Dividends To Capital Gains: I Want A Divorce

Includes: KO, MCD, PG, XOM
by: Counterpoint

I was very frustrated after reading David Van Knapp's recent series on ETFs that purport to be designed for dividend investors. Being more of a total return investor, I don't always see eye-to-eye with Dave, but he was right on here. There are no ETFs or mutual funds that properly replicate the art of dividend growth investing or that provide an innovative adjunct to it. In this vein, I have been contemplating something pertinent to the latter...a mechanism by which one could invest in just the common dividend from a stock or group of stocks separate from the underlying stock itself.

This is not a new idea. In the 1980s, there was "Americus Trust", a series of single stock trusts that effectively separated the dividend from the underlying stock for a five year term. The dividend portion was known by the acronym "PRIME" (Prescribed Right to Income and Maximum Equity) and the capital gains portion by the acronym "SCORE" (Special Claim on Residual Equity). A New York Times article written at the time of the demise of this product gives a good description of it.

Perhaps the time has come for a comparable product to be brought back from the grave....why? As we know from many discussions in this section, there are some people that strongly prefer dividends while others prefer capital gains. This "rift" seems to have grown deeper in the past few years as more people seek income from dividend stocks to substitute for yield-deficient fixed income investments. Many have done so in spite of a fear of the effect an extended meltdown in stock prices would have on their holdings, a risk I think many would like to have a better means to manage. On the other side, tax sensitive investors wish they could hold safer, lower beta mega-cap stocks without having their returns disproportionately diminished by taxes on dividends and fearing that pending tax law changes will make this problem even worse.

Based on that notion, consider the following: Let's say I buy 100 shares of Coke (NYSE:KO) for $76 (a $7,600 investment) with the current yield being 2.66% ($2.04 dividend per annum per share). I am really looking for long term capital gains so I offer my dividend stream up for sale for, say, a 20 year period. How much would you pay me to buy this stream? Let's say I offer it to you for $3,800 ($38 per share), 50% of the underlying share price. This would mean, if you purchased it, that you would have a 5.32% going-in yield on your investment (the $2.04 dividend divided by $38) plus all of the dividend increases for the next twenty years. At that point, I will give you your $3,800 per share back (presuming the stock is not worth less than 50% of its current value...a fairly safe bet I would guess). If you are a dividend growth investor, this would be an attractive investment, would it not? In the meantime, I would have 100% of the price upside potential for half the current price...sounds like a win-win to me. In reality, you would be betting that dividends will provide the lion's share of the return for the next twenty years while I would be betting that capital gains will (there are some additional subtleties here that would make this a much longer article ... perhaps I will try to address these in another article if SA participants show an interest in this one).

OK, in the real world, it would probably be pretty difficult to create a trading platform where individuals could enter into transactions of this sort (although that is a possibility) and there are some tax and collateral implications to this approach, but what if there was a fund product where you could buy the dividend stream and the capital gains potential for a group of core blue chip dividend growth stocks separately? Let's say we create a $100 million fund (legal form to be determined) to purchase thirty sector-diversified true blue chip dividend payers including such names as Exxon (NYSE:XOM), McDonald's (NYSE:MCD), P&G (NYSE:PG), etc. Let's say we buy these stocks at an average 3% yield in a sufficient number of shares for each company such that, to start out at least, each company provides roughly $100,000 in annual dividends to the fund (a total of $3 million; so-called dividend-weighted). Since most of the companies would probably trade within shouting distance of a 3% yield, the total dollar investment in each stock would probably not be too skewed either (the idea of holding thirty relatively equally weighted stocks is just so the risk of insufficient diversity can be set aside for this discussion).

Now let's say we create two classes of shareholders for this fund and offer one million shares for each class at $50 per share (two million total shares at $50 per share would equal $100 million). Class A shareholders would be entitled to all the dividends from the underlying stocks and Class B shareholders would be entitled to price appreciation (or depreciation). This means as a Class A shareholder, if you purchase at the IPO, your dividend would be $3 per share (before fund expenses) on a $50 share price ... a 6% out-of-the-box current yield from a group of blue chip companies with the dividend increases all yours ... sounds great doesn't it? If you still like some limited capital gains exposure, you could, for example, buy 200 Class A shares and 100 Class B shares. Think about the tax efficiency possibilities. You could hold the Class A (dividend) shares in your IRA and the Class B (capital gains) shares in your taxable account.

I am not an expert on tax laws or SEC regulations and perhaps there are things that prevent or discourage such a fund from being created as seemed ultimately to be the case for Americus Trust. Nonetheless, if such a fund product could be created, I am convinced that there would be more than sufficient demand to sustain its existence (provided associated fees are reasonable). Just like we can adjust weightings for stock sectors or foreign versus domestic exposure, wouldn't some kind of product that would allow us to separate exposure to dividends and capital appreciation based upon our investing philosophies, tax positions, etc. be valuable? I think it is quite clear from thousands of comments here on SA that different people have very differing needs and desires in this regard but, unfortunately, we are all stuck buying the entire package of Good & Plenty, even if some of us just want all white or all pink or maybe a skewed blend. Perhaps participants on Seeking Alpha from firms like Blackrock, Vanguard, Fidelity or Wisdom Tree will take note and bring something like this or some other innovative products to the market for dividend growth investors instead of just the reprocessed large cap value funds that are available now.

[Editor's Note - Addendum requested by author after discussion in comment stream below:

Update - May 10, 2012 - Here is a link to another New York Times article about what were called "Dual Purpose Funds". There were closed-end funds almost identical in structure to what I outlined in my article (except the A shares were actually preferred). The identified reason for their demise was that the IRS ruled in 1989 that tax liabilities must be distributed equally among all the shares. This is clearly an obstacle but perhaps not an insurmountable one. Perhaps an MLP structure would circumvent this issue as partnerships are typically allowed to skew the distribution of tax liabilities.]

Disclosure: I am long SPY, SDY.