US Sector Periodic Table of Returns 2001 To 2011

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The Periodic Table of Investment Returns for the nine S&P sectors is shown in the chart below:

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Source: SPDR

Here are a few observations:

  • At the height of the global financial crisis in 2008, financials fell over 55% while consumer staples fell only about 15%. Utilities fell by 23% and healthcare also fell lower than financials.
  • No one sector ranked as the best performing sector any consecutive year except energy in 2004. This shows the need for diversification.
  • Except in 2001, 2002 and in 2008, the energy sector yielded strong returns underscoring the importance of oil and other related sectors in the U.S.

Related ETFs:

SPDR Consumer Discretionary Select Sector SPDR Fund (XLY)
SPDR Consumer Staples Select Sector SPDR Fund (XLP)
SPDR Energy Select Sector SPDR Fund (XLE)
SPDR Financials Select Sector SPDR Fund (XLF)
SPDR Health Care Select Sector SPDR Fund (XLV)
SPDR Industrials Select Sector SPDR Fund (XLI)
SPDR Technology Select Sector SPDR Fund (XLK)
SPDR Materials Select Sector SPDR Fund (XLB)
SPDR Utilities Select Sector SPDR Fund (XLU)

Disclosure: No Positions

Dividend Tax Rate and Long-Term Capital Gains Tax Rate: U.S vs.Other Countries

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The long-term capital gains tax rate is currently at 15%. This rate was implemented as part of the tax cuts package during the Bush administration and is set to expire on Dec 31, 2012. The long-term capital gains rate is applied on gains realized from stocks held for over one year  60 days.

Though the 15% rate seems low, it is unfavorable  when compared with that of other major countries according to a testimony by Pınar Çebi Wilber, Ph.D., Economist of the American Council for Capital Formation to the Joint Hearing House Committee on Ways and Means and Senate Committee on Finance. Changes to the long-term capital gains tax rate can potentially take three different ways as indicated by U.S. 1, U.S. 2 and U.S. 3 in the chart below:

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Source: The Impact of Raising Tax Rates on Individual Capital Gains by Pınar Çebi Wilber, Ph.D.Economist, American Council for Capital Formation

  • In the scenario 1, the Bush tax cut rate will continue at 15% but an investment surtax of 3.8% will be added for all boosting the rate to 18.8%.
  • In the second scenario, the Bush tax cuts expire and the capital gains tax rate will jump to 20%. This is the same rate that was in effect during  President Bill Clinton. With the addition of 3.8% surcharge for Obamacare, the final tax rate will be 23.8%. During his election campaign, Mr.Obama proposed to increase the long-term capital gains tax rate to 20% for high income earners. This group represents people earning $200,000 or $250,000 for married couples.
  • The third scenario is the worst case possible. Under this scenario, Mr.Obama proposed to raise the capital gains tax rate to 30% for many taxpayers using the “Buffett rule”. This rule would apply to people making more than $1 million.

Dr. Wilber testified that the 30% tax rate would make the U.S.the fifth highest after Italy, Denmark, France and Sweden. Higher capital gains tax rate would adversely affect the competitiveness of the U.S. and make the country less attractive to foreign investors.

The top dividend tax rate on qualified dividends is now at 15.0%. This rate is also much higher when it is bench-marked against the rate of other countries according to a research study by Ernst & Young. Instead of using the qualified dividend tax rate they have used a rate called the “integrated dividend tax rate”. The calculations for this new rate of tax measurement is shown in the table below:

 

The U.S. integrated dividend tax rate at 50.0% ranks the country at number four with only France, Denmark and UK having higher rates.

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Source: Corporate Dividend and Capital Gains Taxation: A comparison of the United States to other developed nations, Drs. Robert Carroll and Gerald Prante, Ernst & Young LLP, February 2012

Why its time to look at European Utility Stocks

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The STOXX® Europe 600 Utilities Index can be considered as a proxy for the European utility sector. The index is comprised of 25 utilities from the continent. As of November 25, 2012 the index is down over 58% in the past five years in US $ terms. Since 2008, the index has been on a downtrend trend as shown in the chart below. The sector may be ready for a rebound from the current lows as extreme pessimism haunts European stocks.

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Source: STOXX

How to invest in European Utilities?

Unfortunately there is no European utility sector-specific  ETF available on the US markets for investing in European utilities. ETFs tracking the STOXX utilities index and trading on the European markets include the STOXX® EUROPE 600 UTILITIES ETF by db X-Trackers, iShares STOXX Europe 600 Utilities, SPDR MSCI Europe Utilities ETF and Lyxor ETF STOXX Europe 600 Utilities fund.

