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 (^GSPC -0.15%) 3.8% drop.

^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:

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:

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.