Uncertainty around the future taxation of dividends in the US could result in a slew of companies making special shareholder payouts before the year end.
Increasing the taxation of dividends is one of several measures that president Obama (pictured) is expected to introduce in a bid to help deal with the country’s pending fiscal cliff.
Legg Mason US Equity Income fund manager Peter Vanderlee points out that dividends are currently taxed at 15% generally, and a potential increase in the investors’ nominal rate of tax could have massive implications for the market.
The issue is taking shape as a key battleground between the Democrats and the Republicans, where compromise or agreement seems the most distant.
‘No-one knows what the resolution will be, it is one of the biggest areas of uncertainty,’ Vanderlee says. ‘What I do think you will see in the US is a number of companies announcing special dividends before the year end and the impact will be noticeable.’
Several companies, including American Eagle, Sycamore Networks and DSW, have already announced special dividends and more are expected.
Vanderlee sees the uncertainty around the dividend tax as one of four factors currently holding back the market.
However, he says there does appear to be greater consensus, or at least a willingness to compromise, around the other three, with both parties seemingly agreeing that the existing payroll tax break will lapse on 1 January.
Similarly, the two parties are both against sequestration in January, worried about its impact on the military and although there are differences on both sides over potential upper bracket income tax hikes, there does seem scope for compromise, he says.
But despite the more thorny issue of dividend tax, Vanderlee remains upbeat about the prospects for US equities and in particular income stocks.
‘We have had scenarios where dividends were taxed much higher than they are now. Between 1941 and 1986 the tax rate on dividends was at least 50% and in some cases as high as 90%,’ he says.
‘During that period though dividend stocks continued to do well and outperform the broader market. This issue may drag on into 2013, but it doesn’t change the attractiveness of equity income as a strategy for us.’ He says valuations are not stretched at 13 times next year’s earnings and although the third quarter reporting season did show a trend of slowing earnings growth, he believes this is already priced in.
‘If you look at the S&P 500 in aggregate, corporate America has cash on its balance sheet equivalent to 10% of total assets and the free cash flow yield is 7.5% underlining how cash generative companies are,’ he says.
‘The current payout ratio is only 30%, which is well below the long-term average of 46%. Corporate America continues to be stingy when it comes to paying out dividends, but the demand for income from a retiring generation of baby boomers means this will rise.’
The Legg Mason US Equity Income fund passed its first anniversary last month and over one year it has returned 11.7% compared to an IMA North America peer group average of 13.3%.