Do you still plan to focus on dividend paying stocks if tax rates on dividends go up in January?
As noted in David Nienaber’s article nearby, we don’t know if current laws increasing income tax rates in January will remain unchanged. Many believe it likely that they may be modified. But if they do remain, between the increases in income tax rates, the elimination of a lower rate for dividends, the new 3.8% Medicare tax on dividends (and other “unearned income”), and the impact of the foregoing on some phase-outs, the effective tax rate on dividends for some clients may nearly triple in 2013 compared to rates in effect today. So, shouldn’t we avoid dividend paying stocks?
No, dividends have always been central to our disciplined equity selection process and that fact has predated the 2003 onset of the special 15% federal tax rate for dividends. Dividends accounted for 42% of the total return produced by large company US stocks from 1925 through 2011, and dividend policies represent invaluable insight into each company’s management and their sense of what kind of growth they anticipate.
Dividends were taxed as ordinary income through 2002, and, as a partial adjustment for the fact that dividends represent dollars that have already been taxed once at the corporate level, dividends have been taxed at a special federal rate of 15% from 2003-2012. We’ve studied the history of dividend paying stocks relative to non-paying stocks through time, and the best data on that seems to be a study prepared by Ned Davis Research covering the period from 1972 through 2011. Per their study, dividend paying stocks significantly outperformed non-paying stocks over the 40 year period, but,interestingly, most of that performance advantage accrued prior to 2003.
Moreover, per the same study, a bigger differentiator in performance of dividend paying and non-paying companies has been whether markets have been in bull or bear phases: dividend payers outperformed dividend non-payers duringbull markets, but their outperformance was several times greater in bear markets. So a dividend focused approachis particularly well suited to unsettled times.
Moreover, investors’ need for income in a low yield environment will not go away if taxes on dividends increase. And with relatively large cash balances held by public companies in aggregate, we expect dividends to keep rising, despite potentially higher tax rates.
Will Anything Change in Your Investment Approach if Taxes on Dividends Increase Significantly?
The most likely change would be in preferred “asset location”. Depending on the levels of taxable bond yields, tax-free bond yields, and dividend yields, tax rates and individual circumstances, higher tax rates on dividends may result in us holding more stocks in IRAs and less stocks in taxable accounts. To accommodate that, we may reduce holdings of taxable bonds in IRAs and increase holdings of tax-free bonds in taxable accounts. Such a shift would likely be more pronounced should current capital gains rates go up in January as well, as will be the case if there are no changes in current law.
If Dividend Paying Stocks are better than Non-Paying Stocks over Time, Why Not Only Own the Highest Yielding Stocks?
Some think it works that way, and we wish it did – that would certainly make our job simpler. But the fact is,the very highest yielding stocks often (correctly) reflect poor growth prospects or unusual risk, and the highest 20% of dividend yielding stocks have not been the best performers historically. The best combination is generally moderately high dividend yield (higherthan average, but not extreme), strong financial strength, good dividend coverage, and a strong history of dividend increases. In fact, if one were to add to that mixbetter than average market valuation and sector neutrality, the result is essentially our discipline. Our processis multi-dimensional, but dividends are critical to that process in three different ways: dividend yield, dividend growth, and dividend coverage.
It’s been said that while companies can restate earnings, they can never restate a dividend. In our view,companies can say many things, but the loudest message is the one they convey with the dividends they pay. While we don’t think high tax rates on dividends is good policy (up to 35% at the company level and then up to as much as another 43% + at the individual level),the anticipated tax changes that may take effect in 2013 will not change the importance of dividends to our core investment approach.