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Comments on Potential Tax Changes | Sean Barron

After reading Andy Friedman’s warning that Dividend Stocks are Headed for TroubleSean Barron, Portfolio Manager at Delta Trust & Bank, explains how he sees potential tax changes affecting the stock market.

Thoughts on potential tax changes:
In trusts, foundations, etc. we now look at total return and can “adjust” between income and principal to meet the current and future needs of beneficiaries, trustees, and individual clients. The question should be, “How do we mix accounts and assets in the most tax efficient way to meet the client’s needs, irrespective of income or principal?”

The real opportunity is going to be in pushing income forward into 2012 before any tax increases and taking long-term capital gains in 2012.

On the valuation of stocks (as another frequently stated warning is that stock values will decline):
This is not a “surprise” event and if there is a change in the after-tax value of a stock resulting from a higher dividend tax rate, some of this increase should already be priced in.

Effects on valuation – example: Altria(MO) – Dividend = $1.64, Required Return = 7.5%, Growth Rate (of dividends) = 2.5% Using a simple constant-growth dividend discount model:

Non-taxable investor
$1.64/(.075-.025) = $32.80

Taxable investor at 15% – would be after tax dividend of $1.394
$1.394/(.075-.025) = $27.88

Taxable investor at 39.6% – would be after tax dividend of $0.99
$0.99/(.075-.025) = $19.81

Obviously, to the non-taxable investor, the value of Altria would not change. This would include all non-profits, retirement plans, etc. I do not know the ratio of assets held in non-taxable vs taxable accounts, but I would bet the non-taxable side is at least as large as the taxable side. Now, if I was a NON-taxable investor, MO would be much more attractive to me at $19.81 vs $27.88. Therefore, I would expect some of the slack would be made up for from savvy non-taxable investors. Additionally, this simplified analysis makes at least two large assumptions that would not hold true.

One, future dividend increases would not be at the same projected rate (2.5% growth rate of dividends in previous valuation), as more money would be returned through stock purchases. If MO were to freeze the current dividend, the portion of the stock value attributed to the CURRENT dividend level is (0% growth rate):

Taxable investor at 15% would be after tax dividend of $1.394
$1.394/.075 = $18.59

Taxable investor at 39.6% would be after tax dividend of $0.99
$0.99/.075 = $13.20

Or a difference in value of only $5.39, not the $8.07 drop previously estimated (as $2.68 of the value difference is based on future dividend growth).

Secondly, both valuations make the assumption of a constant tax rate forever into the future. I doubt that anyone would make that assumption and practitioners would discount future dividend expectation assumptions given this uncertainty through adjustments to any valuation models. So, the present value of the tax cut on the CURRENT dividend over a set time horizon (of certainty in future tax rates. Using 7 years for lack of any better guess) of 7 years, would lead to a valuation difference of only $2.14 (discounted PV of $1.394 and $0.99 at 7.5%).

All this leads to a valuation drop of 7.7% ($2.14/$27.88) for a taxable account. As I stated, with nothing having changed for the non-taxable investor, I am sure they would appreciate the ability to purchase at a discount and would pick up a lot of this slack. So 7.7% drop in valuation as a worst case scenario for a stock with a current dividend yield of 5.15%. Since most stocks are more reliant on future growth AND the stock market has known about this tax horizon for 10 years, I would expect the effect on the S&P 500 as a whole to be much less. My guess would be 1.5-2.5% at most. Would we even notice that over and above daily fluctuations?

For the sake of clarity, there would be some indirect costs:

Companies making stock repurchases at the wrong time (they have a great track record of this) Dividends being paid out as stock would increase the value of stock options held by employees and possible dilution

Sean Barron
Portfolio Manager
Delta Trust & Bank

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