Dividends Make a Comeback, And Tax Cut May Fuel Growth

Dividends are making a comeback just in time for investors to take advantage of a possible two-year extension of a tax cap on dividend income.

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An extension of the 15 percent tax rate on dividend income, part of broad tax cut deal between President Obama and Congressional Republicans, may nudge more companies to restore dividends that were cut during the financial crisis, some analysts and portfolio managers say.

“Boards which were hesitant to issue and increase fully taxed dividends (and might have pushed for more buybacks) will now have a higher comfort level, and one less reason not to do dividends,” said Howard Silverblatt, Standard & Poor’s senior index analyst.

For investors, dividend stocks are good bets whether the tax rate cap is maintained or not, says Thomas Huber, portfolio manager of T. Rowe Price Dividend Growth. That’s because companies that pay dividends typically are well managed, and tend not to make poor decisions on how they invest or expend capital, he says.

“If you’re invested in a group of companies that are very thoughtful in terms of how they allocate capital, it’s kind of a winning strategy over time,” Huber says.

On Tuesday, the day the tax cut compromise was announced, General Electric’s GE Capital unit said they expect to return a dividend to GE in 2012. (GE is also the parent of CNBC). And two banks indicated they expect to increase dividends: PNC and Bank of America .

In fact, the number of companies paying stock dividends already is nearly back to 2008 levels, and many more companies have boosted dividends instead of cutting them this year, a big reversal from a year ago, according to S&P.

Through November 30, 370 S&P 500 companies paid dividends, up from 363 in 2009 and only two less than the 372 that paid dividends in 2008, according to S&P.

Moreover, only four companies cut their dividend through November 30, a sharp drop from 78 cuts in 2009, S&P data shows. Those cuts resulted in $37 billion in lost cash for investors in 2009. This year, investors are ahead by $17.8 billion, S&P data shows.

“We’ve stopped the bleeding,” Silverblatt says.

The tax cut compromise remains to be worked out with Congressional Democrats, who strongly object to provisions they see benefiting the wealthy and adding to the Federal deficit. If the agreement does pass, Howard Ward, portfolio manager of GAMCO Growth, agrees the favorable dividend tax treatment will factor into corporate dividend decisions.

“There will be some loosening of corporate purse strings when boards vote on dividend payments, which they must do each quarter,” Ward says.

Companies, which have been accumulating hoards of cash as the economy has slowly improved, have to calculate whether it’s best for their corporations and shareholders to put cash to work in the business, or to use it to buy back shares or pay dividends. A more attractive dividend tax rate weighs the scales in favor of dividends.

“It makes a big difference when the dividend tax rate is 15 percent or 30 percent or 40 percent, whether you think it’s the best use of your cash, or whether you think shareholders would be better off if you were buying back stock,” Ward says.

A Contrary View

But Josh Peters, equities strategist at Morningstar, doesn’t think the compromise, if it plays out, will make any difference in corporate dividend policies.

One reason is the extension would only be for two years, which doesn’t give corporations enough certainty. “If you are going to dramatically change your payout practices you have to think in terms of five to 10 years or longer,” Peters says.

But more significantly, he said, companies have shown they are more interested in holding on to cash for growing their businesses than they are in returning value to shareholders, and he doesn’t see that changing soon.

The so-called payout ratio for dividends, or the percentage of earnings distributed as shareholder dividends, has been drifting lower for more than 15 years, Peters said. From 1960 to 1994, S&P 500 companies paid out 52 percent of earnings on average, while the average dividend yield of S&P 500 companies in the same period was 3.75 percent, Peters said.

Today, the payout ratio is about 30 percent on average, and the average yield is less than 2 percent.

“Tax policy to me is not a key driver of dividend policy, I look at it more like an excuse,” Peters says. “Most companies would rather hang on to their cash flow and then they use those funds to make the company bigger, not necessarily better.”

If the dividend tax rate continues to be capped at 15 percent, S&P estimates investors in taxable accounts will earn another $74.5 billion, according to Silverblatt. That would bring the 10-year tax savings for investors—money that is not going to the government—to $348.4 billion, he said.

Comeback Will Take Time

Whether the dividend tax rate is maintained or not, Silverblatt doesn’t expect the number and dollar value of dividends to resume full strength until 2013, as companies need to see more quarters of sustained growth to feel comfortable that the economy is back on track.

“You can’t play with dividends, that’s a cash flow commitment that’s coming out of your numbers,” Silverblatt says.

Banks have been the biggest dividend laggards, as government regulators have carefully watched their capital ratios in the wake of the financial crisis, requiring the 19 largest banks to undergo a stress test before they get the green light to boost dividends or buy back stock.

In 2007, before the crisis, bank dividends accounted for 30 percent of all S&P 500 dividend-paying companies; last year, banks paid only 9 percent of all dividends, according to Goldman Sachs. Next year, the figure should rise to 11 percent, Goldman says.

Overall, Goldman predicts S&P 500 companies will allocate 39 percent of capital spending to buybacks and dividends in 2011, and said in its annual equity outlook that dividends will grow by 11 percent in both 2011 and 2012.

Bank of America, in fact, said it expects to deliver a dividend to shareholdersof 30 percent of earnings next year. BofA, the nation’s largest bank by assets, cut its dividend to 1 cent a share from 32 cents a share in the first quarter last year after it received $45 billion in U.S. government bailout fund.

Huber of T. Rowe Price Dividend Growth is optimistic about dividend stocks, with or without continuation of the dividend tax cap.

“Look across the market and sectors, with the exception of financials, we have seen a nice recovery beginning in dividends,” he says. “It suggests if the economy continues to chug along and improve, and business confidence improves, you’ll continue to see reasonable healthy dividend increases.”

Unlike Silverblatt, Huber believes several factors, including strong corporate balance sheets and better relative returns for dividend-paying stocks, will lead to more companies increasing their dividends in the months ahead.

Mattel , Marriott , and Johnson Controls—cyclical companies that had not raised their dividends through the financial crisis—recently resumed doing so, Huber notes.