The list of companies offering super-fantastic dividend deals – just in time for the holiday season! – is growing by the day, along with those who are moving up their dividend payout from January 2013 into December of this year. The reason is fairly straightforward: Corporate honchos have little or no faith that Congress and the president will reach an agreement averting a lemming-like rush over the “fiscal cliff” by January 1, or else they don’t believe such an agreement will extend the current favorable tax treatment for dividends.
It’s not just altruistic concern for the welfare of shareholders that is driving this, of course. In a number of cases, when a company’s founder or CEO has a majority interest or significant stake in the business, shifting the dividend payout date will save that person millions in potential tax liabilities. Wynn Resorts (WYNN), for instance, is planning to pay a special dividend that will total $750 million this year; majority shareholder Steve Wynn is likely to save some $20 million in taxes on that dividend income if it is paid out this year instead of in 2013.
In other cases, paying out a big special dividend might get activists off the backs of companies sitting on top of big mountains of cash. There’s also the opportunity for CEOs irked at the election outcome to use the timing of dividend payouts to highlight their concerns about what they fear will happen to the country’s economy during President Obama’s second term.
The taxes paid on dividends and capital gains are artificially low today, having been slashed to only 15 percent in 2003 by President George W. Bush from a rate as high as 39.6 percent, the top ordinary income tax rate, prior to that. There is an argument – made by Wynn, among others – that if the government raises that level or allows it to move higher automatically on January 1 as part of the fiscal cliff package, then companies won’t pay out as much in dividends and governments therefore won’t collect as much in tax revenue.
Here’s my read on this situation: Companies typically pay or increase their dividends if they can’t think of a better use for all their cash. If lower tax rates really inspired companies to up their payouts, then the dividend yield on the S&P 500 would be a lot higher than its current range of 2.27 percent (which, in itself, is higher than it has been of late, thanks to the sudden flurry of dividend payouts and the recent dip in the stock market). While yields did climb during the 2008/2009 period, that, too, had more to do with the decline in prices than an increase in dividend payouts. Yields haven’t been north of 3 percent in about 20 years, even as corporate cash levels soared to more than $2 trillion, according to some calculations.
So it seems more logical to assume that businesses made their decisions to pay out dividends, and at what level, based on whether they expected the payout to result in a higher stock price, and not on the tax consequences to shareholders.
At the same time, it’s hard to imagine that companies sitting on cash will scale back their dividends. Indeed, if anything, they will likely come under greater pressure to return unused capital to investors via either dividends or buybacks, or invest it in some other way to fuel earnings growth.
The outlook for M&A activity is always uncertain, and especially so given the lack of macroeconomic visibility. And the track record of buybacks in boosting share prices is uneven at best. As a 2005 study from McKinsey & Co. analysts pointed out, a buyback may boost earnings per share but doesn’t alter a company’s intrinsic value.
It is even arguable that companies may want to increase their dividend payouts into the new year, especially if they are holding large amounts of cash on their books. If corporate tax rates climb, keeping that cash on hand will become more costly as companies pay out more in taxes on interest income they generate from those cash positions. Admittedly, the dividends may not have the same value in investors’ eyes, but that doesn’t mean they won’t be paid.
Should you prepare to dump companies that are paying out early dividends or big special dividends as soon as the payout date passes? In some cases, that might make sense. In many cases, a special payout shouldn’t be a large factor one way or another.
Take Tyson Foods (TSN), for instance, which announced plans to pay out its first special dividend in 35 years, a 10 cent per share bonus, as well as boosting its regular payout by 25 percent. Up until now, Tyson’s dividend yield has been a meager 0.85 percent. If you believe the meat products company will continue to raise that dividend payout, or that it will continue to post big earnings gains, then you might want to hang on to those shares next month after the dividend record date has passed. But this is hardly a stock that you’d own for its dividend, even at today’s low tax rates.
In other cases, however, even at a higher tax rate, dividend-paying stocks could still be far more attractive than other investments simply because they offer both income and the potential gains from a rising share price. Having to pay a higher tax rate will eat into that, of course, but it won’t eradicate it – especially when yields on Treasury securities remain as absurdly low as they are today.
True, Treasury notes are “risk free” in a way that stock dividend payment can never be – but the upside potential is much more limited. Defense giant Raytheon (RTN) yields 3.62 percent today and trades at less than 10 times earnings; the company is focused on cutting costs to address a more difficult business environment. True, it may get dinged a bit by defense budget cuts scheduled to take place as part of the fiscal cliff, but a lot of those issues have been priced into the stock. And taxes on the $2 annual dividend would go from 30 cents a share to 78 cents a share, but where else would an investor be able to earn as much income on their investment while maintaining as much upside?
Obviously, investors want to know what they own and why. For dividend stocks, know what the yield is, how a tax hike would impact that income stream and what the alternatives are. Most importantly, shareholders will want to inform themselves of the companies’ cash positions. How much cash flow is the company generating, and is that adequate to cover the dividend?
If we do end up careening off the fiscal cliff, that obviously will be bad news for dividend-paying stocks, as it will put impose a new cost on shareholders. But then, it will be bad news for stocks of all kinds – and ironically, regardless of the tax consequences, companies with big cash cushions will be ones best positioned to ride out another recession. Often, these are the same companies that pay out dividends, even if sometimes those yields aren’t among the highest in the market.
So if you’re just waiting to collect the final dividend payments of the year before dumping these stocks, you may want to hit the pause button and consider whether the alternatives – both for income and for stock-price appreciation – are really more appealing.