AC: Tax relief and dividends in your portfolio

(Investor Perspective is a quarterly publication of American Century Investments. This article appeared in the Spring 2003 issue.)

A look at proposed tax relief
and the role of dividends in your portfolio

By Rod Perlmutter, Financial Writer

Investor Perspective: Spring 2003 Issue

In January, President Bush introduced a proposal to eliminate the so-called “double taxation” on corporate dividends, a move his administration believes could save investors more than $360 billion over a 10-year period.

The proposal itself isn’t new, but it is the first time such a plan has headlined a multi-billion-dollar presidential tax-reform effort. As a result, publicity surrounding this highly debated proposal is generating questions about the nature of dividends and the role they play in investing.

Current law, proposed changes

Dividends are cash payouts that companies make to shareholders, generally on a quarterly basis, as a way of sharing profits. As such, dividends are instant returns on investments.

Under current law, a corporation pays tax on its profits at rates as high as 35%. For example, a corporation with $100 million of taxable income could pay as much as $35 million in corporate income tax. Then, if the corporation pays dividends to its shareholders out of the remaining after-tax income of $65 million, shareholders then pay tax on the dividends at their own individual tax rates, the highest being 38.6%. Later, if shareholders sell their stock at a profit, those capital gains are at a maximum rate of 20%, Added up the grand total rate in corporate income tax could be as high as 60%, far in excess of tax rates imposed on other types of income.

The Bush proposal eliminates the tax on dividends. Annually, corporations would be required to calculate the Excludable Dividend Amount (EDA), reflecting income that has already been taxed. In the above example, the EDA would be $65 million. Corporations would report the EDA to shareholders in the same manner that dividends are currently reported — on IRS Form 1099.

Proponents of the proposal estimate that about 35 million households currently receiving taxable dividends will see more profits. Corporate spending will change, too, they say. Currently, because loan interest is tax-deductible and dividends are not, corporations are motivated to borrow money instead of issuing stock. That can lead to greater corporate debt, which could pressure management to become less rigid in its accounting standards. Proponents say that the proposal will encourage companies to issue stock as opposed to borrowing, giving investors greater influence over the companies’ management – based on the notion that when a company with aggressive expansion plans goes to the stock market to raise money, it is subject to more public scrutiny that if it had quietly pursued bank financing.

The case for dividends

Many investors see dividends as a barometer of corporate health, viewing it as a “bird in the hand” – real tangible profits – as opposed to a projected “two in the bush,” or hoped-for earnings after the stock price rises. Dividends also impose “investment discipline” because they represent a corporation’s top priority – its quarterly obligations to pay out cash to shareholders. That’s because doing so reduces the level of capital left for the company to invest in new projects, forcing managers to be more vigilant and fund only those projects or expansions with the highest levels of expected returns. A company that doesn’t pay dividends, according to this argument, would have more money to throw around, perhaps on more speculative projects.

The discipline to issue a dividend means that investors receive a profit, albeit a small one, regardless of the performance of the company’s stock price. That stability is appealing to investors worried about bear markets.

And even if dividends for some stocks amount to only a few pennies per share, they add up. According to one study, from 1926 through 2001, dividends contributed more than one-third of the S&P 500’s total returns.

Ibbotson Associates, a Chicago-based investment research firm, says that could mean a lot in a typical portfolio: $10,000 invested in S&P 500 stocks in 1982 would, 20 years later, be worth bout $60,000. Include dividends that would have been collected and reinvested on those 500 stocks, and the total jumps to more than $100,000.

Another advantage of dividend-paying stocks, according to research by both Ibbotson and Morgan Stanley, is that they tend to be half as volatile as non-dividend payers. This is valuable because high volatility can undermine long-term compounding, since it takes a long time to recover from bear market years. At the same time, the best stocks among more volatile issues are the ones that pay dividends, according to research by Babson College professor Michael Goldstein and University of Georgia finance professor Kathleen Fuller. During the 30 years ending in 1999, among the most volatile stocks, dividend-paying shares delivered returns of 1.4% a month, double the monthly returns of share that offered no dividend.

When looking at yields, look out

One way to evaluate stocks is to look at their dividend yield, which is calculated by dividing a stock’s most recent 12 months’ of dividend payment by its current price. A comparison of two imaginary stocks that both sell at $10 a share serves as an example. Say Company A paid 50 cents in dividends over the last 12 months, giving it a 5% yield. Company B paid $1 during the same period, producing a 10% yield. By looking at both the dividend and the dividend yield, one could assume that Company B was a better investment.

If Company A’s yield jumped to 20%, would that make it a better stock? It depends on why the yield rose. It’s one thing if the yield rose because the dividend rose. But it’s quite another if the yield increased only because the dividend stayed the same and the stock price dropped from $10 to $5. That slumping price could indicate other problems. Obviously, a dividend yield only tells part of the story, and investors should evaluate a wide variety of factors when choosing investments.

That goes for dividends as well. It may be tempting to assume that any stock that produces a dividend is, by definition, a superior investment. A dividend does not carry that guarantee. Enron Corp. paid $523 million in dividends in 2000, a year before it admitted that it overstated earnings by more than $500 million. Shortly after issuing dividends, WorldCom, Xerox and Waste Management all had to restate earnings that had been improperly inflated.

Dividends in a balanced portfolio

While economists debate the long-term impact of the elimination of the dividend tax, many market analysts expect several short-term effects. Some investors are likely to shift, at least temporarily, toward dividend- payers. Some companies that don’t offer dividends will consider changing their policies. And regardless of whether the tax is eliminated, dividends are likely to return to the forefront of the many factors considered in investment decisions.

While some research suggest that dividend-producing stocks are less volatile than non-dividend shares, it is important to remember that they are still equities, and, as such, carry risks. It’s also important to remember that dividends are only part of the investment picture. As the market moves, investors should see greater returns coming from share price appreciation.

Dividend-producing, stocks, then, should be considered just one facet of the equity portion of a diversified portfolio. That balance allows you to spread the risk by potentially lessening the impact of any single investment or discipline. To manage both risk and market volatility, investors should consider a mixture of both equities and fixed income products, based on your individual risk threshold.

– – – –

(Chart information)

A hypothetical $10,000 investment made in the Standard & Poor’s 500 Index on December 31, 1982 grew to $109,438 by December 31, 2002. Dividends represented 43% ($43,868) of the total return, while price appreciation represented 57% ($62,571) of the total return.

This information is for educational purposes only. It is not intended as investment advice.

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