failed attempts by President Obama seeking to raise taxes on the rich.  Republicans in the House of Representatives have blocked all tax hike attempts from the president, even if it meant shutting down the government.  I can see no reason why they would suddenly change now.


I also disagree with a recent Wall Street Journal article entitled "Obama's Dividend Assault," suggesting that the entire stock market would come under pressure if the tax hikes were to be enacted.  That just will not happen.  You only have to go back and look at what happened prior to and after President George W. Bush pushed through the dividend tax cuts of 2003.   Dividend-paying stocks acted no differently from non-dividend payers immediately prior to or after the cuts.  The reason for this is simple, as much as 70% of all stocks are held by non-taxable accounts such as retirement plans, foundations, life insurance, annuities, trusts, and mutual funds that have the ability to manage taxes.      


We have been talking about the potential for a hike in taxes on dividends ever since President Obama took office. That is because President Clinton dramatically raised taxes shortly after he took office.  It is important to remember that Clinton's plan taxed dividends about the same as President Obama is now proposing.  We figured he would get around to attacking dividends sooner or later.


My own personal view and that of our Investment Policy Committee is that it is far too early to make changes based on something that might happen. Indeed, as we understand it, the tax increases would only affect individuals with adjusted gross income of $200,000 and joint filers with $250,000.  For people above those levels we have other strategies to diminish the impact of taxes. 


We will have much more to say about Obama's proposed tax hikes in the weeks and months ahead.  We wanted to get out our early thoughts on all the buzz surrounding the hikes.  We have traveled this road before when President Clinton hiked taxes dramatically on dividends. We lived through that, I am confident we will make it through whatever providence places before us.    

To Dividend or Not to Dividend, That Is the Question?

To dividend or not to dividend, that is the question?  In 2011, most of what we have been saying about dividend stocks for the last 15 years came into full view for everyone to see.  In a weak stock market, the cash payments distributed by dividend-paying companies were more highly valued than betting on the come with the non-dividend payers.  During most of the year, the dividend yields of many stocks were higher than the yield on a 10-year U.S.Treasury bond.  This fact alone lifted many consumer staple, energy, health-care, and utility stocks.  Taken as a group, dividend-paying stocks significantly outperformed non-dividend paying stocks.

In 2011, dividend-paying companies, particularly those that have a history of consistently raising dividends, gradually were seen to be bond substitutes.  This is due to the compounding effect of rising dividends.  A company with a 3% dividend yield today will be yielding 6% in ten years if its dividend grows at a 7% annual rate.   A company yielding 2% today with its dividend growing 12% per year will yield near 7% in 10 years.

During the year, dividend paying stocks became the equity asset of choice.  There was almost a perfect symmetry between dividend yield and total return:  The higher the stock's dividend yield, the higher was its total return for the year.  For example many utilities enjoyed total rates of return of 15% or more in a year when the S&P 500 grew by about 2%.

But here in 2012, the robust early gains for the S&P 500 (5%) and the Global Dow (10%) have presented investors with a very difficult question:  Do we continue to focus on the "knowns"of dividend investing, or do we abandon them for the  "unknowns"  of gut feelings and hot tips?

The reason this question is so important is because the impressive stock market gains in the new year have caused many strategists to raise their estimates of 2012 stock market performance to 15% or more.  A 3% dividend yield looks good in a 2% stock or bond world, but it does not stack up so well against 15% returns.  Because of this many articles have been written arguing its time to move away from dividend investing and start pursuing growth again.

We would argue that dividend paying stocks are likely to perform just as well as non-dividend payers, even if stocks rise by 15%.  The reason is simple, our valuation models now predict that the average stock in our portfolios, which has a 3.5% dividend yield, is undervalued by almost 25%. You must remember, we focus on rising dividends.  To achieve a steady stream of rising dividends, a company must also have a solid stream of growing earnings.

In short "To Dividend or Not to Dividend" may be a false question.  Dividend-paying stocks can offer market-type returns when stocks grow by up to 15%.  In our experience, dividend-payers only begin to lag the overall market when the S&P 500 grows by 25% or more.  Even then, they will get most of the gains.

Considering how well the dividend payers do in down markets, and in view of all of the uncertainties in the world, we still believe "To Dividend" is the right answer for most people.    

