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By Josh Peters, CFA | 09-09-2014 04:00 PM

Peters: Don’t Be Scared by Scotland

The U.K. will remain a good hunting ground for dividend-paying stocks even if Scotland decides to become independent, says Morningstar’s Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. The market's gaze turned on the U.K. this week after a new poll showed a majority of Scots favoring independence. I'm here today with Josh Peters--he's editor of Morningstar DividendInvestor and also our director of equity income strategy--to see why this could potentially be important for dividend investors.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: First off, why should income investors be paying attention to what's going on in the U.K. right now? Is it of a particular relevance to them?

Peters: Yeah. That's because of the structure of the U.K. market relative to what you find for U.S. investors. First, in the U.K., you tend to have higher dividend yields because dividend policies are more generous. You also have what they like to call progressive dividend policies, where there is an expectation that the dividend you get at a particular time of the year will be bigger or at least equal to what you got last year. Companies there tend to be very reluctant to cut their dividend. And that's similar to U.S. companies where the dividends themselves are more generous to begin with. But most valuably, from the standpoint of a U.S. investor, is that there are no foreign withholding taxes on the dividends paid by British companies to U.S. investors.

If you compare that even to an investment in a Canadian company, where you stand to have 15% of the value of your dividend withheld by the Canadian government (or withheld by your broker and remitted to the Canadian government), you can recover that if it's a taxable investment when you file your annual income taxes--there is a foreign tax credit you can use. But that's kind of cumbersome, and you lose the value of the tax until you get to claim the credit. And if it's in a tax-deferred account like an IRA, then those withholding taxes--whether they are Canadian or Swiss or German or whatever it happens to be--they're just a deadweight loss.

So, throw in the fact that the U.K. is home to a lot of giant, well-heeled, and globally dominant companies--it's a pretty good place for income investors in the United States to look for foreign-based companies.

Glaser: Looking right now, if Scotland were to leave he U.K., what impact would that have on some of these big companies? Is it a potential risk that investors need to be worried about?

Peters: I think you do need to pay at least some attention. This isn't something you want to just completely dismiss and ignore. The most immediate impact that you are seeing right now is that the British pound is dropping relative to the dollar, and that's a reversal of a trend that's been in place here for a while. The pound got up to about $1.70 and recently has taken quite a tumble, headed back toward $1.60 range here. And for anything that's denominated in pounds, it's getting cheaper relative to the dollar. So, this is good news if you are tourist--if you're planning a trip to England, now those pounds that you need to spend over there are getting less expensive. But if you've already invested in British companies where, effectively, the global price of the stock is being set on the London Stock market, even if the stock hasn't dropped in London denominated in pounds, then you're looking at a short-term loss of value here in dollar terms.

That trend could continue. It's very hard to forecast where currencies are going to go and actually Britain had the advantage of performing a lot better than continental Europe, its economy has performed better. But now you are throwing some uncertainty into the mix. And if the 'Yes' vote triumphs, then you're going to have this process of negotiating the terms of exit for Scotland from the United Kingdom, and that's going to hang over things for a while. So, you may see a period where the pound is no longer going up but maybe going sideways or going down. And that's going to have some impact on at least the market value of your investments in the U.K.

But if you look out farther and you look at the kinds of companies you are likely to buy in the U.K. that are based there--something like a Royal Dutch Shell (RDS.A) or a GlaxoSmithKline (GSK). These are giant companies doing business all over the world.

For Glaxo, actually in particular, just to make this point, they report their financials and pay their dividends in pounds, but most of their earnings are in other currencies--in dollars and euros and yen and any currency probably anywhere in the world. So, if the pound is falling, that means that their earnings denominated in pounds actually will rise. I know that sounds kind of counterintuitive, but it just shows you how, in the logic of these big multinational companies, even big things like currencies can kind of wash out as major impacts to the fundamental bottom lines of these big companies.

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