Many an investor is confused when it comes to buying dividend stocks compared to stocks that don’t pay dividends. In particular, they are puzzled regarding the consequences they face when holding stocks that pay dividends.
“Many investors are particularly worried that dividend stocks are vulnerable given the potential for a near tripling of the tax on dividends,” according to a recent Advisor Perspectives article.
Logically, a company that does not pay dividends could be unprofitable and may have hit hard times. Then again, it could also be a fast-growing company that needs to invest earnings back into the firm so it can continue to grow.
Fundamentally, a company pays dividends out of its earnings instead of reinvesting the money back into the company.
Any type of stock, not just those that pay dividends, should be looked at based on historical performance, financial wherewithal, profitability, growth potential, and the probability that the stock may pay dividends in the future. Besides, one needs to understand the industry in which the company operates and the risks a particular company faces or might face in the future.
There are three categories when it comes to dividend stocks. The first category is a stock where the dividends increase year after year, including during economic hard times or upheaval.
Then there is also a group of companies that will pay dividends, even during economic disturbances, but will keep the dividend flat, without any increases or decreases. Lastly, there are companies that either cut or eliminate dividend payments altogether.
The stocks in the first category “tend to have conservative payouts of less than 50%, which allows them to maintain their dividends during the tough times. They also have growing sales and earnings—you can’t continue to pay higher dividends unless you have the earnings and cash to back it up,” a November 2011 article on the Dividend Growth Stocks website states.
Dividends as an Income Producer
“Yield isn’t the only key to a good income investment ... you also need to consider a company’s dividend growth. Dividend growth can turn lower-yielding stocks into big income producers over time,” according to an Oct. 18 Investor Update on the Street Authority website.
Historical evidence is a good indication of a firm’s willingness to increase dividends. But this should not be taken as the magic bullet and should be considered in conjunction with the company’s long-term financial performance.
“Of course with investing, nothing is 100% certain. Just because a stock has increased its dividend for 50 consecutive years, it doesn’t mean it’s guaranteed to increase it for another 50,” the Street Authority article advises.
There are 14 companies that have increased their dividends over the past 50 years, according to the Street Authority article. The first one is Lowe’s Companies Inc., which showed the highest dividend increase at 3,552 percent over the past 20 years, followed by Johnson & Johnson with a 20-year dividend increase of 1,120 percent.
Four companies are listed with a dividend increase between 500 percent and 800 percent: Proctor & Gamble Co., Coca-Cola Co., Dover Corp., and Parker-Hannifin Corp. The remainder have a dividend increase lower than 500 percent, with the lowest being Northwest Natural Gas Co. at 55 percent.
An Oct. 17 Motley Fool article published a list of 15 companies that increased dividends over the past 30 years. Companies on the list include: Family Dollar Stores Inc., PPG Industries Inc., Walgreen Co., Wal-Mart Stores Inc., RPM International Inc., PepsiCo Inc., McDonalds Corp., and WGL Holdings Inc.
“While it’s never advisable to buy stocks just for their dividends, a long term history of paying dividends implies a management focused on delivering shareholder value by running the company in the owner’s (your) interests,” the Motley Fool article suggests.
Lastly, an Oct. 4 Street Authority Investor Update published a list of seven companies that have paid dividends on their stock for 113 years, including three companies that have increased dividends over a significant number of past years, that is, Coca-Cola Co. (1893), Procter & Gamble Co. (1891), and PPG Industries Inc. (1899).
The other companies are Colgate-Palmolive Co. (1895), Consolidated Edison Inc. (1885), Exxon Mobil Corp. (1882), and Stanley Works Co. (1877). Exxon Mobile, at 208 percent, had the largest 10-year return, followed by PPG Industries with a 167 percent 10-year return.
The companies on the 113-year list have survived many economic upheavals and are still leaders in their respective industries.
“When you buy the market’s most dominant companies—the ones that have a competitive advantage in their industry and show a commitment to their shareholders—you’re buying companies whose dividend can withstand nearly anything ... including the current economic environment,” the Street Authority article suggests.
Taxation Influencing Stock Purchases
“On Jan. 1, 2013, the maximum tax rate on dividends is likely to go from 15% to either 18.8% or 43.4%,” according to an article titled “The Dividend Cliff” on the Townhall Finance website.
The article suggests that there are two alternatives that could happen with regard to dividend taxation. First, the highest dividend income tax rate remains at 18.8 percent, including the 3.8 percent surtax on investments of those with high incomes.
The other alternative is that dividends could be taxed at an ordinary income rate, resulting in a top tax rate of 43.4 percent, which includes the 3.8 surtax for individuals earning more than $200,000 and married couples earning more than $250,000.
If it should turn out that taxation on dividends are to be greater than the capital gains tax, investors will opt to dump dividend stocks and buy non-dividend stocks.
Historical evidence indicates that this will be disastrous for the stock market, which is exactly what happened when Congress approved lowering the tax rate of capital gains in March 1997, according to the Townhall Finance article.
Furthermore, many companies stopped paying dividends when the capital gain tax rate was lower than the dividend tax rate, leaving many investors, especially retirees, with a drastically reduced income.
“Over time, the ongoing incremental and increasing effect of millions of investors favoring the tax-advantaged stocks of non-dividend paying companies will create real problems in the stock market, with the potential to create real havoc with the U.S. economy,” the Townhall Finance article states.
Election Rhetoric
On the campaign trail, President Barack Obama proposed “dividends taxed as ordinary income for individuals with adjusted gross income of $200,000 ($250,000 for married couples filing jointly),” according to an article on the Bankrate.com website.
Mitt Romney proposed to “eliminate taxes on investment income for taxpayers with adjusted gross income of less than $200,000” and “retain 15 percent tax on interest, dividends, and capital gains for all other taxpayers.”
Neither candidate addressed dividend double taxation, that is, the firm pays taxes on its earnings and distributes the dividend. Then the investor pays taxes again on the lower amount distributed as the dividend.
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