Idea of the Week: Building a Taxmageddon Hedge

August 1st, 2012 by

Why own low dividend payers like Oracle (ORCL.O) and Discover Financial (DFS.N)? As Bush-era tax cuts approach their expiry, companies like this (for a complete list, click here) may help investors do better on an after-tax basis compared to companies that pay bigger dividends.

Released: August 1 2012
Length: 3 Minutes

Watch the 3 minute video to see how you can use Datastream Professional and some StarMine analytics to find stocks that high tax rate investors might favor ahead of the looming end of Bush era tax cuts, portfolios of high tax rate investors should favor stocks with low dividend yields and low payout rates.

With all eyes back on the eurozone and its woes, it’s all too easy to forget that the United States has its own economic issues to confront. But there is one domestic worry that looms large on the horizon: “taxmageddon”, as the possible end to Bush-era tax cuts is popularly known. While the Europe-centric headlines may have pushed this domestic concern out of the spotlight, the fact is that without action by Congress to roll over the cuts to dividend income and other measures before the end of the year, investors could be facing paying tax rates as high as 44.8%, once surcharges for the Obama administration’s new healthcare plan are included.

This creates a challenge for the long-term investor with big portfolio holdings of dividend-paying stocks in their portfolios like Johnson & Johnson (JNJ.N), Exxon Mobil (XOM.N) and Merck (MRK.N). But there is a strategy that you can use to generate returns that are comparable to those offered by high-dividend stocks, but that will leave you with a smaller tax burden. That is because this approach relies on identifying companies whose gains are more likely to come from capital gains; if Congress doesn’t act in a timely manner, those taxes, too, will rise but you’ll still only face a rate of about 23.8%, allowing you to keep a greater proportion of your profits in your wallet.

According to a study by Credit Suisse, stocks that offer high yields and high dividend payout ratios have been the most profitable ones for investors to own over the last two decades. But, given the possible change to the tax rate, that might no longer be the case as taxable investors may be bolting for the exits very rapidly as the clock ticks down the days and hours to the end of 2012. The second-best strategy? That is to own companies that have low dividend yields and low dividend payout rates. These companies pay a dividend but also keep a significant portion in retained earnings to plow back into their businesses and finance future growth. These characteristics tell us that they might be more stable, and that they may well be able to generate growth – growth of a kind that often produces capital gains as stock market investors recognize and reward it.

Using StarMine screens, we sought out U.S. companies that had low dividend yields – in a range of 0.25% and 1.25%, below the average S&P 500 yield of about 2% — and that kept more than 60% of their retained earnings for business expansion. (We also focused on companies with a market capitalization of $500 million and average daily trading volume of 500,000 shares.) We also tossed out companies that scored in the bottom 20% on the StarMine Earnings Quality model, which measures the sustainability of earnings. For the 12 months ended June 30, 2012, that bottom quintile has lost 20%, while the top-tier companies according to this metric have gained 2%. That’s a big argument in favor of applying an earnings quality screen. The chart below plots the top 80% (as measured by the EQ model) of those “low low” companies against the performance of the S&P 500; the “growthier” bias shows up in the bigger jumps by the blue line during periods when the market is less nervous, such as the early months of 2012.

The results? This process led us to stocks like credit card issuers Visa (V.N) and Discover (DFS.N), software giant Oracle (ORCL.O) and Disney (DIS.N), the global entertainment company – and to 110 other companies in every sector except utilities. (For the complete list, please click here.) The greatest number of companies were found in the consumer discretionary sector and in the industrials. Oracle, for instance, a darling of momentum traders, has a stingy dividend yield of only 0.8%; it is hanging on to about 90% of the earnings it has generated in the last four quarters. True, it scores a weak 11 out of a possible 100 using StarMine’s Price Momentum model, but its Analyst Revisions Model (ARM) score is a more impressive 87. Payment services company Discover Financial Services (which initiated another kind of dividend in the form of the credit card industry’s first “cash back” rewards program) also could generate more for investors in the form of capital appreciation than it does in dividend income. With its stock already up more than 50% so far this year, it has a yield of 1.1% and also keeps more than 90% of its earnings on its books. Of course, not all of the 114 names on our list of candidates are equally attractive. It includes plenty of beaten-down energy stocks, for instance; you may well want to hold off and wait to see some positive earnings revisions before you go bargain hunting among that group.

There are a lot of “growth” names on this list; companies that appear likely to be winners should the Federal Reserve opt for a third round of quantitative easing in the months to come, an event that likely would push all stocks higher. Seeking out such low yield, low payout stocks may be one strategy that may help address the risk of “taxmageddon” without running the risk of lagging the broad market: over time, this strategy has beaten the S&P 500. Moreover, as the end of the year approaches, it seems logical that tax-sensitive U.S. investors will be gravitating to just this kind of strategy.

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  • JRJ90620

    I don’t know why writers of financial articles think everyone lives in states without income taxes.Here in So California,after the next election,long term cap gains taxes will be over 13%.Nearly the same as the Federal rate.The only option,other than moving is to have a Buffett approach to investing.Buy great companies with little yield and hang on for decades.