If Taxes Rise, Grab These Dividend Stocks

To tax or not to tax?

That’s the question politicians are contemplating in Washington, DC, as yet another debt ceiling debate looms on the calendar for February 2014.

US Senate Majority Leader Harry Reid (D-Nev.) got a jump on those discussions this week with an interesting comment on Americans and taxes.

In an interview with Nevada NPR on October 24, Reid made his case for new taxes.

“The rich are getting richer and the poor are getting poorer,” Reid said. “The rich know that. The rich are willing to pay more. They’re not the ones out here saying ‘please don’t tax me.’ The only people who feel there shouldn’t be more coming into the federal government from rich people are the Republicans in Congress. Everybody else, including rich people, are willing to pay more. They want to pay more.”

If that’s the start of the Senate Leader’s negotiations, then the next debt ceiling debate will make the last one look like a tea party, so to speak.

So how can investors get ahead of that debate—a debate that if won by Reid’s argument, will result in investors being a target-rich tax environment next February?

Here’s the answer. To find true value in times of market uncertainty and volatility, just as we’re seeing now with the tax debate, find stocks that grow, that outperform, that offer lower risk, and that offer good ancillary benefits, such as lower taxes and easy opportunities to reinvest.

And, above all, don’t pay a lot for them.

Given the tepid recovery and the raging debate over what to do about those taxes and government debt, only one investment meets all the above criteria these days and that is dividend stocks.

It’s no secret that well-established companies that pay regular dividends outperform the overall market over both the short and long haul. According to Standard & Poor’s, since 1927, dividend-paying stocks have returned 11 percent per year vs. 8 percent for non-dividend paying stocks. Moreover, they have outperformed with less volatility.

The added benefits of dividend stocks are fairly straightforward. The fact that a company can pay a dividend at all is a good sign of that company’s financial stability. When companies pay dividends, it indicates they can afford to share profits. Dividends represent tangible profits because companies are paying them in cash directly to stockholders.

If a company increases its dividend each year, it’s generally a good sign that the company is optimistic about its future growth. This positive sign, in turn, can generate investor interest in a company, which could potentially increase a company’s stock price.

Dividends also help contribute to total return, a big advantage when the outlook is so uncertain on Wall Street, as it is at the end of 2013.

Companies that pay dividends generally have lower stock-price volatility than companies that don’t pay dividends, according to data from Ibbotson Associates, a Chicago research firm. The dividend creates a cushion and lessens a stock price’s volatility because it’s one of two elements of total return. The other component is share price, which can appreciate or depreciate. If a company’s share price depreciates but the company issues a dividend, the dividend helps offset some of the decline in total return.

Dividends also provide an opportunity to reinvest. For example, if you had a hypothetical investment of $10,000 in S&P 500 stocks in 1984, it would have been worth $62,465 without dividends 20 years later. However, if you had reinvested the dividends paid on those 500 stocks, the total would have jumped to $119,823, according to data from Ibbotson Associates.

With the jobless rate high, consumer confidence ebbing and the tax policy coming out of Washington muddled, the search for decent yet safe investment yields is more important than ever.

Consumer prices are nearly flat, at about 1 percent, and it’s widely expected that Social Security will forego a cost of living adjustment, or at least keep it low, for next year. And the Federal Reserve has repeatedly stressed its concern about the weak recovery and seems unlikely to raise interest rates anytime soon. So, if you want to find portfolio returns two or three percentage points above prevailing interest rates, you should consider looking for solid stock dividends.

Two dividend-robust companies to add right now are Dominion Resources (NYSE: D) and General Electric (NYSE: GE).

Dominion has a yield of 3.5 percent and is one of America’s largest public electricity providers. That not only gives you a great dividend, but it’s coming from a company that thrives in volatile economies. The stock has maintained a healthy share price in 2013, trading at the higher end of its 52-week range, at $64.

JPMorgan (NYSE: JPM) upgraded Dominion based on valuation, as well as LNG and midstream growth. So let’s call Dominion a “boring is beautiful” stock pick, exactly what we need at a time when the economy and the nation’s tax policy are a potential threat to investors.

General Electric has a lower yield at 3 percent, but that figure has been stable in recent months. In addition, GE is a diversified conglomerate. You’ll profit on everything from aircraft engines to blenders—that’s nice diversity amid a vulnerable recovery. In case that wasn’t enough, GE is also involved in financial services.

So let’s recap: higher return, fewer taxes, less risk.

With the tax situation in flux, stock dividends are the answer for the remainder of 2013, and especially for 2014.

You just have to know what to look for. Check what the analysts are saying, and compare yields and dividend growth (past and future). Also, watch for different sectors. While some may seem guaranteed to have high returns, others may surprise you. As with any investing, don’t put all your eggs in one basket. Spread out your money. Make sure your companies are strong, not just the stocks.

Once you’ve chosen well, buy your dividend stocks and leave them alone. And don’t forget about reinvesting. Buy more dividends with your profits; they’ll be sure to insulate you from any tax-related fallout in 2013-14.

Brian O’Connell is an investment analyst at Investing Daily. He has appeared as an expert financial commentator on CNN, NPR, Fox News, Bloomberg, CNBC, C-Span, CBS Radio, and many other media broadcast outlets.