The Coming Dividend Tax Hike

September 26, 2012

I was going to make the below an issue of The Idea Farm, but there is so much content I want to pass along right now I figured I would post it here. I have considered moving The Idea Farm mailing from once a week on Sunday to “whenever something interesting crosses my desk” (but still only maybe 1 or 2 emails a week). What do you prefer?

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I’ve had an ebook written for about a year on the topic of Shareholder Yield, and hopefully it will be out in the next month or so. Long time readers of the blog will be familiar with the concepts of shareholder yield and net payout yield (combining dividends & net buybacks as a more holistic measure of cash flows to investors).

The coming tax hikes for dividends for the top tax bracket is a massive negative for dividend stocks that is still not appreciated in the hunt for yield. With all of the money rushing into high yield stocks the valuation discount that high yielders have enjoyed to the broad market has compressed to near zero.

Here is a great series from FactSet titled Dividend Quarterly that is worth a read. From the report:

2012: External Factors Have Muted the Threat of a Tax Hike

Is the market now showing a reversal of the trends experienced in 2003? Not particularly. As previously reported in “Dividend Quarterly”, the P/E valuations of dividend stocks have actually increased relative to non-dividend stocks. The trailing price to earnings ratio (P/E) for non-dividend stocks (15.6) led the P/E of dividend stocks (13.5) by only 216 basis points at the end of Q2 2012, which is substantially lower than the 20-year monthly median of 1,343 basis points. Excluding months when non-dividend stocks had a negative P/E ratio, the premium at the end of Q2 marked the fourth smallest in the past twenty years (on a monthly basis). However, valuations in dividend stocks could be elevated because interest rates are historically low and investors are interested in higher-yielding securities.

While it is difficult to isolate changes in valuation due to fear of dividend tax increases from changes in valuation due to investors’ surging demand for higher yields, the long-term impacts that followed the signing of the dividend tax cut in 2003 may indicate how companies will respond to higher dividend taxes. The response could include a reduction in the number of dividend payers or a decline in the number of companies increasing DPS year-over-year, which is especially plausible since both metrics are at multi-year highs. The proportion of dividend-payers in the index broke the 80% threshold for the first time in the 2000’s in Q1 2012, and Q2 2012 had the largest number of companies increasing TTM dividends per share in at least 20 years (296) in the S&P 500.

At least one company has publicly commented on how an increase in the tax would affect the dividend decision. Darren King, CEO of Laboratory Corp. of America, said on a July 19th earnings call that a rise in the potential marginal tax rate on dividends “…really takes away from the attractiveness of a dividend. So some of it [the decision to pay a dividend] is going to depend on what are – what is Congress and the Executive Branch going to do…”.

FactSet Dividend Quarterly: January 2012