Morningstar Dividend Investor
One of my favorite resources to research dividend stocks is the Morningstar Dividend Investor (MDI) newsletter published by Josh Peters, who is a Chartered Financial Analyst and is the director of equity‑income strategy at Morningstar, and David Harrel, the managing editor of Morningstar Dividend Investor. MDI is a monthly newsletter that’s available for $189.00 per year. While this resource is a bit costlier than some stock research tools, it’s well worth the value.
The main feature of the newsletter is the Morningstar Dividend Select Portfolio, which is a model portfolio of approximately 25 dividend‑growth stocks managed by Peters. Peters has been managing this portfolio since 2005 and it has yielded total returns of 176.5% through March 2016, compared to the S&P 500 which has offered a total return of 119.5% during the same period. The goal of Morningstar’s Dividend Select Portfolio is to earn annual returns of 9%–11% over any three‑to‑five‑year rolling time period. The portfolio also seeks to minimize risk, which they define as the probability of a permanent loss of capital. The Dividend Select Portfolio targets companies that have a 3%–5% current dividend yield and annual dividend‑growth rates of 5%–7%; however the portfolio does contain a couple of stocks that have dipped below a 3% yield and holds a few stocks that have yields above 5%. The MDI Dividend Select Portfolio is targeted toward investors that keep their funds in a taxable account, but Morningstar has recently started publishing a second model portfolio that excludes master limited partnerships (MLPs), which is suitable for IRAs, self‑directed 401Ks, and other types of retirement accounts.
The monthly MDI newsletter contains a number of other helpful sections for dividend investors. The newsletter contains a cover story which discusses recent news in the world of dividend investing. It also includes a monthly update that discusses the recent performance of the Dividend Select Portfolio as well as brief updates for each stock included in the portfolio. The newsletter also provides a deep‑dive research report on two or more of the companies included in the newsletter each month. Finally, MDI includes a section titled “income bellwethers” which discusses other dividend stocks that are not in the Dividend Select Portfolio and a section titled “payouts in peril” which discusses companies whose dividends may get cut in the near future.
More information about Morningstar Dividend Investor can be found at http://mdi.morningstar.com.
SureDividend.com
SureDividend.com is a website that provides educational information about dividend investing and analysis of individual dividend stocks. Publisher Ben Reynolds does a great job of going behind the numbers and really analyzing the business model and future growth prospects for any given stock. He also writes great educational content that teaches readers how think about dividend investing and how to analyze dividend stocks.
Reynolds teaches a set of guidelines that dividend investors should follow, known as the “8 Rules of Dividend Investing.” There’s a lot of merit to these rules and they are worth repeating in this book. Here are Reynolds’ eight rules:
The Quality Rule: Only invest in high‑quality businesses that have a proven track record of long‑term stability, growth, and profitability. Only buy stocks that have 25 or more years of dividend payments without a reduction. Reynolds notes that the Dividend Aristocrats have outperformed the S&P 500 by 2.88% per year over the last decade.
The Bargain Rule: Invest in stocks that pay you the highest dividend yield so that you can create a larger dividend income stream. Focus on companies that have higher‑yields compared to other dividend stocks. Reynolds notes that the highest-‑yielding quintile of stocks has outperformed the lowest‑yielding quintile of stocks by 1.76% per year between 1928 and 2013.
The Safety Rule: Invest in businesses that take in more in cash flow than they send out in dividend payments so that the dividend won’t be cut during a downturn. Focus on stocks that have relatively low payout ratios compared to other dividend stocks. Reynolds notes that high‑yield, low‑payout‑ratio stocks have outperformed high‑yield, high‑payout‑ratio stocks by 8.2% between 1990 and 2006.
The Growth Rule: Invest in companies that have a history of solid earnings growth over a long period of time. Focus on stocks that have solid long-term dividend growth and earnings growth. Reynolds notes that stocks with growing dividends have outperformed stocks with flat dividends by 2.4% per year between 1972 and 2013.
The Peace of Mind Rule: Invest in companies that do well during recessions and other times of market panic. These types of businesses tend to have relatively stable stock prices and make them easier to hold over the long‑term. Focus on stocks that have lower long‑term volatility and beta compared to the rest of the market. Reynolds notes that the S&P Low Volatility Index outperformed the S&P500 by 2.00% per year for the 20‑year period ending September 30th, 2011.
The Over‑Priced Rule: If you can sell a stock for more than it’s worth, you should. When a company has a normalized P/E ratio of more than 40, sell the stock and invest it into a company that has higher‑paying dividends. Reynolds notes that the lowest decile of P/E stocks outperformed the highest decile by 9.02% per year between 1975 and 2010.
The Survival of the Fittest Rule: If a company reduces or eliminates its dividend, you should sell it immediately. Reynolds notes that companies that reduced or eliminated their dividends had a 0% return from 1972 through 2013.
The Hedge Your Bets Rule: No one is right 100% of the time. Spread your investments over multiple stocks to reduce the impact of being wrong about any one stock. Reynolds notes that you can get 90% of the benefits of diversification that you would get by owning a mutual fund by buying between 12 and 18 stocks.
