Two Winners from Obama's New Tax Policy

03/11/2010 1:00 pm EST

Focus: STOCKS

Richard Band

Editor, Profitable Investing

Richard Band, editor of Profitable Investing, says two dividend-paying stocks are about to get a big boost from the administration’s surprisingly favorable tax policy.

[President Obama’s] 2011 budget takes an unexpected direction on taxes.

Yes, the top tax on ordinary income (wages and interest) will jump to 39.6%, from 35% currently.  I’m not happy about that. But the same rate applied under Bill Clinton—and the economy survived.

Of greater consequence for growth, the president decided to raise the capital gains tax, but only to a maximum of 20% on long-term gains (from 15% at present). And, in a pleasant surprise, the top tax on dividends will also go to just 20%.

Even in Ronald Reagan’s heyday, capital gains were never taxed at less than 20% or dividends at less than 28%. As an investor, then, I have to view Obama’s tax policy at least as favorably as Reagan’s.

Result: Stocks that pay above-average dividends are about to be revalued upward as the market digests the fact that relatively low dividend tax rates are here to stay.

Which dividend-rich stocks stand to gain the most? My vote goes to the electric and telephone utilities. Largely passed by in the monster market rally since March 2009, many of these outfits are so undervalued today that a mere rustle of buyers in the trees could drive up share prices in a hurry.

PG&E (NYSE: PCG) [is] an unusual business success story. The recession has ravaged the state of California. (PCG is headquartered in San Francisco.) By carefully controlling costs, though, and presenting reasonable rate requests to regulators, this electric/gas ute managed to post record operating profits in 2009.

I’m expecting a repeat performance in 2010, with earnings per share up another 7% or so. Yet the shares are changing hands at a trifling [six times] cash flow—below the average regulated utility, despite PCG’s superior operating profile. Current yield: 4.3%.

Favorable tax treatment for dividends will help domestic stocks the most, but I also expect some spillover into the ADRs of foreign utilities because their dividends, too, will qualify for the 20% top rate.

UK-based Vodafone Group(Nasdaq: VOD), one of the world’s largest cellular operators, is trading at less than [nine times] estimated earnings for the year ahead. Does this pricing make sense?

VOD’s crown jewel is a 45% interest in Verizon Wireless, the most profitable segment of the Verizon empire. Verizon(NYSE: VZ) itself sells for 12x forward earnings. When you can buy a faster-growing business at a 25% discount to a slower one, I suggest you run—not walk—to your broker’s web site and place an order!

At some point, I can imagine Verizon buying out VOD’s interest at a fat premium, perhaps part of a restructuring that would have VZ spin off its declining land-line business. As a pure wireless company, VZ would likely command a higher market valuation than as an all-things-to-all-people telco.

VOD yields a lofty 5.6%, [and] there’s no British withholding tax on dividends remitted to Americans.

Buy PCG at $43 or less and VOD at $23 or less. (Both closed near those prices Wednesday—Editor.)

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