Many of these utility stocks are off by double digit percentages due to regulatory issues such as plans to end nuclear power generation by Germany, high uncertainty towards the sector due to the ongoing fiscal crisis in some Eurozone countries, reduction of dividend payments by some companies and investors’ general apathy towards all European stocks. While all these factors are understandable, many of the worries are way overblown. Despite the fall in share prices the sector continues to pay juicy dividends and has the potential to raise dividends when the crisis ends. Another way to look at the current situation is that most of the negative views are already reflected in the current stock prices.

The table below lists the components of The STOXX® Europe 600 Utilities Index with the ADR tickers if available and the current dividend yields:

S.No.CompanyTickerDividend Yield as of Nov 26, 2012Country
1CENTRICACPYYY4.77%UK
2DRAX GRPDRXGYN/AUK
3E.ONEONGY7.25%Germany
4EDFECIFY7.81%France
5EDP ENERGIAS DE PORTUGALEDPFY9.38%Portugal
6ENAGASENGGY6.48%Spain
7ENDESAN/AN/ASpain
8ENELENLAY8.92%Italy
9ENEL GREEN POWERN/AN/AItaly
10FORTUMFOJCY7.27%Finland
11GAS NATURAL SDGGASNY7.12%Spain
12GDF SUEZGDFZY13.35%France
13IBERDROLAIBDRY0.72%Spain
14NATIONAL GRIDNGG5.56%UK
15PENNON GRPN/AN/AUK
16RED ELECTRICA CORPORATIONRDEIY9.83%Spain
17RWERWEOY6.30%Germany
18SCOTTISH & SOUTHERN ENERGYN/AN/AUK
19SEVERN TRENTN/AN/AUK
20SNAM RETE GASSNMRY9.84%Italy
21SUEZ ENVIRONNEMENTSZEVY7.67%France
22TERNATEZNY6.98%Italy
23UNITED UTILITIES GRPUUGRY4.63%UK
24VEOLIA ENVIRONNEMENTVE8.44%France
25VERBUNDOEZVY3.39%Austria

Note: Dividend yields noted are as of Nov 26, 2012.

Investors looking to add European utilities and willing to hold for at least five years can add some of these stocks at current or lower levels in a phased manner.

Disclosure: Long EONGY, VE, RWEOY, FOJCY

When Selecting Dividend Stocks Which is More Important – Dividend Yield or Total Return?

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When considering dividend-paying stocks, some investors tend to select stocks with high dividend yields rather than the long-term total return. However this is not a winning strategy. Instead of falling into the so-called “yield trap”, investors are better off picking stocks based on total return over the long-term, according to a research report by Invesco published earlier this year.

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Source: Investment Insights: In the Long Run with Dividend-Paying Stocks, Invesco

Among the S&P’s ten sectors, traditionally the utility sector has had the highest dividend yield. But the sector ranks the sixth in terms of total return during the period shown in the chart above. On the other hand, the consumer staples sector has lower yield than the utilities sector and is comprised of many of the oldest dividend payers and growers. But this sector ranked the highest in total returns during the same period. The financial and telecom sectors also returned lower total returns despite having high dividend yields.

In order to test this theory I reviewed the ETFs corresponding to the ten S&P sectors. The current dividend yields of the SPDR ETFs for the sectors are noted below:

S.No.S&P SectorETF NameTickerDividend Yield as of Nov 23, 2012
1Consumer DiscretionaryConsumer Discretionary Select Sector SPDR FundXLY1.45%
2Consumer StaplesConsumer Staples Select Sector SPDR FundXLP2.71%
3EnergyEnergy Select Sector SPDR FundXLE1.71%
4FinancialsFinancials Select Sector SPDR FundXLF1.69%
5Health CareHealth Care Select Sector SPDR FundXLV1.95%
6IndustrialsIndustrials Select Sector SPDR FundXLI2.20%
7Information TechnologyTechnology Select Sector SPDR FundXLK2.15%
8Telecommunication ServicesTechnology Select Sector SPDR FundXLK2.15%
9MaterialsMaterials Select Sector SPDR FundXLB2.08%
10UtilitiesUtilities Select Sector SPDR FundXLU3.60%

Note: The SPDR Technology Select Sector ETF includes represents both the S&P Information Technology and Telecommunication Services sectors.

Source: SPDR

The SPDR Utilities Select Sector ETF (XLU) has the highest dividend yield at 3.60% and the Consumer Staples ETF(XLP) has a yield of 2.71%.

In terms of returns, the 5-year return for XLP is 7.96% while the XLU grew by just 2.15%. For the 10-year period, XLU was up by 10.94% and XLP was up 8.55%.

The following chart shows the 5-year price return of the utilities and consumer staples sector ETFs:

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The utilities sector ETF severely lagged the performance of the consumer staples sector ETF. If dividends were added and total returns calculated the variance would be even higher.

