Dividend stocks draw attention

Further up the risk spectrum are higher yielding dividend stocks. A report by Avery Shenfeld and Peter Buchanan, chief economist and senior economist, respectively, with CIBC, say dividend stocks look attractive for income seeking investors. Dividend stocks are offering yields close to corporate bonds and seem to have reached a predictable level of dividend security.

Both dividend-paying equities and corporate bonds should see a flood of investor dollars from essentially zero-yielding money market instruments.

“For retail investors, the shocker is that playing it safe [right now] means accepting a near-zero yield. Canadians are still sitting on more than $100 billion in excess holdings in money market funds, short-term deposits and cash in brokerage accounts, where returns are negligible,” Shenfeld says. “One of the favourite alternatives — income trusts — are for the most part, on their way out. The spread between TSX dividend yields and those on corporate bonds is now near the tightest in decades. In that sense, investors don’t give up much for going into stocks rather than bonds, and unlike bonds with a fixed coupon, stocks can benefit from increases in dividends per share down the road.”

The report outlines that dividend stocks have historically shown strong comparative performance during periods of price volatility.

“The longer-term history for sectors of the TSX known for high dividend payouts is also encouraging, particularly during precarious times. While we aren’t equity bears, for those concerned about downside risks, dividend stocks should have appeal,” the report states. “In five historical bear markets between 1974 and 1998, a portfolio of utility and telecom stocks outpaced the TSX composite by six to 13 percentage points. The gap was a much greater — 44 percentage points in returns — in the 2000 to 2002 tech meltdown.”

The report highlights that the returns on the S&P Dividend Aristocrats Index — a changing group of TSX-listed companies that have consistently increased dividends per share in the prior five years — has outpaced the broader market in the last five years and over the year-to-date period.

“Indeed, to the extent that reliable dividend payers outperform the broad market, that excess return is more alpha than beta — not simply a reward for additional risk. The dividend aristocrats tracked by S&P have had lower realized volatility than that experienced by the market as a whole,” the report says.

Stability may ultimately be the biggest appeal for dividend stocks. Investors can lose sight of the fact that dividends can be cut at any time, not to mention the underlying price risk of the stock. Shenfeld and Buchanan point out dividends may not increase any time soon, but the wave of cuts experienced in the earlier part of this year appears to be lessening. Dividends on top-flight companies appear to be secure.

“Just three percent of the firms setting dividends so far in Q4 have announced reductions from previous levels. That’s down from the cyclical peak of 16% that cut payouts in the first quarter of the year. Conversely, eight percent, or so, of firms setting dividends this quarter have announced increases,” the report notes. “Dividend payout ratios always rise during recessions as companies try to keep dividends stable in the face of declines in earnings, having typically set them at levels that allow them to be carried through the earnings dip. If anything, this past recession saw a milder rise in the TSX payout ratio than what we’ve seen in past economic downturns. Indeed, firms are paying out only 40% of consensus 2010 operating earnings.”

Dividends expected to drive return

Andy McLean, the director of private client strategy with Richardson GMP, says, dividends are going to become an increasingly important part of a client’s overall total return.

“Companies that pay a solid dividend hold up quite well during a volatile market. That’s obviously part of our investment approach, and it will become even more important over the coming years,” McLean says. “Traditionally dividends and reinvestment of dividends provide a good chunk of the total return for common stock investing. It’s only been in the past 15 years that price appreciation has become a little more important than the underlying dividend growth of the portfolio.”

In fact, in past decades, dividends could account for more than two-thirds of a portfolio’s return, he notes, adding, “If you do get into more muted economic growth, which everybody is expecting, dividends become an increasingly important part of your return. Decades ago, about two-thirds of your return would be explained by dividends — I’m not saying we’re going back to that, but we are not in the immediate past where dividends would account for very little.”

McLean points out that a fair amount of screening may be required to distill a portfolio of solid picks.

“You can’t go out and buy the yield. You have to do a little bit more work than that. You have to look for companies with a good dividend growth track record, a sustainable payout ratio and decent prospects for dividend growth in the near future,” he says. “If you look at those sorts of companies and you apply that criteria, it really does cross out a lot of names within the market. What you’re left with are sort of the ‘best of the best’ from a dividend growth perspective. We think, given where yields are now in the market, you do have a good opportunity to lock in to a dividend portfolio approach [with those stocks].”

Time horizons matter

John Degoey, a CFP and vice-president with Burgeonvest Bick Securities Ltd. is hesitant to use dividend strategies in lieu of income strategies due to the volatility of equities. In all cases, he says it’s imperative that clients understand dividend stocks have the same risk profile as equities in general. One recent experience focused on dividends had unfortunate results.

“In September 2008, I had a client with a one-year time horizon to buy a house — so he would be looking to buy right about now in December 2009. The stock market had dropped by about 20% in September 2008 and he said, I don’t want to just be in cash,” Degoey explains.

“He wanted something very conservative, but he was bugging me to get out of the money market investments. He wanted to do something sexier. I waited until the market had dropped 20% in September 2008, and said on that basis, given that there has been a 20% drop and you have a time horizon of one year, even if the market drops further, I feel comfortable putting it in a dividend-based ETF. It’s cheap, diversified and pays a regular tax-effective income stream well in excess of what you get in a bond.”

Unfortunately, markets did fall drastically further, reaching a bottom during March of 2009. The client didn’t have the fortitude to whether the storm and sold out near the bottom in December, despite Degoey’s recommendation to stay the course.

Degoey says a dividend income strategy may work over a longer time horizon, but it’s just too risky over shorter time frames.

“Financial planning 101 says don’t put you clients money in anything even remotely volatile if that money is needed in 12 to 15 months. I thought I could relax that rule this time, because I thought, how much more risk can their really be? We found out,” he says.

“I really did resist doing it the first couple of times. I really did wait until there was a 20% drop. It was diversified, it was low cost and it was paying a hefty dividend. None of them mattered at the end of the day.”

(12/07/09)