We own dividend-paying stocks.

Dividend Investors Are Willing to Pay Much More For a Bird in The Hand Than for Multiple Birds in the Bush

Dividends matter and a brief look at our three investment strategies reveals a remarkable symmetrical total return distribution.  All three strategies are selected from the same stock-filtering and valuation models.  Stocks are slotted into each individual strategy by our Investment Policy Committee based on financial strength, dividend yield, and rate and consistency of dividend growth.

The Income Builder Strategy -- High Dividend Yield, Low Dividend Growth

• Current dividend yield approximately 4.50%
• Last twelve month dividend growth 6.0%
• Total Return last twelve months approximately 10.0%

The Cornerstone Strategy -- Above Average Dividend Yield, Above Average Dividend Growth

• Current dividend yield approximately 3.5%
• Last twelve months dividend growth of  almost 12.0%
• Total Return last twelve month of almost 7.0%

The Capital Builder Strategy -- Low Dividend Yield, High Dividend Growth

• Current dividend yield approximately 2.2%
• Last twelve months dividend growth of approximately 15%
• Total Return last twelve months of approximately 4.0%.

A simple look at the three different investment strategies reveals that investors have been willing to pay up for higher yielding stocks.  The Income Builder portfolio with its 4.5% dividend yield has run away from the other two strategies on the basis of total return.

Cornerstone, which is our flagship investment strategy, has had good returns over the last twelve months but has under-performed the Income Builder Strategy, even though Cornerstone companies have increased their dividends at twice the rate of Income Builder companies. Finally, Capital Builder companies have had one of the best earnings and dividend performances we have witnessed in many years, yet the strategy has not performed as well as either of the two higher-yielding strategies.

What are we to glean from these data?  The obvious and most simple answer is that in this very low interest rate environment (10-year US Treasury Bonds are yielding under 2.0%), investors have been willing to pay up for higher dividend yield, while dividend growth is being discounted, if not ignored.

While the data clearly show the attraction of high dividend yields, history reveals that over longer periods companies with higher dividend growth normally outperform slower growing companies.  In short, companies that can increase their dividends at low to mid-double digit rates fall in and out of favor, but the long-term trend line of their total return growth is higher than the trend growth of slower growing companies. This means that today the high growth companies are becoming spring-loaded.  That is they are very cheap, and as the European crisis begins to subside, we believe higher growth companies will run away from lower growth companies.

Then the question becomes: when do these spring loaded companies start springing?  Our answer is we don't know.  Furthermore, we don't think anyone knows.

In keeping with the old fashioned concept of "the trend is your friend" we have tilted all of our portfolios to a slightly higher dividend yield relative to the S&P 500 than normal.  Our models tell us that the high-yield, low-growth stocks, which include many utilities, are still undervalued based on historical measures of dividend yield and growth versus interest rates.  For this reason, we believe quality, high yield stocks have room to go higher.

However, because the high dividend growth companies have become the most undervalued of all types of stocks, we continue to nibble on selected stocks, even though they are flat lining price wise.

Our best guess is that there might be as much as six more months of this symmetrical affinity for relative dividend yield. After the Fed has completed its "Operation Twist" initiative, the markets will no doubt reappraise inflationary forces and reprice long time bonds and high dividend yielding stocks.  Until then, the markets are clearly saying that they are willing to pay more for the bird in the hand than the birds in the bush.

Next time we'll talk about another high dividend yield stock that we believe is still undervalued.

         

United Technologies: The Hidden Dividend Star

United Technology (UTX) is the Dividend Star most of the simple dividend-growth filters miss.  This is because they do not raise their dividend every year. UTX takes action on its dividend every six quarters, not every four quarters, as do many dividend stars.

I have even tried to explain to the company's investor relations department that while their every-six-quarters dividend hikes has been quite predictable, that such a policy means that about every three years their annual dividends flat line. Thus, the company is not included on many lists of companies with long-term histories of consecutive dividend hikes.  No matter says the company. They like to do it the their way.

In this case who am I to push against such a winning record, just to make it simple.  UTX has one of the most consistent dividend growth records of any company I follow.  The following are their 20, 5, and one year annual dividend growth rates.

