If congress does nothing, starting January 1st dividends will be taxed at ordinary income tax rates. This means the top dividend tax rate will be 43.4%.
What does this mean for investors? We believe simply that dividend paying companies are dead. We don't mean to say you can't buy Verizon and collect the current 4.61% dividend-which adjusted at the highest tax rate equates to 2.6%. But we are saying this; appreciation in dividend paying stocks will cease to exist. Dividend payers will morph into the hybrid alternative of the preferred. In fact, if you take a swath of preferred universe, the yield is higher than most dividends on the common so why not buy the preferred.
It seems perfectly clear to us that government will take advantage of the recent surge of investors seeking yield in dividend paying stocks. Investors can't get it in Cd's; investors can't get it in Treasuries. The can't get it in Muni's without taking on too much risk. So they are left with the cash rich communities of corporate America paying a nice steadily rising dividend.
We are reminded of the annual crossing of caribou on the Nile, the alligators are waiting for the largest surge of the crossing so they can take out as many defenseless caribou as possible. The government is hiding in the investing water waiting to devour dividend seeking investors.
And why not, at least in the governments mind: investors are circumventing conventional income routes seeking higher yields. If investors are seeking higher yields-the government is only a few steps behind.
Here comes the tax!
What are the alternatives? Investors can seek out companies with a history of buy backs. Buy backs from a tax perspective make 200% more sense. The downfall is companies have a tendency to buy back shares at the wrong time. Most buybacks historically increase as the market values shares of the company higher and higher. In other words-buy high and keep buying.
Another alternative is to purchase companies who have no history of buy backs-the downfall here is most who fall into this category have a high concentration of cash on the books creating a falling, dragging anchor to the firms bottom line. Microsoft is a good example of this. The more cash a company has on its books, the lower return they will have-thank you Stern and Stewart.
Another route is companies with a high percentage of capital expenditures relative to sales. The danger here is acquisitions are hard to manage and continued capital expenditures drain the bottom line.
What's the answer? It's never clear but here is a possibility.
Invest in start-ups and financials with low dividend yields.
An example of a current start up is Solarcity, a financial with a low yield-Bank of America or Citigroup.
More to come on those companies in the coming writings.
Disclosure: I am long BAC.