The goods on dividend investing

It's hard to argue against a buy, hold and get paid strategy

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INVESTING in the stock market has always had one broad, sensible rule to follow: Buy low and sell high.

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Opinion

Hey there, time traveller!
This article was published 19/11/2011 (3971 days ago), so information in it may no longer be current.

INVESTING in the stock market has always had one broad, sensible rule to follow: Buy low and sell high.

But as anyone who has invested in equities over the last decade knows, buying low and selling high is often much easier to preach than practise. After a decade of flat capital gains in the market, this simple rule seems like a cruel joke — one that may continue for another decade.

Still, some investors in equities haven’t fared badly because they have marched to a different mantra. This strategy, too, can be summed up in a simple catch phrase, yet it’s also usually much less difficult to execute.

The Canadian Press ARCHIVES Utility firms like pipeline company Enbridge provide an essential service and can increase their dividends even in the midst of bad news.

So what’s the secret?

Invest in stocks that pay you to hold them. In other words, buy dividend-producing equities. It’s a proven investment strategy, especially when it’s refined one step further: Invest in stocks that have a history of increasing their dividend.

Stephen Watson, an investment adviser with MGI Securities in Winnipeg, is a firm believer in the power of the dividend. And his affinity for this investment style was the topic of a recent presentation he made at the Manitoba Association for Business Economics.

In the talk, he argued dividend investing is a foundational philosophy to create portfolios for both growth and income while managing volatility and fighting inflation.

But Watson admits he wasn’t sold on dividends when he started investing in the ’80s.

“I didn’t think they had growth potential,” he says.

Like many new investors, Watson wanted to hit the home run, buying low-priced stocks he was certain he would sell at much higher prices years later. Yet, after many swings and painful misses, he realized his mistake, made all the more clear as he watched stocks of established companies increase in price over time and, just as important, pay their investors growing dividends.

He says it was a hard lesson, but a valuable one that has convinced him dividends play a key role in building a successful portfolio. And he’s certainly not alone.

Many portfolio managers consider dividend investing an essential part of any strategy for their clients.

Yet, it’s not as simple as finding a company that pays a dividend, or even has a history of increasing its dividend. Portfolio managers search for firms that have strong balance sheets and aren’t overburdened by debt. And they hunt for market leaders with bountiful cash flows, meaning there’s enough cash left over after bills are paid, says Brent Hardman, a senior wealth adviser with ScotiaMcLeod in Winnipeg.

“I try to find sectors where companies are growing their dividends as their profits rise and they’re not paying out too much of their earnings,” he says, adding they retain some earnings to grow and remain industry leaders.

 

Part of the beauty of investing in dividend-paying firms is they are often perennially profitable to shareholders because these companies generally provide goods and services needed by consumers and businesses even during tough times.

In 2008 and 2009, when stock prices plummeted, many established firms didn’t cut their dividends.

For instance, the big five Canadian banks didn’t slash their dividends. Some companies, such as utilities firms, even increased their dividends, Hardman says.

He says he often prefers investing in utility firms — like pipeline company Enbridge or electricity provider Fortis — because they provide a service we can’t live without, and they can increase their dividends even in the midst of bad news.

“They’re not really relying on the price of the commodity they’re transporting. Whether oil is $100 a barrel or $70, they still just have to move the product,” he says.

But it’s not just the utility-sector firms with this positive history.

The Canadian banks have also proven to be sound income-producing investments that have also increased in stock price and grown their dividends over the last 20 years, Watson says.

Again, at the presentation, he offered up his own experience. He purchased 400 shares of Bank of Montreal in 1995 and 100 in 2001 for a total investment of $9,858. By 2009, when he sold half his shares, he had earned $12,358 in dividends. Quarterly dividends rose to 70 cents from 20 cents over the 14-year period, and he reinvested all of the dividends, acquiring 176 more shares.

At the end of 2009, his investment of a little less than $10,000 had grown to more than $36,000, providing a dividend income of $1,893 a year. That’s a 19 per cent yield on the original investment — far better than income generated by a GIC or bond. And BMO isn’t unique. The other banks performed well, even better in some cases, and they all continue to provide value to investors.

Still, not all stocks that glitter with growing dividend yields provide a golden solution. Some can turn out to be rotten eggs. Yellow Pages publisher Yellow Media is a well-known cautionary tale, a firm that grew its dividend but took on too much debt and saw revenues decrease as it lost market share.