1. 20-year growth rate  11.3%
2. 5-year growth rate    12.5%    
3. 1-year growth rate    12.9%

To top it off, the estimate of UTX's three to five year dividend growth rate is just under 12%.  At that rate of growth its dividend will triple over the next ten years.  Not bad for a company that has a current yield of 2.6%.

Despite UTX's consistent dividend hikes and earnings growth over the last twenty years, the Dividend Valuation chart at the top of this page suggests that the company is significantly undervalued based on the historical relationships among its price growth, dividend growth, and interest rates.  UTX's current price (red line) is much lower than its current valuation (blue bar) and even lower yet, than our estimate for next year (checkered blue bar).

The so-called Correlation Index, which measures how tightly the average stock is tracking the major indices, has risen to as high as 85% in recent weeks.  Its normal reading is near 15%.  This means that the constant on again off again European bail out proposals have turned what is normally a market of stocks into a stock market.  What I mean by this is that almost all stocks have been caught in the maelstrom of big up and down days, which would indicate that all companies have about the same future profit and dividend potentials.  If you take a few minutes to think about this, the truth almost smacks you in the face.  The one thing we know for sure is that the future prospects are not the same for all stocks, thus, it is just a matter of time before stocks start to trade on the bases of their own unique fundamentals, not the generalized fears of the European situation, no matter how things turn out.

In this regard, we believe UTX has quite a pedigree and will ultimately break away from the pack and show it star quality..   

I own UTX.

12 Random Ramblings

Every working day of our lives we get questions.  Questions about the stock and bond markets.  Questions about how natural disasters, politics, or economic and business crises will play out in the market place.

In this weekly blog we try to keep our comments narrowly focused on our dividend investment strategy.  As we were composing our most recent quarterly letter we admitted to our readers that at times we sound like a one trick pony:  our solution for every challenge and every opportunity is always -- buy and hold quality rising dividend stocks.  In the long run we know that will work.

Yet the matters we discuss and decide at our weekly investment policy meetings cover the waterfront of issues.  In this regard, heaven help us, we are like politicians because we have to have a basic understanding and a few talking points on just about everything that is going on in the world.  

We thought our readers would appreciate our short takes on a long list of issues facing our nation and the world.  Normally, when we write these blogs or our client letters, we try to offer solid proofs for our positions.  In this piece, we are not going to do that.  We are just going to give our views, without supporting arguments.  This way we can cover a wide range of issues that you may have questions about.  It is our plan to periodically offer an update to what we are calling 12 Random Ramblings from the Investment Policy Committee.

1. Stocks are undervalued by about 25%.  Energy, Industrial, and Consumer Cyclical stocks are very cheap.
2. US Government bond yields are at historic lows, but will not rise much over the next year.
3. Inflation will fall.
4. US Corporate profits will continue to surprise to the upside, driven by business in developing nations.
5. Greece is already bankrupt, but the European Union will keep the country on life support for an extended time.
6. The market has already priced in a Greek default.
7. The US economy will not fall into recession and may surprise to the upside in the fourth quarter of this year.
8. The worldwide economy will grow by at least 3%, after inflation, this year.
9. Dr. Doom, Nouriel Roubini, has signaled better times may be on the horizon for the US and the world by putting his investment advisory firm up for sale. 
10. The average dividend payout ratio for the S&P 500, which is now, under 40%, will move back toward its 80-year average of 50% over the next five years.
11. There is still a chance that Hillary Clinton will run against President Obama if his polling numbers don't improve by December.  She would likely beat any Republican, and the stock markets would rally, not because her views are so much different than Obama's, but because the economy and the markets did so well under Bill Clinton.
12. If  Roubini is selling his company, the price of gold may have already seen its highs.

Greg Donaldson, Chairman of the Investment Policy Committee

Donaldson Capital Management, LLC

Nextera Energy: A Dividend Star on The Rise

Normally we are suspicious when old-line companies take on new names.  We have too many bad memories of the collapse of many of the new-name crowd during the Tech bubble. In rare cases, we believe changes in a company's name makes good business and strategic sense.

We believe Nextera's (NEE) name change is both an improvement over their old name, FPL Group, and an important milepost of the maturing of an exciting business strategy.

