Buy Opportunity for High-Yield Stocks Ahead?

05/13/2010 11:14 am EST

Focus: MARKETS

Kelley Wright

Managing Editor, Investment Quality Trends

Kelley Wright, managing editor of Investment Quality Trends, notes dividend-paying stocks outperform historically, which should continue even under new tax laws.

Since mid-year 2003, the number of stocks that meet our standards for quality and have well-defined profiles of dividend yield [historically, 350] has been steadily diminishing; so much so that our Select Blue Chip universe has been reduced to just 246 companies.

This is not due to a dearth of companies that pay dividends—there are hundreds of dividend-paying companies—but simply paying a dividend does not make a business into a good stock; remember, there is no profitable substitute for quality.

The majority of the recent downgrades are financials, whose Standard & Poor’s Earnings & Quality Rankings have declined below the B+ threshold. I have little doubt that the majority of these companies will return at some point to our regular pages.

From 1995 through 1999, dividend-paying stocks were anathema to the go-go capital gains crowd; that changed in a hurry after the dot-com and tech bust. With the majority of the gains off the March 2009 lows having been made in the high-beta trash-stock sector, it is déjà vu all over again as dividend-paying stocks are being “discovered” again by everybody and their brother.

While investors’ cyclical love affair with dividends is nothing new, many investors tend to move from one cycle or trend to another, with dividends and value investing moving in and out of favor, this latest infatuation with dividends comes at a time with the potential for change looming on the horizon.

More specifically, there is a very real possibility that the favorable tax treatment for dividends will end this year. The lower tax rate for qualified dividends that investors have enjoyed since the 2003 Tax Act will disappear and revert to full individual income-tax rates starting in 2011 unless Congress makes other arrangements. Also little known is that for investors above a certain income threshold, an additional surcharge (tax) on dividends is part and parcel of the recently signed health care legislation.

Now, prior to the Tax Act of 2003 dividends were always taxed at ordinary tax rates and dividend-paying stocks still outperformed non-dividend-paying stocks, which speaks to the reliability of returns for high-quality dividend-paying stocks over those with capital appreciation potential only.

This is to suggest that even if there is a change in tax policy, I would expect dividend-paying stocks to continue to outperform non-dividend-paying stocks. Not all investors are as cognizant of history, however, and the logic of wise, long-term investment decisions can go out the window as the tax tail wags the investment dog. As such, don’t be surprised to see a knee-jerk reaction by the trend-of-the-day crowd that will present us with an excellent buying opportunity.

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