Beyond Bulls & Bears

Speaking of Dividends

Just like the fads that come and go in the world of high fashion, the investment world can also be subject to the whims of the masses. There was a time not too long ago when many investors shunned dividend-paying stocks in favor of companies with strong sales growth. But as economic uncertainty in the United States became the norm in the wake of the 2008-2009 financial crisis, and Treasury and cash-equivalent yields declined to low single-digits or lower, some investors began taking a second look at dividend-paying stocks. By 2011, we had talk of a possible “dividend bubble.”

Now that the fiscal cliff negotiations have resulted in a bump in the tax rate for dividends for some households, the question is: will dividend-paying stocks fall out of favor in 2013? Don Taylor, a portfolio manager with Franklin Equity Group, says even with the tax change, there are still compelling reasons to invest in dividend-paying stocks.

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The dividend tax rate did rise for some households as part of New Year’s fiscal cliff negotiations; individuals making more than US$400,000 and households making more than US$450,000 see the rate rise to 20% from 15%, while taxpayers below that income level but making more than US$200,000/US$250,000 keep the 15% rate. Both groups, however, face an added 3.8% healthcare tax surcharge on investment income. So effectively, there are now dividend tax rate brackets with rates of 15%, 18.8%, and 23.8% for higher income taxpayers.

Taylor believes these changes should have a minimal impact on dividend growth—or how companies treat dividends.

Don Taylor

“The important point is that we now know what the key tax rates are.  We also know that the dividend tax rates aren’t going up as much as many had feared. So what’s the impact? One question is: does it impact the company’s dividend policy in some way? And the other question is: does it impact the price of dividend-paying securities? In terms of policy, we had seen a number of companies move forward their January dividends into December (2012) to take advantage of the lower rates in December. We’ve seen some companies pay one-time special dividends for that same reason.

But what may be more important – that really hasn’t gotten a lot of play in the press and on Wall Street as far as I can tell – is what companies are doing with respect to their regular dividends. We’re in the time of year when many companies have had annual dividend increases, and we’ve seen dividend increases happening the way we’d expect, even if we didn’t have an issue with the taxation.

And, it’s important to keep in mind the fiscal policy decisions aren’t the only thing that drives the market. There are a lot of other interesting things going on that will affect security valuations.”

Taylor says the tax changes won’t affect his strategy; he plans to continue to evaluate companies in terms of all of the factors that influence the price of an individual security. That includes company-specific dynamics as well as other, broader macro influences. Instead of focusing on companies that have high yields, Taylor looks for companies with a consistent track record of raising their distributions and which he believes could continue to do so in the years ahead. In other words, it’s not the current yield he’s focused on, but the potential future yield. He gives some examples of specific stock sectors that meet his criteria at the moment—and that don’t.

“In the case of utilities, they generally don’t have dividend growth rates that meet our screens. In the case of banks, most of them had to cut their dividends during the financial crisis so they don’t have the long record of dividend increases that we look for. The areas in the market that tend to have a lot of nice rising dividends include industrials, a number of consumer stocks, and some healthcare stocks.”

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As far as their appeal to investors, in an environment where interest rates are low, Taylor thinks equities are even more attractive, especially high-quality names with an attractive yield that hold the potential to continue increasing dividends. That said, Taylor says he and his team aren’t managing with blinders on, and yes, there are in fact some circumstances that could make the space less attractive.

“I think very low bond yields and almost nonexistent yields on cash are very supportive for equity valuations, particularly higher-quality names that have an attractive yield, and particularly if they can grow the yield.

The important thing to watch for is what’s going to cause bond yields to increase a lot. Now it doesn’t seem to me that’s going to happen anytime soon, but we spend a lot of time thinking about what might cause that to happen. I think it could be a meaningful pick-up in inflation. When inflation gets to the point where policymakers aren’t comfortable with it, then policy will change, and I think it’s likely to cause bond prices to come under some pressure, yields to increase, and then provide more competition to the equity market.

It’s something we watch very closely and is yet another reason why we think focusing more on dividend growth than current yield is important.  A company that can grow its dividend is more likely to be able to offset the decline in value at least to some extent that would be caused by an increase in inflation, compared to a company that really has a very stable yield or a very stable dividend that isn’t able to grow. It would really have no outlet to offset the competitive pressure from an increase in bond yields.”

While fads and fashions certainly change, some things never go out of style.

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