Why I am not worried about the Fiscal Cliff and Dividend Tax Increases

There has been a lot of talk lately about the Fiscal Cliff. To summarize, this is when Federal spending would automatically decrease and there would be automatic increases in tax rates. The combination of these two events is likely to cause some shockwaves to the US economy. Of course, even if politicians somehow agree to resolve the issue, the markets would probably react in a way to show that they don’t like important issues being resolved or postponed all the time.

As a long-term investor, I typically focus on such short-term noise because it is simply out there, and cannot be avoided. I do not think however that it would have such a large long-term impact that most news pundits are forecasting. I also do not follow daily market fluctuations in the stock market, which is why a 300 point move of the Dow Jones Industrials does not register for me. The fact that certain stocks are getting closer to my buy range is making me excited, but other than that I see the fiscal cliff talk as a non-event.

I typically try to focus my energy on companies that I believe have the potential to grow earnings over time. I focus on the business model, try to understand who the customers and whether the business has any pricing power. I also try to understand at a high level what factors will help it grow earnings over time.

For example, a lot of asset management firms like Eaton Vance (EV) are catering to the needs of millions of investors in the US, who are trying to save to retirement. Eaton Vance is selling different financial products, and earning a management fee on the assets under management. In a previous article I mentioned that the 70 or so million baby boomers need financial products to help them invest for and during retirement. In addition, plenty of younger people just entering the workforce are realizing that they might not be able to rely on traditional pension or social security benefits for retirement, and therefore need to save for their golden years on their own. That is why I find companies selling financial products to have excellent growth prospects.

Another growth story is the rise in the number of middle class families in emerging markets such as India, Brazil, Indonesia, Turkey and many countries in Eastern Europe. This would lead to increase in demand for products that many US consumers use on a daily basis. I think that companies such as Procter & Gamble (PG), Coca-Cola (KO) and McDonald’s (MCD) would certainly benefit from the rise in the middle class globally over the next couple of decades.

The most interesting thing about many of the quality dividend kings I have outlined previously is that they have managed to boost dividends for over 50 years in a row. This includes a few wars, countless recessions as well as situations where the top tax rates of dividends were way over 70- 80%. That is why I do not believe that increasing the top tax rate for dividend income to 43% is going to mark the end to dividend investing.

The problem is that the majority of income investors are not going to make more than $250,000 in annual income. As a result, their tax increases will be minimal at best. In addition, a large portion of stock investments in this country are held in tax-advantaged accounts such as 401(k) plans or Roth Ira’s. Most investors that I know personally, have their house and their retirement accounts as their largest assets. In addition, we have plenty of foundations, endowments etc, which hold investments in stocks, bonds and other instruments. Many of these institutions do not pay taxes on their investment income.

Next, while most investors in dividend paying stocks will see an increase in their dividend tax rates, this tax bite would not be at 43%. In addition, I have always tried to stress that in investing, one needs to focus their attention on making a profit on their investment, and only then worry about taxation of their profits. I would much rather have a portfolio that delivers a passive stream of income that grows above the rate of inflation every year until the day I day but produces tax liabilities, than a portfolio that delivers no gains but tax benefits. In addition, for me and countless other investors, purchasing dividend stocks today surely beats purchasing fixed income instruments which are offering record low yields.

Many companies are now offering special dividends, right before the preferential treatment of dividend income expires at the end of 2012. While many articles and pundits tell you to ignore these payments, I am actually keeping a close look. The reason behind my contrarian view is that these special dividends will decrease stock prices, therefore making valuations and current yields from recurring distributions much more attractive.

I actually hope that the stock market tanks at the beginning of 2013, because this would enable me to acquire positions in companies that are too pricey for me at the moment. I would only consider adding to these stocks if the trade below 20 times earnings and yield at least 2.50%. The companies I am considering include:

Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The company has raised distributions for 38 consecutive years. Over the past decade, this dividend growth stock has managed to boost distributions by 17.90%/year. Wal-Mart Stores trades at 13.40 times earnings and yields 2.30%. Check my analysis of the stock for more details.

Becton, Dickinson and Company (BDX), a medical technology company, develops, manufactures, and sells medical devices, instrument systems, and reagents worldwide. The company has raised distributions for 41 consecutive years. Over the past decade, this dividend growth stock has managed to boost distributions by 15.70%/year. Becton Dickinson trades at 14.10 times earnings and yields 2.60%. Check my analysis of the stock for more details.

Brown-Forman Corporation (BF/B) engages in manufacturing, bottling, importing, exporting, and marketing alcoholic beverages. The company has raised distributions for 29 consecutive years. Over the past decade, this dividend growth stock has managed to boost distributions by 9.50%/year. The stock trades at 24.70 times earnings and yields 1.60%. Check my analysis of the stock for more details.

Colgate-Palmolive Company (CL) , together with its subsidiaries, manufactures and markets consumer products worldwide. The company has raised distributions for 49 years in a row. Over the past decade, this dividend growth stock has managed to boost distributions by 12.90%/year. The stock trades at 21 times earnings and yields 2.30%. Check my analysis of the stock for more details.

V.F. Corporation (VFC) designs and manufactures, or sources from independent contractors various apparel and footwear products primarily in the United States and Europe. The company has raised distributions for 40 consecutive years. Over the past decade, this dividend growth stock has managed to boost distributions by 10.90%/year. The stock trades at 16.60 times earnings and yields 2.30%. Check my analysis of the stock for more details.

YUM! Brands, Inc. (YUM), together with its subsidiaries, operates quick service restaurants in the United States and internationally. The company has raised distributions for 9 consecutive years. The stock trades at 19.90 times earnings and yields 2%.

Relevant Articles:

- Dividend investing timeframes- what's your holding period?
- Dividend Macro trends: The Baby Boomer Retirement Investment
- Eleven Dividend Kings, Raising dividends for 50+ years
- Dividend Investing in a Low Interest Rate Environment
- Buy and Hold means Buy and Monitor