Reynolds’ “8 Rules of Dividend Investing” are worth heeding. While I don’t follow them exactly, they provide a great set of starting guidelines for any new dividend investor. Reynolds and I differ in that I am willing to buy stocks with a shorter track record (5–10 years of dividend growth vs. his requirement of 25‑year dividend growth) in exchange for higher yields. Most of the stocks he recommends have a 2.5%–4% dividend yield, whereas I tend to focus on companies that have yields above that.
Reynolds also publishes a monthly newsletter, simply referred to as the Sure Dividend Newsletter, that costs $79.00 per year. His monthly newsletter contains a cover story that discusses the overall state of the market as well as a list of 10 top‑ranked dividend stocks that he would invest new money into today. Reynolds uses a proprietary formula to calculate which companies make his rankings. The companies he recommends tend to have very low payout ratios, solid long‑term track records of dividend growth, and relatively low volatility (beta). The only downside to focusing heavily on these metrics is that he primarily recommends very established stocks that do not offer extremely compelling yields. In his most recent newsletter, the highest‑yield stock that is recommended yields just 4.3%. While Reynolds and I focus on stocks with different levels of yield and risk, I do personally subscribe to and read his newsletter each month.
You can learn more about SureDividend at www.suredividend.com.
Dividend.com
Dividend.com is another great resource for researching dividend stocks. While the website does publish news and offers a paid monthly newsletter, the best features of the website are its screening and research tools. Dividend.com has a suite of more than 20 screeners and other research tools that allow you to identify great dividend stocks and build income‑generating portfolios. Dividend.com uses a proprietary ranking called DARS, which stands for the Dividend Advantage Rating System, to determine which dividend stocks are the most attractive. Dividend.com includes their DARS rating as a column in each of their screeners.
Some of the screeners and stock recommendations can be accessed for free using the Dividend.com website, but some features are hidden behind a paywall. Their premium section includes a watch list that allows you to keep track of your dividend stocks; a monthly newsletter, access to DARS rankings, and
other premium content. Dividend.com offers two subscription options, which are priced at $99 per year and $149 per year, respectively. Dividend.com does also offer a 14‑day free trial for new investors.
You can learn more about Dividend.com at www.dividend.com.
Seeking Alpha
Seeking Alpha is the one website that doesn’t focus exclusively on dividends that I frequent pretty regularly. If you’re reading this book, you probably already visit Seeking Alpha on a semi‑regular basis. If for some reason you’re not familiar with Seeking Alpha, I’ll explain here: it’s a publishing platform that allows anyone to become a stock analyst and write about the stocks that they’re interested in. While the quality can vary somewhat from article to article, some of the best individual stock analysis I have found is through Seeking Alpha. Because there are dozens of different people writing about any given stock, you can easily read multiple perspectives about a stock in one place.
Whenever I’m researching a new company to invest in, I look up that company on Seeking Alpha and read the 10 most recent articles published about that company. By taking the time to read the most recent analytical pieces on a company, you can usually get a good idea of the company’s future growth prospects, the stability of its dividend, and any future clouds that may be on the horizon.
You can visit Seeking Alpha at www.seekingalpha.com.
Wrap‑Up
I have mentioned many different resources in this chapter and I personally use all of the tools and lists discussed to identify potential dividend‑stock purchases. Remember that these research tools, websites, and resources are a good starting point to identify quality dividend stocks, but they are not a replacement for doing your own analysis. Whenever you trade a dividend stock, you should understand the company’s business model, whether or not it has a sustainable and growing dividend, what the company’s future growth prospects look like, whether or not the stock is currently overvalued, and whether or not you think that you’re buying a fundamentally good company.
CHAPTER FIVE
Taxation of Dividend Stocks
Let’s imagine that you are considering four different investments that all pay a 4.5% dividend yield: a municipal‑bond fund, a blue‑chip dividend stock, a master limited partnership (MLP), and a real‑estate‑investment trust (REIT). The municipal bond fund is not taxable and the after‑tax yield will be 4.5%. Dividends from a blue‑chip stock are taxed at capital‑gains rates and the after tax yield will be 3.825% if your capital gains are taxed at 15%. The MLP will also generate an after‑tax yield of 3.825% but no tax will be due until you sell your interest in the MLP. The REIT is taxed at your ordinary tax rate. If you were in the 28% tax bracket, you would earn an after‑tax yield of 3.24% on the REIT.
These percentage differences may not seem like much, but the difference between a 3.24% after‑tax yield and a 4.5% after‑tax yield is the difference between living on $45,000 per year in retirement and $32,400 in retirement if you had a $1 million investment portfolio. The tax treatment of different types of investments that you buy may be confusing at first, but learning how specific types of investments are taxed is extremely important because of the uneven tax burden that is placed on different types of investment income.
