Political wrangling over the so-called "fiscal cliff," the potential expiration of the Bush-era tax cuts coupled with sharp reductions in federal spending, has stimulated many a conversation about the resulting financial planning implications.
One concern in particular is the possibility of a tax hike on dividend income. Currently, "qualified" dividends are taxed at a maximum rate of 15% but that rate may rise beginning in 2013 without political intervention.
This debate may obscure an important investment fundamental: the reinvestment of dividends has contributed mightily to the total return of stocks during the past 80 years and should not be overlooked; no matter what the current or future tax environment may hold. From 1930 through 2010, reinvested dividends contributed 45% of the total return of the Standard & Poor's 500 Index. They made an especially important contribution in the 1940s, 1960s and 1970s when annualized total returns were lower than 10%.
Many retail investors have lower expectations of market returns than they did just several years ago. If those expectations prove true, dividends may continue to play an important role in overall returns.
There is certainly nothing new about an investment strategy that involves choosing stocks that pay high dividends. However, a recent study from Wellington Management, subadvisor to The Hartford Mutual Funds and one of the world's leading global asset managers, shows that those who invest in dividends may be surprised to learn that "highest" is not necessarily "best."
Wellington Management's research found that stocks offering the highest level of dividend yields have not performed as well as those that pay high-but not the very highest-levels of yields. The conclusion is counterintuitive, at least on the surface.
In the study, stocks were divided into quintiles by their level of dividend payouts. Surprisingly, the second-highest quintile for dividend yields outperformed the S&P 500 seven out of eight decades between 1929 and 2009, or 87.5% of the time. The highest quintile of dividend-paying stocks came in a distant second, beating the S&P just 62.5% of the time.
Wellington Management, in its analysis, offered some insight that can help dividend-oriented investors make better decisions. The research found that many of the first quintile, or highest-yielding dividend stocks, had higher dividend-to-earnings ratios, making it more difficult to sustain their dividends, let alone grow them, especially if earnings weakened.
Many investors view dividend reductions as a sign of weakness, one that often coincides with the decline in the price of a company's stock. Inadvertently, they create their own fiscal cliff for stockholders.
Stocks in the second quintile tended to have lower dividend-to-earnings ratios, allowing more flexibility to maintain or increase their dividends over time. It should also be noted that Ned Davis Research, in a separate study earlier this year, reported that the ability to maintain or grow dividends over time may be regarded as a sign of company strength-one that is often rewarded by investors relative to companies that reduce or eliminate their dividends.
Advisors should note that there are two trends of particular interest for dividend-oriented investors:
- High Corporate Cash
Corporations have been accruing cash on their balance sheets over the past several years, which could be used to expand their business, make acquisitions, provide a financial cushion or-initiate, sustain or raise dividends.
- Low Interest Rates
Historically low interest rates have challenged investors to consider additional sources of income. As of June 30, 2012, Ned Davis Research reported 57.5% of the stocks in the S&P 500 Index had dividend yields higher than the 10-Year U.S. Treasury rate.
Although taxes are an important factor in determining an appropriate financial recommendation, advisors need to be mindful about keeping tax implications in perspective. Tax policy tends to change frequently, thereby hampering long-term planning.
To help your clients achieve their long-term investment objectives, revisit investment fundamentals such as dividend history. Considering stocks with solid track records of earnings and dividends may provide a more solid foothold as you help clients prepare to scale a fiscal cliff.
John Diehl, CFP, is a senior vice president for The Hartford's
wealth management business. The views expressed here are
those of John Diehl and should not be construed as investment advice.
"The Hartford" is The Hartford Financial Services Group, Inc.
Annuities are issued by Hartford Life and Annuity Insurance Company
and Hartford Life Insurance Company. The Hartford is a founding
partner of the MIT AgeLab, which is not an affiliate or subsidiary of The Hartford.