We’re hearing lots of hubbub over the “fiscal cliff” lately, regarding its impact on the economy and social programs. But dividend stock investors have been particularly concerned with how one element of the Bush-era tax cuts will affect the individual stocks in their portfolio should the cuts expire.
That item would be a jump in the tax on qualified dividend payments from 15% to 39.6% for the top marginal income bracket.
An increase of more than twofold is nothing to sneeze at, and many are fearing that the result would be a mass exodus from dividend payers as a result. As the thinking goes, why not simply seek out higher growth in other investments if your dividends are going to get eaten up by the IRS?
Philip van Doorn, a senior analyst at The Street, wrote a great in-depth column about this taxation change and what it may mean for your individual tax burden and your dividend stocks. He talks about the benefit of higher-rated bonds as income-generating assets or preferred stock as an alternative.
And back in April, I had a good Q&A with Keith Voight of the Edison Electric Institute, a consortium of utility stocks and other related businesses, about the Defend My Dividend movement to stop a tax hike on dividends. In that column on dividends, Voight focused on the fact that dividend stocks like utility companies pay out money primarily to older Americans and small-time income investors — not CEOs or well-heeled traders making a mint off of their distributions. And that a tax would unfairly punish many retirees.
So does all this add up to a disaster on the dividends stock front?
Well, dividend payers have been a bit too fashionable lately in my mind. Sleepy stocks like telecom AT&T (NYSE:T), up 25% so far in 2012, and Big Pharma mainstay Merck (NYSE:MRK), up 19% YTD, have exploded higher and could be overbought. It’s also worth noting that the ETF crowd is falling over itself to launch kinky new income and dividend funds to tap into demand — including the ill-advised ETRACS Monthly Pay 2x Leveraged S&P Dividend ETN (NYSE:SDYL).
But on a share appreciation basis, there may be a little bit of hope … at least according to experts at Fidelity. They claim that a sunset for the dividend tax breaks wouldn’t do much to counteract a secular shift into dividend payers. Here are the highlights and two charts.
Click to EnlargeFirst off, tax cuts didn’t affect top dividend performers much to the top side after the legislation was passed in 2003 — so it’s not like big gains are priced in that will evaporate.
Furthermore, dividend investors have been much more common since the financial crisis as investors simply aren’t interested in risky assets. Look at this chart for proof, measuring income vs. domestic equity funds. Clearly, the money has been moving into dividend payers on this front.
Click to EnlargeAnd here’s the payoff from Fidelity:
Regardless of changes in tax rates, dividend stocks are likely to play an important — possibly an increasingly important — role in investors’ portfolios. These tend to be large, mature businesses that generate a lot of cash flow. These positive attributes need to be in place before a company even pays a dividend, so the stocks of dividend payers tend to be less risky than other stocks.
Meanwhile, the baby boom generation is entering its retirement years. Some 77 million investors are looking to generate income from their portfolios — and they are facing historically low interest rates on bonds. While Fidelity believes retirees should consider adopting a total return-based investment strategy with a careful withdrawal plan, the increased appetite for income-producing assets could support share prices of dividend-paying stocks.
Dividend stocks are very appealing to this group. Shares of strong, dividend-paying companies are likely to continue benefiting from this demographic tailwind. Higher taxes are never good — but in my view, the possibility that rates will increase doesn’t alter the fundamental case for dividend-paying stocks.
In short, don’t expect a collapse in dividend stocks due to the fiscal cliff. If anything, a shake-up of that magnitude could drive more older and risk-averse investors into capital preservation mode and prop up this low-risk asset class.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at firstname.lastname@example.org or follow him on Twitter via@JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.