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Are Dividend-Paying Stocks a Good Investment for 2013?

“It was the best of times, it was the worst of times . . . While most of you recognize this famous line as the opening to Charles Dickens’ A Tale of Two Cities, you could use the line to describe dividend investing in 2012. On the one...

“It was the best of times, it was the worst of times . . . While most of you recognize this famous line as the opening to Charles Dickens’ A Tale of Two Cities, you could use the line to describe dividend investing in 2012. On the one hand, it truly was the best of times in terms of dividend increases. According to Standard & Poor’s, 2012 saw 2,883 positive dividend actions, up nearly 48% from 2011 and more than double the 1,191 positive actions recorded in 2009.

“Roughly 44% of 2012’s positive dividend actions occurred in the fourth quarter. Overall, actual cash payments of dividends increased 18% for the year. And yet, while it may not have been exactly the worst of times for dividend investors, there were certainly several negatives in 2012:

• Dividend stocks as a group underperformed the market in 2012. Especially soft areas within the dividend space were utilities, with the Dow Jones Utility Average postingatotalreturn(price appreciation and dividends) of just 1.6% versus a 10% return for the Dow Jones Industrial Average and a 16% total return for the S&P 500 Index.

• While the number of positive actions increased sharply, so did the number of negative actions. For 2012, negative dividend actions totaled 275, more than the negative actions for 2010 and 2011 combined.

• The expectation of higher taxes on dividends in 2013 was a dark cloud over the group, especially in the fourth quarter, and likely spurred selling in dividend stocks as the year progressed.

“So what is the state of dividend investing in 2013? Actually, I think a number of trends favor the group:

“Low interest rates remain a positive for dividend stocks. As it becomes more difficult to generate meaningful returns from fixed-income investments, you are likely to see a transition from bonds to stocks in 2013. In fact, I believe this transition is already taking place and will accelerate if the stock market can maintain its upward pace that we have seen so far this year. While I’m not sure I’m ready to go as far as calling dividend stocks ‘the new bonds,’ as some pundits have labeled them, I do expect to see dividend stocks getting increased interest from bond investors who may be searching for better vehicles for growing their cash flow.

“Clarity on the tax situation is a plus. Yes, taxes on dividends are going up for some income groups. In 2012, the maximum tax rate on qualified dividends for all income groups was 15%. That rate was scheduled to jump in 2013 to an individual’s ordinary tax rate (which could have meant a tax increase of more than 180% for individuals in the top tax bracket). However, the fiscal- cliff compromise maintained the maximum 15% rate on qualified dividends for all but those individuals earning more than $400,000 per year ($450,000 for a couple). The tax rate on dividends for these high earners jumps to 20%.

“It is worth mentioning that a new 3.8% surtax on investment income (including capital gains and dividends) to help pay for health care will hit some investors—individuals with more than $200,000 in modified adjusted gross income and married couples filing jointly with more than $250,000 of MAGI— beginning this year, so that surtax adds to the tax rate on dividends for some income groups.

“Admittedly, I’m not a fan of seeing anyone’s tax rates on dividends increasing. Nevertheless, given where dividend rates were headed without the fiscal-cliff compromise, the situation could have been much worse.

“With much of the tax uncertainty on dividends removed, and many investors left unaffected by the tax changes, I expect there to be renewed interest in dividend stocks.

“There’s plenty of room for more dividend increases. By historical standards, the percentage of corporate profits that are being paid out to shareholders in the form of dividends is still on the low side. Corporate America is paying out just slightly more than one-third of profits in dividends, down from the historical average of 52%. Thus, companies have plenty of flexibility to boost dividends if they so choose.

“Whether dividend-paying stocks can outperform the broad market, like they did in 2011 but failed to do in 2012, will depend largely on the risk-aversion of investors. Said differently, if investors become more comfortable with market risk, a greater focus will fall on more aggressive stocks. In such environments, dividend stocks will tend to lag. If, on the other hand, market volatility returns, dividend stocks should find ample attraction.”

Charles B. Carlson, CFA, DRIP Investor, February 2013

Charles B. Carlson is the editor of the DRIP Investor newsletter. A Chartered Financial Analyst (CFA) and a MBA holder (University of Chicago), he is Dow Theory Forecasts’ chief market strategist and writes a weekly financial column for Editor’s Copy syndicate. Mr. Carlson is a member of the Association for Investment Management & Research. He is the author of best-selling Eight Steps to Seven Figures, Buying Stocks Without A Broker, No-Load Stocks, The 60-Second Investor, and his newest book, The Smart Investor’s Survival Guide. Mr. Carlson is frequently quoted as the primary information source for dividend reinvestment plans in Money Magazine, Barron’s, Business Week, The New York Times, Kiplinger’s Personal Finance and Boardroom Reports. He is also a frequent guest expert on numerous radio and television programs around the country, including appearances on CNBC, CNN, and NBC’s Today Show.