One of the impacts of the looming fiscal cliff is that an increasing amount of attention is suddenly being paid to the role of dividends. If the economy is allowed to go over the cliff, the tax rate on dividends will rise from 15% to the individual's tax rate on ordinary income. The artificially low interest rate environment that has persisted for the last several years has pushed investors to look for yield beyond the fixed income market, and stock dividends, have had a natural draw.
This appeal has led to the so-called "yield trap," which refers to a stock that pays an attractive dividend yield but offers a negligible or negative net return on investment as a result of the stock's performance. While not all high-yielding stocks are yield traps, even market darlings like Annaly Capital (NLY 1.33%), Chimera Investment (CIM 2.24%), and other mortgage REITs have come under scrutiny. Mortgage REITs are of even greater interest because their "dividends" are actually considered distributions for tax purposes, meaning that they are already taxed as ordinary income . The expiration of the Bush-era dividend tax could actually improve the appeal of these companies compared to those taxed at the current low dividend rates.
With the swirling role of dividends as a backdrop, a recent report from Bank of America's (BAC 3.35%) Merrill Lynch unit concluded that dividend growth stocks are at as deep a discount to dividend yield stocks as they have been for two decades. For the sake of clarity, dividend growth stocks are those whose dividends have grown the fastest, and dividend yield stocks are those that carry the highest outright dividend yield. Typically, mREITs and utilities fall into the dividend yield category , while technology firms tend to be dividend growth stocks. These categories are tendencies only -- last August, fellow fool Dan Caplinger highlighted 4 "Dividend" Aristocrats that came from different sectors.
Dividend yielders
Annaly and Chimera have been interesting stories thus far this year. The two companies have dividend yields of 13.9% and 13%, respectively. Unfortunately, a fair amount of that yield has come as the underlying stock has underperformed. Both companies have had to lower their dividends, but their yields have remained strong as a result of falling share prices. This has allowed each to look appealing to potential investors, but many longer-term shareholders have been hurt. On the basis of stock-price return, over the past year, Chimera shareholders are down slightly, while Annaly's stock has slid more than 10% .
As mREITs, each of these companies is in a unique position to be both interesting and somewhat outside of the scope of a pure comparison of yielder versus grower. The pending changes to the tax code will benefit mREITs in the sense that they will not see the net return to shareholders change significantly. As mentioned above, because their dividends are already taxed as ordinary income, a trip off the fiscal cliff makes the mREITs look better because it would put other dividend payers on the same footing tax-wise. As we come ever closer to the precipice, you should keep an eye of this sector for significant moves.
Dividend growers
On the other end of the spectrum from the clunky utilities and mREITs are the sleek tech names that have consistently grown their dividends over time. Looking at the chart below, you can see that both Intel (INTC -2.40%) and Microsoft (MSFT -1.27%) fall into this category. Each of these companies has dramatically and consistently increased its dividend over an extended period. In just the past five years, Intel has increased its dividend by over 76%, and Microsoft's has more than doubled.
INTC Dividend data by YCharts.
The general premise behind dividend growers is that they are able to grow their dividends because the companies are producing robust growth. Because the yielders tend to be in mature businesses with relatively stable fixed costs, they are more able to pay large dividends based on high payout ratios. The growers tend to retain more of their earnings in order to invest in the future. The growth in their dividends comes from a growth in earnings at a stable, but somewhat lower payout ratio.
Prepping for 2013
In general, finding a balance between yield and dividend growth is a prudent diversification technique, particularly in an environment where a significant portion of your portfolio's income is not coming from fixed income instruments. Companies that are consistently growing their dividends are most typically growing earnings; this should help the underlying stock to add something to the net performance of the investment. The higher yielding stocks tend to have stagnant stock prices, where the net investment performance is dividend driven.
In light of the B of A research, however, the relative position of the dividend-growing companies looks particularly attractive at current levels. As investors have flocked to higher yielding options, the dividend growers have been overlooked. This should position them for significant stock price appreciation to complement their slowly growing dividend. Based on this relative position analysis, I think both Intel and Microsoft are buys at current levels to streamline your portfolio for 2013.
