Will the Fiscal Cliff Destroy Dividend Stocks?

With three weeks to go and Congress in a stalemate, investors are worried their portfolios are about to make a fiscal cliff flop. We've all heard the doom and gloom stories, but let's put some numbers to this problem to see what a tax rise would actually mean for your portfolio's profits.

The hardest hit
If
Congress doesn't get its act together, investors can expect dividend stocks to receive double damage. Not only will these companies suffer from a widespread dysfunctional economy, but a rising dividend tax rate will also pull the plug on investor's excitement in dividend stocks. The rate is a lean 15%, but it could be headed as high as 43% for those in the highest tax bracket.

The deadline is fast approaching, and many investors are rearranging their portfolios to snip dividend stocks right out of their portfolio. But before you make the mad dash to ditch dividends and gobble up growth stocks, let's take a look to see what the damage could potentially be.

Dividend dynamite
Among sectors hardest hit by fiscal cliff fears, utilities have fared especially poorly. Strictly regulated, these companies have historically been the tortoise to the market's hare, the steady backbone of stock market growth. In the past couple months, utilities have lost nearly double the S&P 500's (INDEX: ^GSPC  ) 3.8% drop.

^DSUT Chart

^DSUT data by YCharts

Those same dividends that had investors drooling during the Global Recession are now tainted with the terror of higher taxes, and investors want nothing to do with utilities.

Calculation station
But as any savvy shareholder knows, mainstream market fears often present unprecedented opportunity for a value grab. As a good stock market steward, I ran the numbers to see what this tax hike could potentially mean for utility investors. Here's a quick breakdown of profit squeeze on $1,000 investments in each of the following stocks:

Company

Dividend Yield

15% Tax Loss

43% Tax Loss

Fiscal Cliff Tax Difference
(% of investment)

Exelon (NYSE: EXC  )

6.9%

 $10.35

 $29.67

1.9%

FirstEnergy (NYSE: FE  )

5.2%

 $7.80

 $22.36

1.5%

Duke Energy (NYSE: DUK  )

4.6%

 $6.90

 $19.78

1.3%

Southern Company (NYSE: SO  )

4.5%

 $6.75

 $19.35

1.3%

National Grid (NYSE: NGG  )

4.1%

 $6.15

 $17.63

1.1%

NextEra Energy (NYSE: NEE  )

3.5%

 $5.25

 $15.05

1.0%

Source: Yahoo! Finance and author's calculations 

It doesn't take a rocket scientist to see that stocks with high-yielding dividends are hit hardest by the potential tax increase. But even a company like Exelon, with its current 6.9% yield, only ends up with 1.9% knocked off its final investment return. That's comparable to many mutual fund fees, and just under the broker's fee that most investors pay to buy and sell a stock. 

But that's all assuming that we do go flying off the fiscal cliff. To further quantify your risk, go ahead and multiply that "Fiscal Cliff Tax Difference" by your personal take on the odds of Congress filibustering its way through December. Here's how they'd stack up for Exelon:

Probability of Fiscal Cliff

Fiscal Fear Discount

100%

1.9%

75%

1.4%

50%

1.0%

25%

0.5%

10%

0.2%

0%

0%

Source: Author's calculations

In other words, if you believe there's a 50/50 chance we fall off the fiscal cliff, your value proposition for Exelon drops just 1%, and even less as the odds decrease further.

Dividends do best
It's easy to get lost in future calculations, but history has a lot to say about dividends. There are dozens of research papers touting dividend stocks as some of the soundest investments. With study periods dating back to before the Great Depression, dividend stocks have consistently outperformed non-dividend-paying stocks by 5%, and up to 18% during market recessions! 

Warren Buffett summed up the value proposition perfectly in a recent New York Times opinion article:

Suppose that an investor you admire and trust comes to you with an investment idea. "This is a good one," he says enthusiastically. "I'm in it, and I think you should be, too."

Would your reply possibly be this? "Well, it all depends on what my tax rate will be on the gain you're saying we're going to make. If the taxes are too high, I would rather leave the money in my savings account, earning a quarter of 1 percent."

For famed investor Warren Buffett, tax rates come second to investment opportunities. It would be foolish for an investor not to understand and consider various tax rates, but a company's long-term-value proposition doesn't change with tax policy.

The time is now
Fiscal cliff fears have crowned utilities as the worst-performing sector of late, but history and common sense shows that investments aren't meant to be based on fiscal policy alone. Investment in a company because you believe in its long-term potential, whether it's Exelon's and NextEra's green energy grab, or Duke's recent merger with Progress Energy. You might like National Grid because of its international presence, or perhaps Southern Company seems poised for population growth.

Whatever your decision, rationalize your fiscal cliff fears and go forth as a more confident and informed investor.

Exelon has dropped a whopping 20% in the past three months, even as the company sets itself up for a cost-effective and increasingly profitable future. An increased focus on renewable energy and EXC's recent merger with Constellation places Exelon and its best-in-class dividend on a short list of top utilities. To determine if Exelon is a good long-term fit for your portfolio, you're invited to check out The Motley Fool's premium research report on the company. Simply click here now for instant access.


Read/Post Comments (3) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 07, 2012, at 3:20 PM, nownow01 wrote:

    I think that the IRS has too many definitions of INCOME. All capital gains should be considered as ordinary income, period. This would eliminate market playing and reduce the volatility . High time people stop leaving the house keys on the floor and walking away from their obligations. Same goes for the Governments.

    The younger generation is not going pay for this generations opulence..They saw how easy it was to walk away debt over the last four years..Even those in Washington are considering walking from obligations..ie. social security,medicare, etc.

    I guess that another great war is in the making.

    ab

  • Report this Comment On December 07, 2012, at 7:13 PM, motleymarty wrote:

    I urge every investor to email their congressperson or senator or call them and tell them: This Sort of Haggling over Taxes is ... Un-American! Of Course the "Wealthy" Should Pay their Fair Share. So you have $100K investment income per year, and you don't want to pony up a few extra bucks in taxes? Get Real. How narcissistic. How embarrassing. THIS is the largest issue our country faces??

  • Report this Comment On December 10, 2012, at 11:41 AM, ETFsRule wrote:

    Good article, but I have some quibbles over the analysis.

    The "Fiscal Fear Discount" is really an annual discount, not a one-time discount, because the dividend tax must be paid every year. So with Exelon, for example, this Fiscal Fear Discount really means that your expected return should be lowered by 1% per year. So with that in mind, the DSUT's 6% drop makes more sense.

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