Typing ‘fiscal cliff’ in Google search currently returns 630 million references! Nationally (and internationally) it is clear our attention is focused intently on lawmakers in Washington D.C. and what they will do with pending automatic tax increases and spending cuts due to take effect at the start of the new year.
As investors we need to prepare for the likelihood of a debate that will be all too public and filled with rancor, likely resulting in a fair amount of volatile price action for stocks. As news is incrementally digested over the course of the next month or so, there will be days filled with gloom and despair and other days that may offer some hope. In either case, we need to focus on what matters – and outside of an outrageously unexpected result, it ultimately won’t matter much over an investment time horizon what does get decided in Washington. It might to a trader, but not to an investor.
We are not trying to convey a tax increase as a positive development, but it’s extremely important to keep it in perspective. Dividends have accounted for a huge part of the stock market’s total return for many, many decades. In addition, dividend paying stocks have a long record of outperforming non-payers, and have done so even in periods of oppressive tax regimes. The table below illustrates the performance disparity between dividend growers, constant dividend payers, non-payers and cutters over the period from 1972 to June of 2011.
Stocks by Dividend Segment Annualized Return Cumulative Return
Dividend Growers 9.66% 3722% Constant Dividend Payers 7.44% 1599% Non-Dividend Payers 1.83% 105% Dividend Cutters -0.56% -20%
Returns from 1/31/1972 through 6/30/2011
Source: Ned Davis Research Group
Initially, one might think that periods of very high dividend tax rates (particularly relative to capital gains) would cause investors to gravitate away from dividend paying stocks – but that is not what has happened. In the time frame cited above, dividend tax rates exceeded 38.5% exactly two thirds of the time, with an astounding top rate of 70% levied for a full 10 years of the analysis period! What’s more, the average difference between the rate on dividends and capital gains was vast, with capital gains spending 82% of the time at a maximum rate of 28% or under – but often significantly below that. Investors who are worried that a rise in dividend taxes will be commensurately larger than capital gains taxes – and therefore seek to avoid significant dividend payers – may end up being thoroughly surprised by the eventual performance outcome.
Morningstar looked at 100 years of tax rates on dividends compared to capital gains and termed the spread between the two the ‘dividend tax penalty’. In an environment where a large spread exists, we might conclude that corporate management would opt not to pay out a high portion of earnings (referred to as the payout ratio), but this has not been the historical case. In decades where the ‘penalty’ was highest – in the range around 60% – the three year average payout ratio hovered well above half of all profits being distributed through dividends. Compare this to the last nine years, when the penalty has been 0% (no difference between capital gains and dividend taxes) and yet payout ratios have resided near the historical nadir of roughly 35%. In other words there has been no correlation between a high ‘dividend tax penalty’, and the inclination of management to reduce commitments to dividends through lower payout ratios. Just recently Goldman Sachs issued a report estimating dividend growth for the S&P500 to be 11% in 2013, even after assuming a dividend tax increase into the 25% range. If dividend taxes rise further that may tilt some return of cash to shareholders via share buybacks, but would still result in additional growth of dividend income over current levels.
Also, most American investors hold a significant portion of their stocks in tax deferred accounts such as Individual Retirement Accounts, both Traditional and Roth, and 401(k) accounts. Frequent reports estimate the percentage of stock holdings in all forms of these tax deferred portfolios to be greater than 60% to 65% of all equity ownership. Given that no tax is paid on investment income earned while inside of these accounts, a change in dividend tax rates has no direct impact.
We clearly don’t prefer to see tax increases on investment income, but even if tax burdens do rise, dividends will continue to supply substantial, durable and growing streams of income. We would rather capture a dollar up front, taxed at prevailing rates, than receive the promise of capital gains we may never get the opportunity to pay taxes on. Bonds, already taxed at ordinary income rates, cannot provide growth of income, and at today’s rates they hardly even provide interest. Stocks that do not pay dividends provide neither income nor predictable capital gains. With the added support of demographic trends and the absence of material income from bonds, we believe investors will continue to seek consistent dividend payers.
It is worth repeating the characteristics we seek in the companies we want our clients to own, terming it QDG: Quality, Durability and Growth. Generally businesses fail or are at risk due to some combination of intense competition, low returns on capital and unmanageable debt levels. Additionally complacency and/or arrogance manifest’s itself in insufficient attention to the balance sheet when times are good – in turn putting the enterprise at risk when times aren’t so good. As these are the characteristics often associated with failure, we look to turn that around and focus on Quality franchises with very strong competitive positions (often global leaders in their industries), with consistently high returns on capital, favorable gearing ratios (debt to capital levels) and other important marks of balance sheet attention. Identifying the Durability and Growth of dividend income are key steps in finding those companies that not only survive the turbulent times but thrive in the next phase. We look for a history of dividend payment through market cycles, an identifiable, established and committed dividend culture or one that is making a rapid and decisive conversion to an attractive dividend payer. Strong cash flow and prospects for earnings growth to support payout growth is crucial. We would rather accept a lower yield that consistently grows, than stretch for a higher yield we believe may not be sustainable. Ultimately we believe a portfolio of quality companies with durable and growing dividend payments – where we’re treated as an owner, sharing in the profits consistently on a cash basis – has the opportunity to produce attractive risk-adjusted returns.
Below are a few examples of current portfolio holdings and the extraordinary length of time they have paid uninterrupted dividends to their shareholders. These companies have survived and prospered while sharing their wealth with investors for over a century and through umpteen changes in the tax codes:
Bank of Nova Scotia: 180 years
Coca Cola: 119 years
General Electric: 113 years
Pfizer: 111 years
Norfolk Southern: 111 years
Public Service Enterprise Group: 105 years
Chevron: 100 years
The successful application of our dividend growth strategy has never solely been a function of low tax rates, as the intrinsic advantages of durable dividends have allowed shareowners to prosper through a wide variety of tax environments. We don’t see any reason why that should change.