A sizable tax break on corporate dividends has some analysts gushing about the virtues of dividend-paying stocks, but it's worth noting that since President Bush unveiled his original tax plan back in early January, these stocks have seriously underperformed. Now it's true that a dividend tax break was never a certainty over the past few months. Many investors didn't expect a total elimination of dividend taxes as the president had initially proposed, and some thought the plan would be vastly watered down, if it came at all. Still, the dramatic underperformance of dividend-paying stocks so far this year seems to suggest that dividend tax cuts may be less important to investors than some analysts think. Stocks that paid a dividend have posted a total return of just 6.23% since the start of the year, compared with an almost 21% climb for non-dividend-paying stocks, according to Howard Silverblatt, a quantitative strategist at Standard & Poor's. The average S&P 500 stock posted a total return of 10.5% during that time. Last year, of course, high-yielding stocks were the place to be, with dividend payers down just 5.9% compared with an almost 20% drop for non-dividend-paying stocks. But this year the trend has reversed, with investors bidding up riskier assets amid hopes for an economic recovery. "There's so much going on in the market now that dividends are just one minor item," Silverblatt said. "And we're not talking about a lot of money here." Indeed, many investors might not even feel the benefit of a dividend tax cut because their stocks are held in 401(k) plans or IRA accounts, and only dividends paid in taxable accounts are eligible for the tax break. Furthermore, the dividend tax cut is set to expire in the year 2008.
Congress passed the $350 billion economic package Friday, which among other things, reduces dividend taxes to 15%. The maximum rate currently paid on dividends is 38.6%. Investors in the 15% and 10% income tax brackets will pay just 5% tax on their dividends through 2007, and in the last year of the bill they won't have to pay any taxes on dividends. While some argue that the bill provides an incentive for investors to move into high-yielding stocks, others aren't so sure, noting that the plan also allows for a reduction in long-term capital gains taxes. Most investors currently have to pay a 20% tax on any profits they make after selling a stock that they have owned for more than a year. But the new bill says investors should only have to pay a 15% tax on these gains. This provision actually encourages investors to focus on a stock's capital appreciation, not just its yield, so it's unlikely that there will be any major shift in investor behavior, and speculation could continue to thrive. Joe Lisanti, editor in chief of The Outlook Newsletter from Standard & Poor's, said the dividend tax cut might not do much to change corporate behavior either. "You may see a few companies divert some of money to paying dividends, but that does not necessarily mean that all of them are going to increase their payout ratios enormously," he said. "It's still to the benefit of corporate managers and directors to buy back shares, boost the per-share earnings and drive the stock price up, because they benefit from options or restricted stock or other mechanisms tied to the stock. They still have an incentive that is not necessarily the same as the shareholders." Still, Lisanti said he believes the dividend tax break is more important in some ways than the capital gains tax cut, which he said is only "theoretical" because the benefits aren't seen unless the investor sells the stock and realizes a gain.
Stocks that pay high dividends generally performed well Friday, with Southern Company ( SO) up 5%, SBC Communications ( SBC) up almost 4% and Eastman Chemical ( EMN) and Philip Morris ( MO) up about 3%. To be sure, dividend-paying stocks have historically outperformed. From 1980 to 2002, the total return from dividend-paying stocks was 2.7% better than the return from non-dividend payers, according to Standard & Poor's. And if the economic recovery is more sluggish than investors are hoping for, dividend-paying stocks could come back into vogue as investors seek out safe havens. Still, a weaker recovery could also force some companies to cut their dividends or eliminate them entirely. In the fourth quarter of last year, the dividend payout ratio for stocks in the S&P 500 stood at 145%, according to S&P. That means firms were paying out more to shareholders than they were making in earnings. Although the ratio has fallen sharply since then amid a pickup in corporate profits, some analysts worry that dividends at some firms could be in jeopardy. In an effort to preserve much-needed cash, several companies have already been forced to suspend, eliminate or cut their dividends, which were very high relative to their depressed stock prices. Goodyear Tire and Rubber ( GT) eliminated its dividend earlier this year, while El Paso Energy ( EP) said it would reduce its quarterly payout. Meanwhile, speculation about whether J.P. Morgan ( JPM) and some of the tobacco companies can maintain their dividends remains. Although Microsoft ( MSFT) began offering a token dividend earlier this year for the first time, the company has some $40 billion of cash on its balance sheet, which is unusual for any company.