Several Camelback Fund investors emailed me this week about an Op-Ed piece in the Wall Street Journal by Jeremy Siegel and Jeremy Schwartz (link to bios) that reiterates their feelings that Treasury bonds are in a bubble, and suggests that dividend-paying stocks are the answer to a Treasury bond market that they feel is dangerous.

I try to read whatever I can by Jeremy Siegel, and I did see this piece, but I very much appreciate when investors and other interested parties share these kinds of things with me.

It should be noted that one of the primary points of the article is the authors' acknowledgment that a subset of investors has avoided dividend-paying companies because the big banks and related financial companies pretty much all cut their dividends in 2008.  Their share prices also crashed.  With few exceptions, they haven't returned to pre-crash levels.  Siegel and Schwartz don't think financials will have the same impact if we see a repeat performance, as they now make up only 16% of all dividends in the S&P 500, and dividend-paying companies in every other sector have rebounded nicely.  They point out that, aside from financial companies, dividends for other stock sectors actually grew in the period from 2007-2009.  While it felt to many like the stock market was imploding, investors in non-bank dividend-paying companies were able to bide their time and actually see an increase in cash flows if they simply stuck to their strategy.

Some other highlights from the piece:

• Corporations are more profitable than ever, and those that pay dividends are generally better able to pay them than they've been in a long time.  The average payout ratio of less than 30% provides a "huge cushion" for companies to continue paying their dividends even if a double dip recession materializes.  
• The dividend yield for S&P 500 companies is now more than 2%.  That means that simply investing in a decent S&P 500 index fund will provide exposure to capital appreciation as well income that stacks up very nicely against Treasuries.  Of course, a more focused strategy will pay considerably more than that.
• Dividends for S&P 500 companies have grown at a faster pace than inflation over the past 50 years, in periods of low inflation as well as high inflation.  A lot of people are flocking to gold to protect against impending inflation.  (Others don't actually know why they're flocking there, except that it has been going up lately).  In fact, it's hard to say when we're going to see higher broad-based inflation.  Dividends will outpace it if we do, and they'll outpace it if we don't see it any time soon, based on the historical record.
• Dividends in the S&P 500 have grown by 10% over the last 2 years, as corporations are holding record amounts of cash, and many are "rightly" returning some of it to shareholders.  One of the key points that seems to have been forgotten in the recent market turmoil is the fact corporations have been turning in record profits, and those profits have generated record cash hoards.  More and more companies are choosing to return to the old ways by distributing at least some of this cash to its owners.

Recently, I ran across an article from the May issue of Kiplinger Personal Finance discussing the wisdom of investing in dividend-paying stocks.  The information in the article is pretty well-covered territory at Foothills Financial Planning, but a sub-article covering Why Dividends Matter almost sounded like an advertisement for the Camelback Fund, so I decided to summarize the high points.


The article points to five reasons to favor dividend paying companies, using Procter & Gamble as a representative stock.  For purposes of full disclosure, P&G is not currently a holding of the Camelback Fund, but it is a significant holding in Warren Buffett’s Berkshire Hathaway portfolio, and it has a lot of the characteristics we look for in evaluating candidates for the Camelback Fund.

The high points:

Dividends are big drivers of stock returns

Although the S&P 500 is currently yielding less than 2%, dividends have accounted for 43% of the market’s long-term return of nearly 10% annually.  At the time of the article the yield for the S&P 500 was 1.9%, and we’re not far off of that right now.

Dividends can grow

Many companies make it a practice to increase their dividend on a regular basis, typically annually or every other year.  Owning these shares on a long-term basis not only ensures that the investor receives the dividend income he or she signed up for, but also that the income will grow over time as the dividend grows.  In contrast, the interest payment on bonds - which are another place income-seekers look for a steady paycheck - will never increase.  This is a particularly important issue when inflation is factored into the equation.  The fact that P&G has raised its dividend an average of 10% per year for a very long time provides reassurance that the income provided from such an investment will outpace inflation in most economic environments.