A Brief History of Taxes on Dividend Payments in the United States
Prior to 2003, qualified dividends were taxed at the same rates as ordinary income. It didn’t matter whether you received investment income from a corporate bond, a savings account, or a dividend stock, you would pay have to pay your ordinary tax rate on your income. The lone exception to this rule was municipal bonds, which are tax free under almost all circumstances.
Then President Bush proposed eliminating the U.S. dividend tax, saying that “double taxation is bad for our economy and falls especially hard on retired people.” He also argued that “it’s fair to tax a company’s profits, [but] it’s not fair to double tax by taxing the shareholder on the same profits.” Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003 soon after. While Congress didn’t totally eliminate the dividend tax, they did make the dividend tax rate the same as the capital‑gains tax rate, which was 15% for most individual taxpayers at the time. Dividend income for filers in the 10% bracket or the 15% bracket would have their dividends taxed at 5% through 2007.
The lower dividend tax rates were set to expire at the end of 2008, but the Tax Increase Prevention and Reconciliation Act of 2005 extended the lower tax rate through 2010 and cut the tax rate on qualified dividends to 0% for filers in the 10% and 15% income tax brackets. In 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 which extended the lower dividend tax rates through 2012.
Many of the Bush‑era tax cuts were set to expire at the end of 2012, which would have raised tax rates from 10%, 15%, 25%, 28%, 33% and 35% back to Clinton‑era rates of 15%, 28%, 31%, 36%, and 39.6% percent. Had all of the Bush‑era tax cuts been allowed to expire, qualified dividends would no longer be taxed at favorable capital‑gains rates, but would have been taxed as ordinary income. Fortunately, Congress realized that it wasn’t in the best interest of the economy to raise everyone’s taxes across the board. Through a compromise in Congress, most households were able to maintain their lower tax rates. The lone exception was individuals that made more than $400,000 per year or families that made more than $450,000 per year, whose top tax rate rose from 35% to 39.6%. Individuals and families in the top tax rate would pay a new capital gains and dividend rate of 20%, up from 15% previously.
Under today’s tax code, filers in the 10% and 15% brackets pay no tax on their qualified dividend income. Most individuals pay 15% tax on dividend income and filers in the top tax bracket pay a 20% tax rate on qualified dividend income rates. In addition to the normal dividend tax, the Affordable Care Act of 2012 instituted a new 3.8% net investment income tax that applies to dividends, capital gains, and other kinds of passive investment income which is charged to single filers that make more than $200,000 per year and joint filers that make more than $250,000 per year. This means you could pay a dividend tax rate as low as zero if you don’t have much of an income or a dividend tax rate as high as 23.8% if you are in the top tax bracket.
Please note that Congress tends to change tax laws pretty regularly. New tax legislation may have changed dividend tax rates since this book was published. If you are reading this book more than a year after it was published, you should confirm independently that dividend tax rates have not changed.
What are Qualified Dividends?
In order for a dividend payment to be considered a qualified dividend and be taxed at preferential capital‑gains rates, it must meet a few basic criteria. The dividend payment must have been paid by an American or a foreign qualifying company. A foreign corporation is considered qualified if it is incorporated in the United States, it is eligible for the benefits of a comprehensive income tax treaty with the United States, or if the stock is readily tradable on an established securities market in the United States.
The recipient of the dividend payment must also have held the underlying stock for a specific period of time in order for a dividend to be considered qualified. The required holding period for common stock is 60 days during the 121‑day period that starts 60 days before the ex‑dividend date. The required holding period for preferred stock is more than 90 days during a 181‑day period that starts 90 days before the ex‑dividend date. These rules are effectively designed to disincentivize short‑term trading by using lower tax rates to reward dividend investors that hold shares for a longer period of time.
Finally, there are some types of dividend payments that are explicitly excluded from receiving qualified dividend rates. Dividends paid by real estate investment trusts (REITs), master limited partnerships (MLPs), employee stock options, tax‑exempt companies, and money‑market accounts do not receive qualified dividend treatment and are taxed as ordinary income. Special one‑time dividend
s also do not receive qualified dividend treatment. You should not avoid REITs, MLPs, and other investments that do not receive qualified tax treatment, but you should consider what tax rate you will be paying when making an investment.
These rules may sound complicated, but most dividends that you receive by investing in companies like Coca‑Cola, General Electric, AT&T, Apple, and Wal‑Mart will be qualified dividends as long as you’re not regularly trading in and out of positions.
Taxation of Dividends on International Stocks
As an investor that is targeting both income and diversification, you may look to international dividend stocks to add to your portfolio. There are many companies outside of the United States that offer consistent dividend payments and dividend growth. However, you can’t always compare a 5% yield in another country to a 5% yield in the United States. Many foreign countries see dividend payments to international investors as an easy source of tax revenue and charge foreign investors dividend tax rates between 5% and 30% on dividend payments. Foreign governments collect tax payments on dividends before they are delivered to your brokerage account, because they know compliance rates would be almost zero if investors had to mail in tax payments. Some countries, such as the United Kingdom, India, and Argentina do not tax dividends paid to U.S. investors due to various tax treaties that the United States has with those countries.
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