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Caution pays

Investors need to be careful about falling into a dividend trap

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Tried and true -- that's what many experienced market-watchers might say about investing for the long term in stocks that pay dividends.

Certainly, plenty of proof exists to back up that approach. Year after year, some of the world's most established corporations pay shareholders an increasing dividend.

The dividend measuring sticks:

When it comes to evaluating a stock and its dividend, it's helpful to use a couple of financial metrics to determine whether its dividend payment is too low, too high or just right, says Nizar Amarsi, an equity analyst with Morningstar Canada. "Two things that I always look at are payout ratio and yield," he says. "So payout ratio is basically the dividend divided by the earnings per share (EPS) or cash flow per share." And the dividend yield is determined by dividing the annual dividend by its share price. If the yield is high, over five per cent, a good starting point for further investigation is figuring out the payout ratio.

For example, if a company pays a six per cent dividend and it has a 120 per cent payout ratio, that's a red flag because it's paying out more than it earns. The company is using cash it has on hand or borrowing to continue paying its dividend.

So one would infer a company paying close to 100 per cent of its profits in dividends is unsustainable, but yields and payout ratios vary by sector.

And each company must be compared to its peers in its respective industry.

"Real estate investment trusts, REITs, have higher yields and payout ratios because they typically pay more of their profits to investors, but if you have a company that is growing, like a tech firm, the dividend-payout ratio would be lower because they want to put money back into the business."

For example, if a REIT has a payout ratio of 85 per cent compared to its competitors, which average 90 per cent, it may be worth investigating further to determine whether that REIT is a good investment.

In contrast, if the industry average yield payout is 50 per cent, and the company you're looking at is paying 90 per cent, this may be an indication its payout is unsustainable.

 

Dividends, the tax-friendly income:

Dividends from most Canadian publicly traded companies are eligible for non-refundable tax credits that reduce the amount of tax an investor pays on dividend income. It is a complicated calculation, but the tax credits are applied because shareholders receive dividends from corporate income on which a corporation has already paid taxes. So it's a form of double taxation. To make the situation fairer for investors, the tax credits eliminate the problem of double taxation, using what's called the 'dividend gross-up.' To make a long story short, the credits essentially make taxes payable in Manitoba on dividend income about four per cent for people with taxable income less than $31,000, instead of about 26 per cent for regular income. The benefit of the credit becomes less as your income increases, but even the highest income earner, more than $136,270 annually, pays about 32 per cent on dividend income instead of about 46 per cent on other forms of income. Furthermore, because you're invested in stocks, only half of any capital gain -- an increase in a stock's value while you own it -- is taxable at your marginal rate when you sell it.

 

-- The Motley Fool; Ernst and Young

And a number of charts and studies do demonstrate dividend stocks pay off in the long run over other strategies -- such as passively investing in an index such as the TSX, or buying growth stocks.

A BMO Capital Markets chart, for example, reveals Canadian dividend stocks outpaced the TSX composite index and non-dividend-paying stocks from January 1998 to January 2013 by a large margin. The annual return for dividend stocks, including dividend payments, was 7.8 per cent while the TSX was 4.3 per cent and Canadian non-dividend-paying stocks -- growth companies -- averaged 2.4 per cent.

That kind of track record attracts a lot of investors, but many more have climbed aboard the dividend bandwagon in the last couple of years, especially retirees seeking income from their investments to support their lifestyles.

And why wouldn't they? Established publicly traded titans -- such as Canada's big six banks -- pay steady dividends that increase almost annually and currently outpace returns from interest-bearing investments such as GICs and bonds. (To boot, dividend income is taxed more favourably than interest income.)

And one could argue dividend stocks are the balm for whatever ails an investor, even when markets go awry.

Recently, Edward Jones released a report with a list of stocks with a history of paying steady dividends where investors could find shelter for their money to ride out the next bear market.

The report contends the current bull market is getting long in the tooth -- at least in dog years. Now in its fifth year, this bull would be about 35 if it was a dog, so perhaps we should be taking steps to guard against the bear scratching at the door.

