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Originally published Saturday, April 19, 2014 at 8:00 PM

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The Motley Fool: Every Sunday, useful tips on investing


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Q: Is it true that dividends are taxed twice?

A: Yup, it is. Here’s why: Imagine that a company rakes in $100 million in sales, and after subtracting expenses, keeps $20 million as its operating profit. It will then be taxed on that.

The U.S. corporate tax rate is 35 percent, though many companies shield much of their income, with some of them paying an effective rate in the single digits — or lower!

The company can do many things with its post-tax earnings. It can buy back and retire some of its own shares (increasing the value of remaining shares), build more factories, hire more workers and so on.

If it pays dividends to shareholders, though, the shareholders will be taxed on that as income. Presto — that money has now been taxed twice.

This is why some investors prefer to see a company using its money to build more value for shareholders without paying out dividends.

It’s also why some companies opt to repurchase shares, rewarding shareholders in a tax-free way. Repurchasing shares is wasteful, though, when a stock is overpriced.

If you own some mutual funds, they may be less diversified than you think, not likely to outperform their benchmark indexes and overcharging you — thanks to closet indexing.

The benchmark for many mutual funds is the S&P 500 index, featuring 500 of America’s biggest companies.

You can invest in low-cost index funds that hold its components and roughly match its performance (this is called passive investing), or in funds actively managed by financial pros who decide which securities to buy and sell, and when to do so.

In exchange for their expertise, and to cover the costs of their trading, you generally pay steeper fees as you hope for bigger gains.

Here’s the problem, though: Many managed mutual funds are engaging in closet indexing, with their holdings greatly overlapping with those of their benchmark indexes.

Clearly, it’s problematic if you’re paying 1 to 2 percent per year for a managed fund when you could be paying a tenth of that for an index fund.

Making matters worse is that the closer to the index’s composition a fund gets, the less likely it is to outperform the index.

Identifying closet indexers is not a piece of cake, but you can get a rough idea by looking at a fund’s “R-squared” number, which reflects the percentage of its performance that can be explained by its benchmark’s returns.

An R-squared score of 98 percent would suggest significant overlap with the benchmark, while a lower number would reflect more independence.

You can look up a fund’s R-squared score at Morningstar.com. Once you plug in its ticker symbol and go to the fund’s page, click into the “Ratings & Risk” section.

Mutual funds can be great investments, but if you want to own an index fund, invest in an index fund, not an expensive mimicker.

Nike (NYSE: NKE) stock has averaged annual gains of 18 percent over the past 20 years, and despite its market value topping $65 billion, the company isn’t done growing.

Nike’s last quarter featured revenue up 13 percent over year-ago levels and earnings per share up 4 percent, both exceeding analyst expectations.

Big markets were particularly strong, with revenue increases of 12 percent in North America, 22 percent in Western Europe and 17 percent in Central and Eastern Europe.

Growth in China hasn’t been as strong as hoped for, though, and the company has been facing currency headwinds in many markets recently. Another concern is growing competition from Under Armour.

On the plus side, orders surged by 12 percent to $10.9 billion, and Nike has been boosting its international marketing efforts, particularly in India and China.

Nike should also benefit from a five-year, $1.1 billion deal with the NFL to supply gear, and from growth in yoga apparel and wearable technologies such as its FuelBand.

Nike is an undisputed industry leader, with an enormously valuable brand power and generating solid performance on a global basis. With its forward-looking price-to-earnings (P/E) ratio near 21, the stock isn’t quite a screaming bargain right now. Consider adding it to your watch list or perhaps buy into it gradually.



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