Dividend Funds Gird for Yearend Tax Hike

There's no question that income-oriented investors have benefited over the past seven years from the broad tax cuts the Bush Administration implemented in May 2003, which included slashing the tax rate on dividends and capital gains to 15 percent from 39.6 percent. With those lower rates due to expire at the end of 2010, fund managers focused on providing steady and rising income to investors are pondering how they can reduce the inevitable hit to their returns.

The size of the tax increase on dividends could be a key consideration in taxable shareholders' decisions whether to hold onto dividend-paying stocks. The Obama Administration budget proposal for fiscal 2011 calls for the tax rate on both dividends and capital gains to rise to 20 percent, but some portfolio managers think Congress favors a higher rate—at least 28 percent—to help pay down the ballooning federal budget deficit over the next several years. Unfortunately for investors, the Obama budget plan includes a number of other contentious items, which could cause Congress to reject it outright. That would automatically push dividend and capital-gains tax rates back to 39.6 percent on Jan. 1, 2011—where they were before the Bush tax cuts took effect—unless Congress elects to pass individual provisions in the budget. Not least of the budget features likely to invite stiff opposition is a proposal borne of the financial crisis that seeks to impose a 0.15 percent annual fee on banks and other financial institutions with $50 billion or more in total assets.

Cliff Remily, co-manager of the Thornburg Investment Income Builder Fund (TIBAX), believes the market is pricing in a dividend tax rate of 20 to 25 percent. If the rate were to default to 39.6 percent on a budget hangup, that would be "catastrophic" for companies and investors, he says, since it practically ensures that companies would cut dividends to lower the tax hit to investors. "Management is naturally biased toward cutting dividends. If they hold cash, they can either buy back shares, which props up stock options and increases earnings per share, [or have an] increased ability to do M&A, which is frequently overpriced," he says. Paying dividends lessens the potential for value-destructive capital allocation by companies, he and other fund managers argue.

New Dividend Initiation

Contrary to what one would expect, Viacom (VIA.B), owner of MTV Networks and Paramount Pictures, initiated a dividend on June 9, apparently unconcerned with the looming rise in the tax rate. Don Taylor, manager of the Franklin Templeton Rising Dividends Fund (FRDTX), believes a tax hike would tend to discourage new dividend initiation but says there are other factors—large cash balances or reluctance to commit capital to specific projects—that are probably driving Viacom's decision. Nine other companies have initiated dividends year-to-date as of May 31, while 122 others have increased their dividends since the start of this year, according to Howard Silverblatt, senior analyst for indexes at Standard & Poor's and a contributor to Businessweek.com's Investing Insights blog.

Taylor says he isn't doing anything to position his portfolio ahead of the tax hike mostly because he doesn't believe it will uniquely affect his holdings compared with the broader market. Also, "it seems to me it ought to be so well-known that it's already [priced into] the market, and there are other influences on stock prices that should overwhelm it."

He thinks the "overwhelming majority" of institutional investors probably anticipate a tax rate in the high 20 percent range for both dividends and capital gains.

If that's not the case and the market is waiting for the new tax rates to take effect before it reacts, higher-yielding dividend-paying stocks would be more vulnerable to a sell-off than lower-yielding ones since "there's just more dollars lost" on an aftertax basis, he says.

Most of his holdings aren't particularly high-yielding, he says. The fund as a whole has a gross pre-expense yield of roughly 2.5 percent, vs. the 2.05 percent yield on the S&P 500 index.

Seeking Dividend-Raising Companies

Since the Thornburg Investment Income Builder's mandate is to increase its dividend per share each year, Remily says he looks for companies that, in the face of a tax hike, would still be willing to increase their dividend. He steers clear of "marginal dividend payers" that either prefer share buybacks or are in a weak financial position.

"I try to find companies with good business models and that have good internal cash generation," he says. "Instead of spending a lot of time analyzing the income statement, I spend time on the cash statement. I look at cash flow less [capital expenditures on current operations] and does that cover the dividend?" For example, if a company's free cash flow is double its annual dividend payout, that's a signal it is able to grow its business while paying a healthy but not excessive dividend, he says. He also looks at whether a company has a history of meeting its earnings and dividend forecasts.

Four out of five companies in his portfolio are expected to maintain or raise their dividend in the future. He cites McDonald's (MCD) as an example. The company's profits are growing at 10 to 12 percent per year and its dividend is expected to increase by 9 percent. Its recent turnaround, which included selling more of its company-owned stores to franchisees, lightened McDonald's asset base and boosted its cash generation.

While "there's nothing I can do to protect the individual investor from dividend tax increases," Remily says, a skilled stockpicker should be able to put together a portfolio that protects investors from dividend cuts. He estimates that the aggregate value of his portfolio is far below its intrinsic value and sees a weighted average appreciation potential of 35 percent for the portfolio.

The impact of the largest possible tax hike on certain investors, especially retirees, would be more serious than on companies, since the growing income stream from dividends is often their only defense against inflation, says Remily. If the tax rate surges to nearly 40 percent, "you've just lost 25 percent of your income going to tax penalties. If you're living on $1,000 a month, now you're at $750 a month." That would compound the lingering cash crunch of the recession for retirees, he says.

Worries About U.S. Stocks

With the broad stock market down 13 percent since a recent peak on Apr. 23, and mounting concerns about how severe an impact economic slowing in China and Europe will have on the U.S., there's a lot of trepidation about U.S.equities. The effect of higher tax rates on both dividends and capital gains exacerbates those worries.

Silverblatt predicts that the tax hike will spur buying and selling ahead of the change, which would make for a volatile fourth quarter of 2010. "If I'm sitting on a lot of profit [from my stock positions], do I want to sell and, if I still like the company, come back to it in a month? If I get a gain, do I want to take it before the capital-gains rate changes?"

Jere Estes, co-manager of Rising Dividend Growth Fund (ICRDX), thinks some people are overestimating the adverse effect of the higher tax rate on stock prices. It won't make much difference in how investors treat their dividend-paying stocks, except for "maybe some psychological impact," he says.

With yields on cash and Treasury bonds so low, investors can still get a yield of as much as 5 percent on stable equities or 8 percent by owning units of an energy master limited partnership, he says. While investors' preferences aren't likely to change, companies' capital allocation decisions probably will. He doesn't expect to see companies initiating a dividend as Microsoft (MSFT) did just months before the Bush tax cuts took effect so that top managers and employees could save money on the tax they paid on stock options, adds Estes.

That may be so, but Silverblatt at S&P expects the pace at which companies raise their dividends to pick up again near the end of the third quarter or early in the fourth quarter "if—a huge if—the economy continues to get better and jobs tick up."

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