Special Dividends Can Be Especially Destructive
Maxxwell A.R. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Bush Tax Cuts, which began in 2003, are due to expire at the end of 2012. It’s not really as apocalyptic as the mainstream media makes it sound; several taxes are simply returning to pre-2003 levels (Reminder: investors with sound strategies still made money before 2003). That hasn’t given pause to the 173 companies that are offering special dividends to shareholders (up 137% from 4Q11). You have to wonder: are these one-time payouts knee-jerk reactions that will hurt shareholders in the long-term?
This clip from Majestic Eagle Agency, an insurance and wealth management agency, summarizes the coming changes to dividend taxes:
“Dividends will be taxed as ordinary income. The expiration of the Bush tax cuts brings an end to the preferential treatment for dividends. Instead of the rate of 15% that has applied since 2003 for investors in the higher tax brackets (the rate was 0% for taxpayers in the 10% and 15% brackets), dividends will be taxed as ordinary income.”
Fellow Foolish blogger Daniel Sparks points out that not all special dividends are created equally. His analysis can serve as a great blueprint for evaluating the integrity of a long-term investment spurred by the changing tax codes. But in reality, the only investors who gain across the board from special dividends are those who were invested well before any announcements.
No special dividend should ever be described as sustainable. Most special dividends erase capital from balance sheets just to return it to shareholders, who initially invest to realize a permanent appreciation of capital. Hmmmm…
Is the long-term financial flexibility of a company compromised by a special dividend? Judge for yourself. Here’s a table of selected special dividends and their equivalent payout period with the normal dividend:
Source: Google Finance
COSTCO is financing a special dividend with a debt offering with reasonable terms. CFO Richard Galanti recently pointed out the company’s focus on growth in defending the offering (rather than using cash) by stating: “with our expansion we like to feel comfortable doing what we want to.”
So why not use the $3.5 billion debt offering to chase your highest priority growth opportunities, expedite your transition into new markets, and give shareholders confidence in your long-term ability to return value? The company could still use the upcoming tax changes as a backdrop, but instead of making a mad dash to return capital in the short-term they would be showcasing themselves as a reliable income investment during changing times.
What’s worse than knee-jerk reactions? Special dividends that have one goal in mind: returning capital to heavily invested insiders who have the most to lose from tax changes. The following table shows how insiders stand to profit from their respective company’s payout:
Source: David Peltier of TheStreet
It must be pretty easy to overlook the damaging effects of a large, liquidating payout when you have so much to gain. Individual investors beware.
There are always other options. Forgoing a special dividend, companies like Wal-Mart (NYSE: WMT) have chosen to instead move their payout date from early January to late December. No special dividend required, even with the company’s $8.6 billion cash on hand or the Walton family’s net worth of over $95.4 billion (4x that of Sheldon Adelson). And although my growth initiative mentioned above seems like a good idea to me, as of this writing no companies have chosen to make a special push for growth in light of the changing tax code.
Foolish bottom line
The Special Dividend Rush of 2012 is certainly unique, but ultimately it will just be a blip on the radar. Shares will go up before the ex-dividend date and adjust accordingly afterwards. Balance sheets aren’t as elastic. The worst thing investors could do is invest on emotion, which was caused by knee-jerk reactions of companies in the first place. If a company doesn’t fit into your long-term plans for you portfolio, then it probably doesn’t make much sense to chase an eye-popping, one-time payout.
The fact is that no one knows how dividends will be taxed on Dec. 31, 2013. Even if the Bush Tax Cuts expire as expected at year’s end with no immediate action from lawmakers, any future agreement (such as a simple tax hike from 15% to 20%) could be enacted retroactively. The basic premise doesn’t change: companies that sport dividends are paying you to own shares. Don’t complain about making easy profits.
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BlacknGold has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale and Dillard's. Motley Fool newsletter services recommend Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!