With President Obama's re-election earlier this week, all eyes have now focused on the looming expiration of the current tax rates at year end.
The fear is that with Obama continuing in office there will be a significant, maybe even dramatic rise in the tax rate on dividends, and that dividend paying stocks will lose their appeal and suffer in the market.
For much of this year, we have extolled the benefits of having a portion of your assets in mature, lower volatility, higher dividend paying stocks. While a modest negative, the prospect of a higher tax on dividends does not shake our conviction as to the attractiveness of this investment class.
We believe the knee-jerk reaction to abandon dividend paying stocks is a wrong step. Here are a few reasons why:
1. First and most importantly, the worst case scenario for dividend taxation is not likely to play out. The default tax rates contained in the legislation mandating required higher rates in the event of no agreement to the contrary, were deliberately set punitively high precisely to force the players to come to a realistic compromise. Will rates increase? Very likely, but a rise to 20% to 25% is far more likely. Plus, higher dividend taxes might be progressive such that lower bracket tax payers end up paying little or no higher taxes.
2. In addition, while a higher tax rate will affect the mindset of taxable investors, the ownership of many, probably most, dividend paying stocks includes IRA, private and public pension plans, and other tax exempt entities. Therefore even if rates were higher than expected, high dividend paying stocks would still have a great appeal to a large investor base.
3. Most stocks pay a dividend. Dividend paying stocks are no longer a discrete sphere within the market, but increasingly the norm. Therefore, disparaging dividend stocks is in effect making a broad-based negative call on the market itself. An incremental increase in taxing dividends should not warrant such a wholesale anti-market reaction.
4. Even at higher tax rates, dividends still look very attractive compared with fixed income alternatives. The explosion of interest in dividends tracks the collapse of bond yields. Even taxed at higher rates, dividends would still be very competitive when stacked up against many fixed alternatives.
5. Companies generally raise their dividends over time. One of the great relative attractions of dividend stocks to fixed income investments is that many dividend paying companies regularly boost their dividend payout, providing a rising cash stream to investors. This should also help maintain the attractiveness of dividend stocks in a higher tax rate environment.
6. Strong, high quality dividend paying companies will remain attractive notwithstanding higher tax rates. The great, reliable dividend payers are valued in the market for a great many attributes beside their dividend yields. Competitive advantage, financial strength and consistency of earnings growth define many attractive dividend paying companies. Those attributes will not change in the wake of any legislation.
7. Higher dividend stocks have a self-correcting mechanism that helps to insulate them against dramatic declines. As a stock's price declines, its dividend yield rises. For investors who will continue to search for attractive income, a higher dividend yield becomes a lure to buy. Such buying ultimately helps prop up the price of a stock, and can provide a floor to its price.
Finally, let's remember some other important reasons why dividend stocks are attractive: they often tend to be more stable, less volatile stocks, a benefit that has been greatly sought after as markets lurch from macro-obsessions to bottom-up analyses.
So, while the upcoming tax changes creates near term uncertainty, there are a great many reasons to continue to like dividend paying stocks, even if the government gets a bigger piece of that pie.