Don’t Buy a Dividend Stock Until You Read this

I doubt you’ve ever heard of Howard Silverblatt.

Mr. Silverblatt is a senior analyst at Standard and Poor’s. He covers a lot of topics when it comes to his work at S&P, but what’s made him a hot commodity for reporters (and why I like to keep tabs on him) is his knowledge of dividends of S&P 500 components.

His position offers access to the raw data behind payments, and he compiles this information so we can know how many dividend cuts or increases S&P companies have announced and how much total cash that means for investors. In addition, he regularly gives forecasts on where dividend payments are headed. Given his background and unrivaled access, I always think his view is worth a listen.

Fortunately, the current news for income investors is good — 402 members of the S&P 500 are now making payouts to shareholders, with payments expected to hit a record $275 billion this year. 

But serious risk lies ahead.

As Silverblatt was recently quoted in a blog post on MarketWatch:

“Under current legislation, taxes on dividends to individuals will almost triple in 2013, rising to 43.4% from 15%. From a planning perspective, this will force corporations to reexamine their return to shareholders policy, potentially pulling back on dividend increases and increasing share buybacks. From an individual investor’s prospective, the risk-return ratio shifts significantly since you would now be keeping less than 57 cents on the dollar compared to the current 85 cents.”

Nearly 140 S&P companies have increased or initiated payments so far in 2010 — with only two decreases (last year there were a total of 78).

So what’s the bright side?

Well, you may not realize it, but corporate America is currently sitting on its biggest pile of cash in history. Companies in the S&P held $1.2 Trillion in cash reserves in Q4 2001, according to a recent estimate by Moody’s — a 9.1% increase over the year-ago figure. (For reference, that amount of cash is higher than the GDP of South Korea.)

There’s no doubt these companies will hang on to a lot of that money, but eventually some of it will find its way to investors in the form of share buybacks and more dividend increases.

Dividend Increases Are Only One Side of the Story
As income investors, however, we all know our total returns don’t just rely on increasing dividends. We also take into account the appreciation of our capital. Dividends can rise sharply, but it means nothing if the value of our holdings falls.

With the market up sharply past few months, many are uncertain how long the rally can last, given the many potential threats that lie ahead. So ensuring the safety of investments looks more important than ever. That’s why, despite Silverblatt’s uncertain outlook for dividend taxess, I think the time may have come to rotate away from speculative plays to more “boring” high-yield investments.

Risks to Consider: Concerns about a weak global recovery amid austerity programs in Europe, a tightening economy in China and continued high unemployment in the United States continue to weigh on the market. If it becomes clear after the November presidential election that the “fiscal cliff” problem isn’t solved — or that a dividend taxe hike is part of the “solution,” then all of these factors could send the market markedly lower, including safer income investments.

Action to Take –> With the economy still not robust, I think now’s a good time to be playing “defense.” I’d suggest the same to you. (Just to be clear, I’m not saying that we’re sure to see a prolonged downturn. Instead, I simply think it’s a good time to start looking toward more defensive stocks.)

I tell my High-Yield Investing readers to start by looking for stocks that have a long history of steady or rising dividend payments, as they tend to hold up better in down markets (as a bonus, look for companies with a large cash stockpile). “Non-cyclical” income stocks — those backed by companies that don’t rely on the momentum of the broader economy — may be a good place to look.