The moral of this stock story is investors must sift through a firm’s financials and understand the market it serves, Watson says.

In addition, diversification in a variety of companies is essential. That, however, may be difficult for many investors of modest means.

“In that case, mutual funds may be an option,” says Watson, who does not sell mutual fund products.

For investors with a few dollars to save every month, mutual funds are a relatively low-cost way to invest in a diversified portfolio of dividend-paying companies.

Many funds offer dividend-reinvesting plans (DRIPs) — as do many stocks themselves — that use the dividend earnings to purchase more fund units and help increase the original investment’s growth over time.

But income-needy retirees should also consider a dividend strategy, because it can provide a fairly reliable income stream that is both inflation protected — because the dividends often increase over time — and tax efficient.

Craig Roskos, chairman of the tax committee of the Institute of Chartered Accountants of Manitoba, says the highest marginal tax rate for eligible dividends is 26.74 per cent in Manitoba — much better than taxation for interest earnings.

“If someone was earning interest income, they’d be taxed at the highest marginal rate at 46.4 per cent,” says the managing partner at Ernst and Young in Manitoba.

Tax advantages aside, dividend strategies offer a sense of security when times are tough, Watson says. Pure growth stocks can be a stressful experience; just ask someone who bought into Research in Motion a year or two ago. By comparison, a boring old dividend-yielding company looks pretty sexy — if your idea of a sexy time is getting a good night’s sleep.

“The real value here is the ability to be comfortable during periods of market crisis,” Watson says. “If you are earning dividends and see your investment as a source of good income, it makes it much easier to behave as you should — that is, staying invested in the markets.”

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Proven track record

 

DIVIDEND-PRODUCING stocks between 1986 and 2010 outperformed growth stocks in terms of overall returns, says investment adviser Stephen Watson. Of all of the stocks on the S&P TSX Index, companies that grew their dividends averaged 12 per cent returns and dividend paying companies — regardless of increasing their dividend — had about 10 per cent returns. Meanwhile, the overall index had 6.4 per cent returns, and firms that cut their dividends had 2.2 per cent returns. Firms that didn’t pay a dividend averaged 1.1 per cent returns.

— RBC Capital Markets

Mutual fund or ETF?

Exchange-traded funds (ETFs) are attractive to many investors because they have much lower management costs. And high management costs are undesirable because they erode returns. But when it comes to dividend mutual funds versus ETFs, Watson says the mutual funds bear closer consideration.

He says the most popular ETFs mirror the ups and downs of an underlying broad index, and many investors often assume they are buying a diversified portfolio.

But that’s often not the case. For example, the TSX 60 and the most heavily traded ETF that follows this index — the iShares S&P/TSX 60 Index Fund — include companies across 10 sectors. That may seem diversified until you take a closer look. Three sectors — energy, financial and materials — account for about 79 per cent of all of the listed firms. Furthermore, of the 60 listed companies nine produce gold. That may sound great given gold’s meteoric rise. But Watson says gold companies average dividend yields of one per cent.

Furthermore, the TSX 60 — and its related ETFs — adds companies when their stock price is on the upswing and delists them when their stock price is nearly worthless. In effect, they buy high and sell low. For instance, Yellow Media was delisted from the TSX 60 when it had lost 99 per cent of its value. And Silver Wheaton, a silver producer, was recently added when its stock value had soared with the high price of silver, which has since come down. “You’re buying a portfolio that buys stocks after they’ve become expensive and sells them only after they have fallen to become really cheap.”

Dividend-oriented mutual funds, however, may come with higher management fees, but the cost — for well-managed funds — is worth it, Watson says. They are often better diversified than related ETFs, they pay a regular income and their managers select stocks for safety and sustainability, he says. The CI Signature High Income Fund, for instance, has a 1.6 per cent management expense ratio (MER) and outperformed its benchmark by more than 19 per cent over the last five years.

It has also provided a 6.3 per cent yield over the last 12 months as of Sept. 30.

Watson says these funds may not outperform a related index fund in good times, but they will often soften losses or even provide modest returns when the going is tough.

And given all the bad market mojo of late and likely for the foreseeable future, fund managers just might be worth their keep.

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