By John Wasik
CHICAGO, Nov 30 (Reuters) - With a tax increase on dividends and capital gains looming, high-dividend paying stocks may hold up well - even if investment income rates climb on Jan. 1.
Unless Congress acts by the end of the year, taxes on dividends will automatically rise from the current 15 percent to as high as 39.6 percent. While that sounds like a draconian increase, it should not discourage investors from owning high-dividend paying stocks nor should it trigger a lasting market decline.
You can blame inertia, but individual investors are likely to stick with their dividend stocks anyway. And those who do may even be rewarded for the fear factor of higher rates. Companies like Wal-Mart have moved up dividend payments to December. Others like Costco, Wynn Resorts and Tyson Foods are declaring special dividends, some of them quite substantial.
If history provides any clue, the market should get over its anxiety quickly and move on. According to a study by Ned Davis Research, dividend stocks performed well during past periods of higher dividend taxes. The firm studied years when rates ranged from 28 percent (1988-1990) to 70 percent (1972-1978).
In every period studied, except for 1987, high-dividend stocks outperformed non-dividend payers. The margin of outperformance was as high as nearly 15 percentage points.
What's the connection between tax rates and dividend-paying stock returns? According to Milller/Howard Investments in a recent report: "There is no correlation between lower dividend taxes and the performance of dividend-paying stocks."
There are some fundamental financial and psychological reasons why dividend payments and tax rates are unlinked. Here are the four most compelling ones:
1. Investors still know how to play the ongoing contest between bonds, insured vehicles and dividend-paying stocks. Savvy investors buy on the spread, or the difference between asset classes. Right now, that gap is big.
The national average rate on a one-year certificate of deposit, according to Bankrate.com, is a miserable 0.29 percent, although you can find a CD yielding 1 percent if you shop around.
You can get a 2 percent yield on the Vanguard Dividend Appreciation ETF right now. The exchange-traded fund holds a basket of stocks that consistently boost their dividends. This spread is unlikely to narrow soon since the Federal Reserve has said it will leave interest rates close to zero into 2014 if the economy continues to be sluggish.
I know I'm comparing apples and oranges - an insured investment with stocks - but long-term, total-return investors are willing to take on the extra risk.
2. The best dividend-paying stocks combine income with potential growth in the payout over time. Conventional bonds and insured deposits pay a fixed rate until maturity. While there may be some compounding, your income stream won't change during the time you hold your bond to maturity.
Dividend payers can increase their payouts every quarter - and many have done so consistently over time. Energy company Chevron, for example, has been paying dividends since 1912; Colgate-Palmolive since 1895, and Stanley Black & Decker since 1877, according to Investorplace.com's list of "dependable dividends."
Investors will continue to embrace consistency paired with dividend growth even if tax rates climb.
3. Dividends still provide a modest cushion in calamity. While dividend-payers still are subject to stock market risk, they are much better to own in a pinch in a low-yield, slow-growth environment.
If you examine the most elite companies that have raised dividends for at least 20 years - the S&P High Yield Dividend Aristocrats - those companies have outpaced the broad S&P 500 index over the past one, three and five years through 2011.
Even when you include the disastrous results from 2008, the Aristocrats turned in a 1.53 percent return for the half decade versus a negative 0.25 percent for the stocks of the S&P 500. Keep in mind that one-third of total stock returns have come from dividends since 1926, so in the absence of appreciation, dividends provide some insulation in bear markets
4. Total return still matters. Yield isn't the only reason dividend payers will prevail in the event of a tax increase. Companies also offer the potential for capital appreciation in growing economies.
The most consistent payouts come from sectors of the economy that straddle defensive and growth categories. Utilities, for example, many of which have been around for a century, have traditionally paid out large portions of their cash to shareholders. Combined with an increasing demand for electricity and energy, they've done well in recent years.
The Utilities Select Sector SPDR, for example, has returned nearly 14 percent over three years through Oct. 30, with a recent yield of about 4 percent.
The Vanguard Consumer Staples ETF, which tracks an index that holds "consumer defensive" companies like Altria and Coca-Cola, is up nearly 15 percent with a 2 percent yield.
The market will get nervier the closer Congress gets to the end of the year - dividend payers will likely provide the modest bulwark they always have for buy-and-hold investors. There are no guarantees, but the lion's share of dividends won't suddenly disappear just because tax rates change.