With so many concentrating on the upcoming January Fiscal Cliff it is easy to forget we were in almost exactly the same position only two short years ago. Late 2010 Washington was deadlocked over the looming expiration of tax cuts which would drastically change the economic and fiscal landscape.
Last week I wrote an article about some patterns I expected to develop. But now a working report of a study by Michelle Hanlon of MIT and Jeffrey L. Hoopes of the University of Michigan essentially verifies my thoughts while backing it up with some solid research.
The study primarily looked at the effect of companies' dividend payouts in relation to changes in tax law. Hanlon is an MIT lecturer in accounting while Hoopes is a doctorate candidate. Together they have been conducting a series of accounting and economic studies dealing with taxes. According to the report: What Do Firms Do When Dividend Tax Rates Change? An Examination of Alternative Payout Responses to Dividend Tax Rate Changes, Hanlon and Hoopes contend that companies reacted to pending dividend tax increases in three primary ways:
- Issuing large special dividends
- Moving January 2011 dividends to December 2010 to avoid potential 2011 tax increases, and...
- Aggressively increasing share buyback programs in the last two months of the year.
After studying almost 500,000 regular and special dividend issues since the 1920s, they found that many companies responded to potential tax increases in some fairly predictable ways. In fact the study targets the 2010-2011 tax fear in a number of ways, looking at it as a dress rehearsal for our current fear of the Fiscal Cliff. Along the way they discovered some patterns that investors can act on now.
First, some background on dividends and taxes.
Beginning in the 1960s taxes and tax rules on dividends changed. With rates as high as 70%, dividends were much less desirable. Companies went away from paying dividends and concentrated more on reinvesting retained earnings and eventually into share buybacks to maximize shareholder value.
During the Reagan and Bush years the dividend rates were gradually cut to as low as 28%. The effective tax rate rose back up to 39% under Clinton. Then finally a new round of tax cuts under George W. Bush brought the tax rate for dividends all the way down to 15% in 2003. Dividends were attractive again, especially for income investors. The number of companies offering dividends grew by 25%.
This continued until the closing days of 2010 when a political standoff in Washington threatened to allow the Bush era tax cuts to expire. With time ticking away many were afraid the Fiscal Cliff would cause dividend taxes to return to regular income tax rates, which for many investors turn into a 39.5% tax. Others thought a rate of around 20% would be agreed to, while few thought the dividend tax rate would remain the same.
In the end, a post-election compromise was ironed out that extended the tax cuts for another two years. Two years later we are back to where we were before. However looking at the frazzled activity of companies and investors during the time of our last Fiscal Cliff is instructive.
As I first reported in this article, in 2010, cash rich companies, especially those with a high level of insider ownership, drastically increased their return to owners. They did this because of the fear that taxes would rise for any dividends or capital gains taxes in 2011.
According to the study's working report:
Indeed, if a 35 percent tax rate would have applied to the 2011 dividends, companies that shifted dividends would have saved shareholders roughly a third of a billion dollars in tax by doing so.
The study went on to say:
In additional analysis, we do not find evidence that real estate investment trusts (REITs) which have different tax incentives, shifted their regular dividends in response to the tax rate change, lending support to our hypothesis that our results are tax driven and not caused by macro-economic factors.
The study also noted that not only increases in year-end dividends came about, but that...
Finally, we find no evidence that firms substituted special dividends for share repurchases near the end of 2010 (and thus, not increasing overall payout). Indeed, we find a dramatic increase in the dollar value and incidence of repurchases in the final quarter of 2010 as well. This increase may also have a tax explanation-capital gains tax rates were also expected to rise at the end of 2010.
So if 2012 follows the model of 2010, companies that are concerned with maximizing shareholder value will be looking for solutions. The study notes that those companies with high insider ownership are not doing this completely altruistically. The managers are paying themselves!
The goal is to look for cash-rich companies with high levels of insider ownership. The study finds that these companies are most likely to give special dividends, accelerate early payments of regular dividends and initiate accelerated share buyback programs in the last two months of this year.
While you are at it, concentrate on looking at small and medium cap stocks. Large caps by their very nature generally have small insider ownership levels and tend to be less concerned with shareholder return, according to the study.
Sycamore Networks (SCMR) fit the bill in what may be the first of the potential wave of companies releasing their hoarded cash to grow shareholder return. The $15-a-share company recently announced a $10 per share special dividend with an ex-div date of 12 October for shareholders of record 1 October. It is a cash-bloated company with a high level of insider ownership.
Some companies that at first blush look like good candidates are in a good cash position, have sizeable insider ownership and a history of taking actions that benefit owners: HollyFrontier Corporation (HFC), Daktronics (DAKT), Wynn Resorts (WYNN), Armstrong World (AWI), The Limited (LTD), Tootsie Roll Industries (TR) and AFLAC (AFL).
No doubt there are more, but this is a good place to begin to search out companies that might be giving some extra dividend help the last two months of this year. With the recent market correction, this looks like a perfect opportunity to take advantage of some companies and their holiday gifts to their ownership.
Disclosure: I am long SCMR, HFC.