Friday, February 24, 2012

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

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.    

Friday, February 10, 2012

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.