NEE changed its name from FPL Group a little over a year ago.  The name FPL Group was a change from the company's original name of Florida Power and Light and became necessary when the company began expanding well beyond Florida.

But the most important reason we like the new name is because we believe NEE is truly a very different kind of power company.  Indeed, since 1989 they have increasingly taken on a "Next Era" attitude toward electric power generation.  In the above link, they state that they now produce nearly 95% of their electric power from clean or renewable sources.  They are now North America's leader in sun and wind energy.  In addition they have a long history of safely operating nuclear power plants.  In short, today Nextera is one of the nation's top clean and renewable electric power producers.  We believe they are just beginning to reap rewards for their 20+ years of investing in alternative energy sources.

Recently, we have been adding to our NEE holdings because we believe the stock has a very bright future and our Dividend Valuation Model (above) indicates the stock is approximately 20% undervalued.

Even with President Obama's pullback on more stringent EPA emissions standards, existing clean air regulations are forcing more and more electric utilities to close old, less efficient coal-fired generating plants and abandon new coal-fired plants.  The bottom line is that many Midwestern power companies are scrambling to gain access to clean and renewable energy sources, and NEE has it for sale.

Here is a short list of other reasons why we like NEE:

1. Current dividend yield is near 4%.
2. 5-year dividend annual growth of just under 8%.
3. Projected 3-5 year dividend growth of near 6%.
4. Current dividend payout ratio is near 50%, much lower than industry average of 70%.
5. Paid a dividend since 1990
6. Increased its dividend for 15 consecutive years.
7. Stock is currently selling at a PE of 12, much lower than the industry average of 15. 
8. Company operates in 26 states mainly in the growing southern region of the US.
9. One of the most forward thinking management teams in the industry. 

NEE's exposure to nuclear power may be seen by some as a negative.  However, with Southern Company's recent application to construct the first nuclear power plant built in the United States since the 1970s, we believe there is a growing belief among many investors that nuclear power will continue to be an important low cost source of electric power. 

We own NEE and have no plans to sell it.

Greece is Burning But Many Multinational Dividend-Paying Stocks Are Still Cool

CNBC.com recently quoted excerpts from one of our blogs about the great values in dividend-paying multinational corporations.  CNBC.com's article included our views along with other money managers that are saying the same thing.  Here is the link to the article: CNBC.com.

The quote used in the article was taken from a July 29 blog written by Randy Alsman, one of our senior portfolio strategists.  Here is a link to Randy's full blog: Rising Dividend Investing.

We are happy that CNBC picked up our story-line.  We believe the evidence is conclusive that global companies have a flexibility and financial power that is being completely ignored in today's stock market.  We are particularly pleased that it is CNBC that is digging into the great story of multinational dividend payers.  CNBC and its multiple media brands have a reputation of being aimed at traders and speculators, spending little time and attention on long-term value investing. In that regard, we tip our hats to CNBC.com.  They took the time to talk with some veterans in the business who have been through crises before and believe that the current level of fear in the market cannot last.

One day the panic will subside, and when it does we believe the first place investors and even traders and speculators will go is to the financially strong, multinational companies for exactly the reasons that Randy detailed in his blog.

Yet, as we write this edition of our blog, traders and speculators are abandoning stocks of all stripes and rushing into US government bonds, driving bond prices to unbelievable heights and bonds yields to depths not seen since the 1950s.  Is there a bubble under Treasury bond prices? -- you bet!

When considering that our government is borrowing 40 cents of every dollar it spends, and is so politically stalemated that the only thing legislators can agree on is TGIF (but only if G stands for goodness), the confidence speculators are bestowing on US Treasury bonds is nothing short of amazing. 

Multinational corporations possess qualities that are not being fully appreciated or valued in today's market.  That old saying about cream rising to the top is very applicable today in our judgment.

Greece is burning.  Indeed there are signs of smoke in many countries in Europe, but the earth will still be spinning when this most recent "debt spiral" winds down.  For reasons included in the long list of attributes that Randy detailed in his blog, the safest bet we know of is to stick with with what we know and what we know is good.  That is multinational corporations that pay a generous dividend.

Thanks again to CNBC.com.  To our knowledge this is the first time they have quoted us. We are honored that they included us in their story of the merits of dividend-paying companies.

We own many multinational companies that pay a generous dividend.