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By Brian Nelson, CFA

With a potential hike in the dividend tax rate just around the corner, there is no more important time than now for income investors to evaluate their existing portfolio holdings to determine whether they are well-positioned for a higher-tax environment. Assuming there are no changes to the current trajectory, the top dividend tax rate is expected to rise to 39.6% next year (up from 15% currently), and the highest-income earners will see a Medicare surtax on top of that.

Evaluate All Aspects of a Dividend Investment

First of all, we think those investing in high-yielders (firms) at any price (HYAAP) may be most affected by this change in tax rates. These high-yielders at any price tend to be favorites of those at or near retirement, particularly given the paltry payouts on fixed income investments these days. If there is one tidbit to take away from this article, it is the importance of evaluating all aspects of a dividend investment, not just the firm's dividend. Purchasing a vastly overvalued stock only because of its dividend can have profound implications on the existing capital of your portfolio (should it fall to reflect its intrinsic value), limiting long-term financial flexibility (especially if one or one's descendants are forced to sell at an inopportune time). Our view is that overvalued stocks will eventually fall to intrinsic value over time. Some high-yielders that we think are trading above intrinsic value are Air Products (NYSE:APD), AT&T (NYSE:T), and Colgate-Palmolive (NYSE:CL).

All Investors Will Be Impacted from Tax Changes

If you are not part of the group of the highest-income earners who are the chief targets of the current administration, it may be too soon to breathe a sigh of relief. After all, the U.S. tax system does not operate in a vacuum, and there are far-reaching consequences that will impact all investors.

Research has shown that there is a correlation between the dividend tax rate and dividend payments--meaning that with a higher tax rate, fewer companies would pay dividends, and many would decrease the pace of dividend growth, instead opting to buy back more shares of stock. As Valuentum subscribers know, most firms won't cut the payout per share simply in response to a change in the tax code because the negative perception that would arise about its future business prospects would punish the stock. However, in a higher dividend tax rate environment, companies that are financially able to hike their dividends significantly may choose to slow the pace of dividend growth and return more cash to shareholders via buybacks. Still, we do not expect to make any changes to our dividend growth forecasts in our reports at this time.

What We Think Will Happen to Dividend Stock Prices

Many pundits believe that stock prices would fall over the long haul to better reflect the new lower after-tax rate of return. This is similar to the phenomenon that occurs when home mortgage rates fluctuate. All else equal, as the interest rate increases, home values tend to decrease, and when the interest rate decreases the opposite occurs. Though such a relationship has not held true over the past several years as both interest rates and housing prices have fallen, this has been a temporary condition relative to history.

However, our view is that one's personal income tax rate has little bearing on the intrinsic value of an entity. There are a variety of parties that may be interested in a firm, and many investors have tax-sheltered accounts. Importantly though, as some income investors move away from certain high-yielders, a company's investor base may shrink, putting selling pressure on the stock (driving it lower). Our members know that there is a distinct difference between the price and value of a stock. Price is what investors pay for a stock, while value is what a stock is worth on the basis of its future free cash flow stream (and what we spend a lot of our time trying to figure out).

For dividend-paying firms that are overvalued (or firms where their price is significantly greater than their intrinsic value), we think excess selling pressure will not be absorbed by investors of the value variety, causing perhaps a permanent reset in the company's stock price for some time (a greater number of sellers will drive down the price of the stock in order to attract buyers). However, for undervalued stocks, selling pressure caused by income investors moving out of dividend-payers will likely be absorbed by value investors looking for bargains.

By extension, we would anticipate little direct long-term impact from a change in the dividend tax code on undervalued, high-yielding stocks (or firms in our Dividend Growth portfolio).

While the U.S. tax system may be due for an overhaul, there has yet to be consensus on how to reach that goal. But whatever the future may hold for income investors, we think a dual focus on both valuation and high-yielders remains the best way to achieve portfolio income growth, while reducing the risk of permanent loss of capital from valuation missteps and exogenous events, namely potential changes in the dividend tax rate. Undervalued, high-yielding stocks with strong dividend growth potential such as Microsoft (NASDAQ:MSFT)--click here--or Johnson & Johnson (NYSE:JNJ)--click here--are probably best shielded given their attractive valuations. We think Microsoft is trading at almost half its fair value estimate, while Johnson & Johnson has a price/fair value under 0.8.

Source: Combat Dividend Tax Rate Changes With A Dual Focus On Value And Yield

Additional disclosure: JNJ and MSFT are included in our Dividend Growth portfolio.