In the past -- before the "new normal" -- wary investors could seek the safety of bonds to protect against a potential bear market. If it did come, interest rates would fall and the value of their bonds would increase, offsetting stock-market losses.

But that isn't necessarily the case today, says Jonathon Rivard, a Toronto-based adviser with Edward Jones.

Interest rates are at record lows, so investors can't count on rates to fall much further and spur enough growth in their bond portfolio to offset stock-market losses.

The answer, Rivard contends, might lay with dividend stocks of quality companies.

"These are not necessarily the highest dividend-paying stocks, but instead are companies that have a history of increasing their dividends," he says.

"There are a variety of companies that fit into this category, like Proctor & Gamble, which has a history of increasing dividends over a long period of time."

This well-known producer of domestic goods such as toothpaste has increased its dividend 57 years in a row -- during bull and bear markets, he says.

Another consumer staple producer, Johnson & Johnson, has also performed well no matter the weather, increasing its dividend 51 years in a row, he says. Neither company pays a high dividend. Both firms pay a dividend yield of about three per cent or less, but that's the point. They don't pay out too much profit, but they increase dividends over time as profits grow.

These types of companies are also typically good hedges against inflation. When prices rise as the economy picks up steam, so, too, do the profits of these firms and, in turn, dividends.

But in the search for yield, many investors have become increasingly attracted to high-yielding stocks, paying dividends in excess of five per cent of their share price, says Nizar Amarsi, an equity analyst with Morningstar Canada.

Amarsi recently co-authored a report with fellow analyst Ameenah Charania on the potential problems with high-yield dividend stocks.

Amarsi says investors should be concerned about the sustainability of a high dividend and getting caught in a value, or dividend, trap. That's when a stock pays an attractive dividend at first glance, but once you scratch below the surface, the payout is like applying lip gloss to filthy pig.

"The dividend trap is when you have such a high payout that it's not sustainable," he says. "For example, this would be a company that has a lot of debt with a lot of interest to pay."

Yet many inexperienced investors are buying companies that pay a generous dividend that may not be sustainable for very long.

"Yield-chasing can cause investors to overlook the fundamentals of a company," says Hardev Bains, president of Winnipeg-based Lionridge Capital Management.

Growing profits, ample cash flow and a solid balance are more important measures of future success than a stock's current dividend yield, he adds.

"They (dividend stocks) can be a plus, but the trouble with dividends right now is they can cause investors to make decisions that put their wealth at risk, or set them up for mediocre, subpar performance."

For instance, some companies that pay high yields often only do so because their share prices have fallen as a result of deteriorating business fundamentals. And they may be unwilling to cut their dividend, fearing their stock price will take an even bigger hit.

A good example is Eastman Kodak, Bains says. Its film business was disintegrating because of digital photography, but for a brief period Kodak had a lot of cash to keep paying its dividend. "As its stock price fell, just by default, its dividend yield kept going higher and higher, so it attracted a lot of less astute investors because of the high yield."

That's an extreme example, but even investors in so-called blue-chip dividend stocks -- the steady-Eddie investments -- could be setting themselves up for trouble if they over-allocate.

"You might have someone living off their portfolio, and if you look at their risk profile, spending needs and time horizon, their asset mix might call for a very conservative mix with minimal exposure to equities," Bains says. "But right now, because interest rates are so low, they're attracted to investing in equities just for the yield because they need the income."

Out of fear of eroding their capital too quickly, some retirees have reduced their exposure to low-interest fixed-income securities such as GICs and bonds -- despite these investments paying a very reliable income while preserving capital. Instead, they invest more money in dividend stocks, which offer a higher income but unlike fixed-income payments, dividends can be cut suddenly.

And even more importantly, a stock's value can decrease dramatically in a bear market, in turn substantially reducing an investor's capital.

"So this dividend strategy might work in the short term, but you also might be setting yourself up for capital losses beyond what you can tolerate," Bains says. "Yes, it's true that when the market overall deteriorates, companies paying dividends tend to be a little more resilient, but if the markets are going to correct and you have a dividend stock that is overvalued, the laws of financial gravity eventually prevail."

giganticsmile@gmail.com

Republished from the Winnipeg Free Press print edition April 19, 2014 B19

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