Dividend-paying stocks enjoy a tax advantage

At least through the end of 2010, dividends are taxed at a 15% rate for taxpayers in most tax brackets, while ordinary income can be taxed at a rate as high as 39.6%.  Those in the 10% and 15% brackets pay no tax on qualified dividends.

To be clear, the current favorable tax treatment for dividends is set to expire at the end of 2010.  Lately, there has been a lot more indication that they may be extended for a year or two, at least for most taxpayers, but that is far from a done deal.  If the tax treatment does expire, rates will return to the rates paid on ordinary income.

It’s worth noting that the out-performance that has been attributed to dividend stocks has mostly occurred during times when they were taxed at ordinary income rates, rather than the current lower dividend rate.  Nonetheless, the more that goes to taxes, the less the investor keeps.

Dividend-paying stocks tend to be less volatile than non-dividend stocks

While the stock market as a whole has been very volatile in recent times, and dividend payers have not been entirely exempt from that volatility, they tend to move up and down less than the overall market.  One backward-looking measure of volatility is beta, which in this case typically refers to how closely a stock tracks with the S&P 500.  The article points out that dividend-paying stocks as a whole (i.e. those that pay dividends, big or small) tracked pretty closely over the past 5 years, with a beta of .98.  However, Proctor and Gamble’s beta was only .55.

Bad markets treat dividend-paying stocks more kindly

Dividend-paying stocks tend to maintain their value in down markets more than their non-dividend paying brethren.  Perhaps the most eye-opening bit of data offered in the article is the fact that dividend-paying stocks lost only 10.9% in 2002, just after the bursting of the dot com bubble.  By contrast, non-payers dropped 30.3%!  In fact, P&G actually gained 9.4% in 2002.  

Yesterday's MarketBeat blog in the Wall Street Journal featured an entry titled Drumbeat for Dividends Grows, which highlights the fact that more and more analysts are calling for companies to raise their dividends in light of the historically low payout rates that current exist.  While we at Foothills Financial Planning and the Camelback Fund are pretty loathe to be aligned with what is trendy in the world of investing, we're not at all surprised that the world has woken up to the fact that many dividend companies are good values right now.  The fact that payout rates are relatively low underscores the fact that many dividend payors are perfectly capable of covering their dividends long into the future.

Also, note the recent performance of the S&P 500 companies whose dividend yields exceed the average yield on 10-year corporate debt.  Per the post, they have outperformed their S&P 500 peers by 700 basis points since April.

Wow.

Foothills Financial Planning has introduced a new option for savvy investors, called the Camelback Fund. The Camelback Fund is a new breed of fund called a spoke fund - a cross between a mutual fund and a traditional separately managed account. The spoke fund combines the best qualities of these vehicles, leaving the high fees and other negatives behind.

A spoke fund is a collection of separate investment accounts, or spokes, that are linked to and invested in the same way as a primary central account, or hub. The hub account is managed by the portfolio manager, who maintains a significant percentage of his or her net worth in the spoke fund. Unlike mutual funds, spoke funds feature accounts that are independent from other investors. This provides tax flexibility, voting rights and the ability to exclude specific investments on moral or ethical grounds. For more information about spoke funds, please visit http://www.spokefunds.com/.

The Camelback Fund is so named for two reasons, the first for Camelback Mountain, a major landmark in Phoenix, that reinforces the fact that investment decisions are made far from Wall Street. More importantly, the fund looks for companies that behave like camels – fortified to the extent that they can live off of their stored resources, or continue paying dividends – even when times are lean.

“Dividend paying stocks are typically less volatile than non-dividend paying stocks,” said Kevin O’Reilly, manager of the Camelback Fund and CEO of Foothills Financial Planning, Inc.. “They tend not to decline as much as other stocks in a down market. Also, multiple studies have shown that companies paying dividends have outperformed the broader market over long periods. While there is never a guarantee that such performance will be replicated, we think the reasons behind that discrepancy still hold true.”