The following chart shows the price return of the utilities and consumer staples sector ETFs since 1999:

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Source: Google Finance

In the long-term also, the utilities sector ETF’s return was lower than that of the consumer staples sector ETF’s return.

At the individual stock level,a $10,000 investment in Exelon Corp (EXC), a randomly electric utility, would be worth $4,602 now. However the same investment in two consumer staple stocks Procter & Gamble Co(PG) and Colgate-Palmolive Co(CL) would be worth $10,609 and $15,104 respectively. Hence investors may want to avoid picking stocks purely on high dividend yields and instead focus on long-term total returns.
Disclosure: No Positions

What Will be the Impact of Higher Dividend Taxes on Dividend-Paying Stocks?

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Currently the top U.S. tax rate on qualified dividends is 15%. This rate applies to tax-payers who are in the 25% to 35% tax brackets. This means that hypothetically an ordinary American in the 25% tax bracket having an earned income of $50,000 and getting a $1,000 in qualified dividends pays $150 in dividend taxes and a multi-millionaire in the highest tax bracket of 35%  having an earned income of $120.0 million and getting the same $1,000 in qualified dividends also pays $150 in dividend taxes.  Qualified dividends are dividends earned from stocks held for more than one year 60 days. This low dividend tax rate is set to expire on Dec 31, 2012 unless Congress extends the current tax rates.

The Wall Street Journal’s Jason Zweig discussed this issue in an article last month. From Dividends: Start Screaming:

At one second after midnight on Jan. 1, 2013, the maximum tax rate on dividends is likely to go from 15% to either 18.8% or 43.4%. The best-case scenario: Congress retains the top dividend-income tax rate of 15%, and the only increase is the scheduled 3.8% surtax on investment income for high earners. The worst case: Congress decides dividends are to be taxed at ordinary-income rates, and the highest rate jumps to 39.6%, plus the same 3.8% surtax.

The payout ratio for U.S. companies is near the all-time low of 34%. Here is another interesting quote mentioned in the article:

C.J. MacDonald, a portfolio manager at Westwood Holdings, an investment firm in Dallas, points out that companies paid out roughly 60% of their earnings as dividends in 1960—even though the tax rate on dividends topped out then at a confiscatory 91%.

So U.S. firms paid out a larger portion of their earnings even when the top dividend tax rate stood at 91% compared to the low rate now and they did not withhold profits due to the higher taxes for shareholders.

What will be the impact of a higher tax rate on dividends for dividend-paying stocks?

The investment advisory firm of Miller/Howard Investments, Inc. has published a white paper analyzing the answer to the above question. The paper states that it will not matter for investors in dividend stocks if the tax regime changes.

The research paper referenced a Federal Reserve study where the authors analyzed the effect of tax changes using US stock market vs. European markets, US stock market vs. REITs (as the tax cut did not benefit income from REITs), and high-yield dividend stocks (3% yield and greater) vs. low-yield stocks and non-dividend payers. Their conclusions were:

  • There was little if any imprint of the dividend tax cut on the value of the aggregate stock market.
  • High-yield stocks did receive a boost but the effects were short-lived.
  • REITs dropped on the day before bill was signed but recovered within days.
  • A substantial portion of US stocks were held in accounts or entities for which the lower dividend tax rate did not apply.

Similar to the top dividend tax rate at 15%, the top long-term capital gains tax rate is also 15% for investors in the 25% or higher tax-brackets. Long-term capital gains applies to gains from assets held for over one year.

How did dividend-paying perform when the capital gains tax rate and dividend tax rates were different?

The following chart from Ned Davis Research comparing the performance of dividend-payers and non-dividend payers over different tax regimes in the past offers the answer:

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via Ned Davis Research

The chart shows that there was no impact on the performance of dividend-paying stocks even with beneficial capital gains tax rate over dividend tax rate.

Source:  A dividend tax hike? What does it mean for dividend-paying stocks?, Miller/Howard Investments, Inc.

I agree that any tax changes on dividends after Dec 31, 2012 will not affect the performance of dividend stocks. Even though there may be a slight impact in the short-term, prices should recover quickly. Another factor that must be considered is that most of the stocks are held in non-taxable retirement accounts such as 401(K), IRAs etc. where earnings grow tax-free until withdrawn.Hence in summary, dividend investors need not worry too much about any tax law changes. Instead of wondering about what Congress might do, investors can take advantage of the current lower dividend stock prices and add to their portfolios now through the rest of the year.

Related ETFs:

iShares Dow Jones Select Dividend ETF (DVY)
SPDR S&P Dividend ETF (SDY)
Vanguard Dividend Appreciation ETF (VIG)
Vanguard High Dividend Yield ETF (VYM)

Disclosure: No Positions