DIVIDEND

Neither income investors nor dividend-paying companies should let the tax tail wag the income-paying dog. Solid income stocks will outperform regardless of tax issues, observes Kelley Wright of Investment Quality Trends.

The three days prior to Thanksgiving generally marks the beginning of the traditional end-of-the-year jockeying that takes place in the markets and therefore portfolios.

This year appeared to be no different. The markets shook off the October doldrums with better-than-expected economic news, along with the (eventually justified) belief that the Federal Reserve would replace Operation Twist with a similar program of buying government securities to keep long-term interest rates low.

What was different about the latest Fed statement is we now have a new definition of infinity. Infinity, if you will remember, is the term many attached to the Fed's previous version of quantitative easing (QE), as in QE to infinity. We now know that infinity means an unemployment rate of 6.5% or less and/or when the inflation rate exceeds 2.5%.

Now that we have some hard and fast metrics as to when the Fed will begin to exit their easing activities, the markets can focus on other areas of uncertainty, such as fiscal policy. Many, however, are not waiting to see what comes out of Washington, and are engaged in their own game of sorts-more specifically, the application of game theory.

Without taking you over the hills and through the woods to Grandma's house, game theory is primarily a mathematical and statistical exercise where potential outcomes are modeled in an effort to predict said outcomes within a range of statistical confidence. In very simplistic terms, we could call it sophisticated guessing.

This is most apparent in the deluge of special dividends that have been declared over the last several weeks. Ostensibly, the purpose of these special dividends is to allow companies to reward their shareholders with an extraordinary distribution that will be taxed at the current favorable rate of no more than 15%, as opposed to what many believe will be a higher tax rate come January 1, whether the government takes us over the fiscal cliff or not.

Whether this largesse proves to be foresight or poor knee-jerk analysis to a possible but as of yet unrealized event remains to be seen. While as a general rule, we are opposed to all taxes on risk capital, we remind our readers that dividend payers have outperformed non-dividend payers even when the tax rates on dividends were at the ordinary income rate or higher. In short, stick with the tried and true, and don't let the tax tail wag the investment dog.

Although we welcome all distributions to shareholders, as they represent a return on investment, we do not take special dividends into account when identifying the dividend yield profile for a Select Blue Chip. The reason for this is simple: special dividends are typically one-off events and not part of the long-term dividend policy.

It is the long-term dividend trend that establishes the repetitive dividend yield boundaries that mark the areas where investors tend to buy and sell shares, which we call Undervalue and Overvalue respectively.

In contrast to the special dividend, some of our Select Blue Chips from time to time, for varying reasons but generally for tax purposes, pay a fifth dividend in a calendar year. By example, Nike (NKE) will pay a normal dividend originally slated for 2013 on December 26. Nike has done this before, most recently in 2010, and then distributed dividends only three times in 2011. Our projection is they will do the same thing in 2013.

Since Nike is merely frontloading a dividend into the current year, this distribution does not qualify as a special dividend, and therefore will be considered in the dividend profile calculation for the company. Time and space limit a full listing of all the Select Blue Chips that engage in this practice, but the point for readers to understand is that this is a common practice. As a side note, NKE will also split its shares 2 for 1 on December 26.

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Related Reading:

Is QE4 Coming Soon?

Brinksmanship Alive and Well in DC

Will Next Year Be the Same?

Tickers Mentioned: NKE

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