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The Fiscal Cliff: Are Dividend Stocks Doomed?

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If you're just waiting to collect the final dividend payments of the year before dumping these stocks, you may want to hit the pause button.

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The outlook for M&A activity is always uncertain, and especially so given the lack of macroeconomic visibility. And the track record of buybacks in boosting share prices is uneven at best. As a 2005 study from McKinsey & Co. analysts pointed out, a buyback may boost earnings per share but doesn't alter a company's intrinsic value.

It is even arguable that companies may want to increase their dividend payouts into the new year, especially if they are holding large amounts of cash on their books. If corporate tax rates climb, keeping that cash on hand will become more costly as companies pay out more in taxes on interest income they generate from those cash positions. Admittedly, the dividends may not have the same value in investors' eyes, but that doesn't mean they won't be paid.

Should you prepare to dump companies that are paying out early dividends or big special dividends as soon as the payout date passes? In some cases, that might make sense. In many cases, a special payout shouldn't be a large factor one way or another.

Take Tyson Foods (NYSE:TSN), for instance, which announced plans to pay out its first special dividend in 35 years, a 10 cent per share bonus, as well as boosting its regular payout by 25 percent. Up until now, Tyson's dividend yield has been a meager 0.85 percent. If you believe the meat products company will continue to raise that dividend payout, or that it will continue to post big earnings gains, then you might want to hang on to those shares next month after the dividend record date has passed. But this is hardly a stock that you'd own for its dividend, even at today's low tax rates.

In other cases, however, even at a higher tax rate, dividend-paying stocks could still be far more attractive than other investments simply because they offer both income and the potential gains from a rising share price. Having to pay a higher tax rate will eat into that, of course, but it won't eradicate it – especially when yields on Treasury securities remain as absurdly low as they are today.

True, Treasury notes are "risk free" in a way that stock dividend payment can never be – but the upside potential is much more limited. Defense giant Raytheon (NYSE:RTN) yields 3.62 percent today and trades at less than 10 times earnings; the company is focused on cutting costs to address a more difficult business environment. True, it may get dinged a bit by defense budget cuts scheduled to take place as part of the fiscal cliff, but a lot of those issues have been priced into the stock. And taxes on the $2 annual dividend would go from 30 cents a share to 78 cents a share, but where else would an investor be able to earn as much income on their investment while maintaining as much upside?

Obviously, investors want to know what they own and why. For dividend stocks, know what the yield is, how a tax hike would impact that income stream and what the alternatives are. Most importantly, shareholders will want to inform themselves of the companies' cash positions. How much cash flow is the company generating, and is that adequate to cover the dividend?

If we do end up careening off the fiscal cliff, that obviously will be bad news for dividend-paying stocks, as it will put impose a new cost on shareholders. But then, it will be bad news for stocks of all kinds – and ironically, regardless of the tax consequences, companies with big cash cushions will be ones best positioned to ride out another recession. Often, these are the same companies that pay out dividends, even if sometimes those yields aren't among the highest in the market.

So if you're just waiting to collect the final dividend payments of the year before dumping these stocks, you may want to hit the pause button and consider whether the alternatives – both for income and for stock-price appreciation – are really more appealing.

Editor's Note: This article by Suzanne McGee originally appeared on The Fiscal Times.

For more from The Fiscal Times:

Why Most Tax Deductions Will Survive the Cliff

Carbon Tax: Two Problems Solved for the Price of One

Tax Fears Take a Big Chunk Out of Spending


Follow The Fiscal Times on Twitter @TheFiscalTimes.
No positions in stocks mentioned.
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