Strategic Value Dividend Newsletter

Transcription

1 Strategic Value Dividend Newsletter Investment Team Dividends and Taxes Walter C. Bean, CFA Senior Vice President, Senior Portfolio Manager Head of Income and Value Equity Management Teams Daniel Peris, Ph.D., CFA Vice President Senior Portfolio Manager As long-term dividend investors, we are committed to delivering the attractive total return which results from investing in those companies that provide high current dividend income and modest dividend growth, regardless of market conditions. While we are unwavering in our approach, proposed changes in taxation of dividend income are garnering headline attention; we would like to share a few of our observations. Simply stated, we believe there will be minimal impact to the dividend payment policies and performance of the stocks we invest in if the rates on dividend income rise. Our investable universe consists of those companies that have consistently paid and raised their dividends for decades through a variety of administrations, tax rates and economic environments. Currently, qualifying dividend income and long-term capital gains are taxed at the same 15% level. Under the new proposal, the long-term capital gains tax rate will increase to 23.8% and the dividend income marginal tax rate could jump to a maximum of 43.4%. The new rates include the capital gains flat rate of 20%, the marginal dividend income rate of 39.6%, and an additional 3.8% tax that is imbedded in the 2009 Health Care Law that will be applied to all investment income. These changes go into effect if Congress doesn t act by the end of the year. At first pass this may be concerning, but it should be considered in the context that tax rates have not been shown to play much of a role in the performance of dividend paying stocks. Deborah Bickerstaff Vice President Associate Portfolio Manager Source: IRS, March 2012

2 It s important to note that dividends have been continually tax disadvantaged relative to long-term capital gains for the life of the S&P 500 Index. (In only two instances were dividends and long-term capital gains taxed at the same levels. First, in , they were both taxed at 28%. Most recently, the Bush Era tax cuts in 2003 brought the tax levels on both down to a flat 15%). Nevertheless, dividend paying stocks have consistently outperformed when quintiling the S&P 500 Index on this feature. Even at the onset of the S&P 500 Index in the 1950 s when the marginal tax rate on dividends was as high as 90% and long-term capital gains were taxed at just 25%, high dividend stocks still outpaced non-dividend stocks that rely on capital appreciation to deliver returns to shareholders. Historically, this long-term outperformance gap between high-dividend stocks and non-dividend stocks has generally been greater than the tax savings associated with lower capital gains rates. Source: Siegel, Jeremy, Future for Investors (2005), With Updates to 2011 Each stock in S&P 500 is ranked from highest to lowest by dividend yield on December 31st of every year and placed into quintiles, baskets of 100 stocks in each basket. The stocks in the quintiles are weighted by their market capitalization. The dividend yield is defined as each stock s annual dividends per share divided by its stock price as of December 31st of that year. Beta is a measurement of an index s trailing 36-month returns in relation to the appropriate market index. It analyzes the market risk of a stock by showing how responsive it is to the market. Usually, higher betas represent riskier investments. As of 12/31/11. This chart is for illustrative purposes only and is not representative of performance for any specific investment. Past performance does not guarantee future results.

3 Examining the most recent Bush Era tax cutting period provides further insights into the effects of taxes on dividend-based total return. The market is currently speculating whether dividend stock performance will decline if tax rates rise. Similarly, it was anticipated at the onset of the Bush Era tax cuts that the equalization of tax policy would bolster dividend paying stocks relative performance. However, looking at the past 40 years, we see that before and after the equalization of tax rates, almost regardless of tax policy, dividend paying stocks outperformed non-dividend payers. The Bush Era tax cuts really didn t create a performance benefit for dividend paying stocks. Going forward, it is our expectation that due to the multitude of other variables that affect share price and return, the advantage that dividend paying stocks have delivered through a variety of tax environments will still continue. The sheer magnitude of the outperformance of dividend paying stocks relative to capital appreciation dependant strategies dwarfs the proposed tax increases. As a result, investors should be mindful not to be penny wise and pound foolish. Past performance is no guarantee of future results. For illustrative purposes only and not representative of performance for any specific investment.

4 The commitment of corporate management to paying progressive dividends in a punitive tax environment is also coming into question. If we look at recent history, the Bush Era tax cuts were expected to herald in a period where corporate managements would step up their payout ratios to take advantage of the lower dividend tax rates. Ironically, we observed quite the opposite. Payout ratios have continued to decline across the past 10 years to under 30% currently. Rather than taking up dividend policy, it was noted that corporations in the S&P 500 instead stepped up their share repurchase programs. It is appropriate to note that the broad US market has largely ignored the benefits of dividend investing over the last four decades. As dividend investors, we focus on the dividend income producing sectors of the market such as Consumer Staples, Utilities and Telecomm Services. The companies we re currently invested in have paid consecutive dividends for longer than 60 years on average. We are focused on those companies with the managerial ability and inclination to pay a rising income stream to shareholders regardless of market and tax conditions. For example, Kimberly Clark and Proctor and Gamble have paid consecutive dividends for 77 and 122 years respectively. We believe the course of their dividend policies won t alter due to a shift in taxation. A change in managerial mindset may be observed by those companies on the periphery of dividend payers, such as the tech giants, who are not consistently high dividend payers. While dividend growth from the overall market might slow, we would not expect it to affect the areas where we invest. Dividend and Buyback Yield S&P 500 7% 6% Dividends and Capital Gains Taxed at 15% 5% Yield 4% Total Yield 3% Buyback Yield 2% 1% Dividend Yield 0% Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Source: S&P, Credit Suisse Quantitative Equity Research March, 2012 Past performance is no guarantee of future results. For illustrative purposes only and not representative of performance for any specific investment.

5 In conjunction with our expectations for little change to performance and corporate mentality, we also believe that investor preference for dividend paying stocks will be relatively unaffected by an increase in dividend taxation. According to ICI, about 50% of all mutual fund assets are in tax deferred or tax advantaged accounts. The new tax law will apply the marginal tax rate to those with individual income over $200,000 or combined income over $250,000 and in recent years, this group has equated to about 2% of the population. When taken in conjunction, we believe only a small fraction of investors will be nailed with the highest dividend tax rate. Of greater consequence is the affect the aging Baby Boomer population continues to have on the demand for income as they enter the distribution phase of their lives. 10,000 baby boomers are expected to turn 65 every day for the next 18 years, during a time when pensions have fallen by the wayside, Social Security struggles, and Medicare is already underfunded by about $23 trillion, putting heavy pressure on the Federal budget. As those eligible for benefits double over the next 18 years, the associated annual cost will likewise double from $500 billion/year currently to almost $1 trillion/year by 2020(David Walker, former US comptroller). Baby boomers are wisely seeking alternate sources of income to supplement declining benefits. In fact, retirees currently receive about half of all dividend income earned. Since Social Security and Medicare aren t sustainable at current governmentally funded levels and with little in the way of meaningful alternatives for income, Baby Boomers will continue to reach for dividend paying stocks that offer inflation protecting growth potential to supplement their needs. Views are as of 3/19/2012, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. There are no guarantees that dividend paying stocks will continue to pay dividends. In addition, dividend paying stocks may not experience the same capital appreciation potential as non-dividend paying stocks. Federated Investors, Inc. Federated Investors Tower 1001 Liberty Avenue Pittsburgh, PA Contact us at FederatedInvestors.com Or call Federated Investment Counseling (3/12)