For many investors, in fact, it's hard to remember anything positive that has come out of the nation's capital in recent months, but something very positive for the investor community has happened, and it actually wasn't too long ago.
Had the so-called Bush tax cuts been allowed to expire at the end of last year, qualified dividends would have been subject to ordinary income tax rates, which for high earners is currently 39.6%. In a rare show of bi-partisanship, both sides came together and hammered out a deal that essentially capped qualified dividend taxes at 20% and made such tax rates a permanent part of the tax code.
Unlike so many of the budget and tax battles that consume Washington today on a recurring basis, the issue of dividend tax rates has largely been decided: They are simple and transparent and there are no expiration dates or sunset provisions attached.
While this has positioned dividend-yielding stocks as a very attractive option for investors, not every dividend-paying stock is created equal. With interest rate hikes possible in the near future due to the Fed potentially paring back its bond purchases, yield is increasingly taking a backseat to growth potential.
Consider utilities, which historically pay high dividends. In a rising interest rate environment, utility stocks tend to behave much like bonds, as prices drop and competition from Treasuries picks up. There is also the reality that many dividend-paying companies are already maxed out. In the face of declining cash flows, such companies will be unable or unwilling to increase dividends.
Rather than plowing headlong into dividend-paying stocks that have little prospect of increasing their payouts, investors should focus on companies with lower dividend yields but longer runways for growth. Such companies typically have low debt levels and significant pricing power, allowing them to pass any additional expenses to the end customer.
The following are four companies that are set to grow their dividends more than the S&P average and remain attractive in a rising interest rate environment:
Digital Realty Trust (DLR) – Digital Realty is real estate investment trust that invests in properties that house data and tech professional service companies. It has 127 holdings in 32 markets across the world, but most of its properties are located in the United States. The dividend yield is 5.5%, which has steadily increased at a compounded annualized rate of 21% over the last ten years, nearly triple the rate of the S&P 500. The good news is that Digital Realty is likely to grow its dividend even more as global demand for "anywhere access" data increases.
Equity Residential Equity Residential (EQR) – Also a REIT, Equity is placing an heavy emphasis on apartment complexes located on both coasts, where rents tend to be higher and turnover is generally lower than the national averages. Following its acquisition of Archstone late last year, the company is now poised to sell $8 billion in properties. Equity pays three even quarterly dividends, plus a special year-end dividend, totaling a 3.6% yield over the last year. Its dividend growth rate has accelerated to 25% on a trailing 12-month basis.
Wells Fargo Wells Fargo & Co. (WFC) – The bank currently pays out a dividend that yields 2.8%, which is only 30% of its net income. Don't expect income to rise beyond the S&P average in coming years, as the company is not positioned to make any major acquisitions in the near future. Although Wells Fargo cut its dividend dramatically in 2009 (like most financials), there is a good chance there will be annual dividend increases of at least 20% over the intermediate term.
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On the opposite end of the spectrum, there will be companies that will suffer greatly in the event of an interest rate spike, which would increase borrowing costs and imperil capital intensive, low-growth industries that are typically highly leveraged. Based on that, the following are two equities to avoid:
Exelon Exelon Corp. (EXC) – Exelon is the largest owner and operator of nuclear reactors in the U.S. While it currently offers a 4.3% dividend yield, it cut its dividend in early 2012 and again in spring 2013. Weak pricing power has cut into the company's cash flow, which is down nearly 90% over the past year. With limited opportunities to reinvest in the business, Exelon's payout, which is already high as a ratio of net income, is very unlikely to increase.
American Electric American Electric Power (AEP) – American Electric Power is yet another utility that is experiencing declining cash flows. While its stock yields 4.4%, its dividend has grown at a disappointing annualized rate of 1.6% over the past 10 years. And like Exelon, it also has limited opportunities to reinvest in the business, and its payout ratio is similarly high.
The long and the short of it? When it comes to dividends, growth is becoming king. Investors who have always focused on yield need to realize that while size of the dividend matters, there's much more to the equation with respect to building long term value.
Ben Marks is president and chief investment officer of Marks Group Wealth Management, a Minneapolis based independent registered investment advisory with approximately $500 million in assets under management. Marks Group owns certain aforementioned stocks on behalf of clients.
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