The Camelback Fund targets firms that have demonstrated a substantial history of paying – and increasing – dividends. In all cases, investment candidates must have fortified balance sheets that ensure a high likelihood that they can continue to pay dividends, and must be strong companies that trade for significantly less than their intrinsic value.

Unlike a mutual fund, which has sales and distribution fees, management fees, trading fees and redemption fees, the Camelback Fund has only a flat management fee. Investors are rarely aware of all of the fees charged by mutual funds. The spoke fund model promotes transparency, so an investor knows how much of his or her investment will go toward fees right from the start.

For more information, please call Foothills Financial Planning at 480.445.9072, or visit www.foothillsplanning.com.

A key question looming on the minds of dividend investors and the stock market in general surrounds the taxation of dividends in 2011.

By way of context, dividends are taxed at the corporate level – as income, as well as at the individual level. This results in double taxation, and has long been fodder for philosophical debate over the fairness of the system. One school of thought holds that individuals should not pay taxes on dividends at all, because they’ve already paid as partial owners of the companies in question.

 In 2003, President Bush signed a tax reform bill into law that brought the dividend tax rates down from the standard wage tax rate.  For “qualified” dividends, taxes were paid at a rate of either 5% or 15%.  Lower income taxpayers saw qualified dividend rates drop to 0% in 2008-2010.  This rate structure mimics the long-term capital gains rates.  Note:  qualified dividends are paid on stocks held for all of the 120 day period around the ex-dividend date, which is the date on which the shareholder base is determined with regard to who will receive dividends.  In other words, if a shareholder owns the stock on or before ex-dividend date, he or she will receive a dividend for that period.

The 2003 cuts were significant, as the top tax bracket had dividend taxes cut from 35% to 15%.  Perhaps more importantly, the two lower brackets dropped from 10%/15% to not paying any taxes on dividends.  Unfortunately, the dividend tax rate is set to expire beginning January 1, 2011.  At that point, taxes on dividends will revert to the rates paid on wages.  Right now it is unclear what will actually happen at that point, however.

Simply extending the lower dividend rate seems like an option.  However, that would be considered a tax cut, which would require Congress to justify under PAYGO rules.  In short, the higher rates are factored into our federal revenue projections, and we’d have to pay for lower rates – even in the case of an extension – by cutting spending or raising revenue somewhere else.

Undoubtedly, any plan to raise taxes on dividends is designed to raise revenues to help pay for the dramatically increased government spending that has taken place over the last decade.  However, in its most extreme form, an unintended consequence could be to weaken the balance sheets of US corporations, such that they are less well equipped to deal with economic downturns.  That is because raising taxes on dividends could incent corporations to use debt instead of equity.  At least, it may dis-incent them to use equity, as the tax would be the same on interest payments as on dividends.

Furthermore, the recent health care bill already includes an additional 3.8% tax on investment income beginning in 2013.  This includes dividends.  So the rate is going up, one way or another.

What makes this a particularly stick situation is that the dividend tax decision impacts the wealthy as well as lower-income taxpayers.  Per a  Wall Street Journal report, the Tax Policy Center estimates that six million lower-income households will return to paying taxes if the Bush administration changes are simply allowed to lapse. Most Republicans, many Democrats, and President Obama have all stated that they believe dividends should be taxes at the lower capital gains rate, rather than standard income tax rates.

Bottom line

It is still anybody's guess as to how this will play out for taxpayers.  How will it play out for investors? Certainly, dividend stocks are more attractive under the current taxation plan than they were when dividends were taxed at the standard income rates.  However, the outsized returns achieved by dividend stocks that I highlighted in a previous blog post were  were largely gained under non-preferential tax rates.  Consequently, the argument for dividend stocks outperforming the market over the long-term remains strong, regardless of the direction of dividend taxes.  Within reason, of course.