The Ins and Outs of Dividend Investing

Fall 2010 CSANews Issue 76  |  Posted date : Sep 17, 2010.Back to list

Looking for income and growth? Look for dividends.

Lately, investors have been faced with a difficult choice. On one hand, equity investors have been shaken by ongoing stock market volatility. On the other hand, fixed-income investors are dismayed by interest rates that remain near all-time lows. Neither option looks very attractive. 

So what's an investor to do? The answer: invest in dividends. 
Dividends are payments made to a company's common shareholders - think of them as a slice of a company's profits paid out to its owners. While they're certainly not a replacement for GICs, bonds or other fixed-income investments, dividends can offer a stream of investment income. And because the kinds of companies that pay dividends are usually mature, stable businesses, dividend-paying stocks can often be less volatile than the market as a whole. 

Before you invest in dividends, you need to get into the "dividend mindset." That is, you need to think a little differently about what you're doing when you invest. 
Most investors view a stock as a vehicle for capital appreciation. They invest in a given stock at a (hopefully) low price; over time, the value of that asset increases, and so too does the investor's profit. At some point in the future, the investor will sell the asset, thereby "harvesting" the profit. 

A dividend investor views things differently. To a dividend investor, a stock is an access point to a stream of tax-efficient income. While dividend investors certainly aim to buy stock at a low price and obviously expect the value of their investment to appreciate over time, short-term price fluctuations aren't as much of a concern. After all, they're in it for the income. 

Because the dividend investor doesn't need to sell in order to accomplish his or her primary investment goal, he or she can afford to ride out stock market volatility. This is a fundamentally more conservative way of investing, more in line with the "buy and hold" philosophy of such great investors as Warren Buffett and Peter Lynch than the frequent trading strategies of market speculators. 

Lower Risk

This conservative mindset is echoed by the way in which the dividend investor picks stocks for his or her portfolio. Because dividends are paid from a company's operating profits, a dividend payment can be considered a de facto screen for corporate profitability and, to a lesser extent, overall business health. 
This connection between profitability and dividends tends to make a portfolio of dividend-paying stocks less volatile than the overall market. Screening for dividends generally excludes startups and other speculative stocks that are in the process of building their businesses and have little or no profit yet. It also tends to exclude "turnaround" situations, in which a company is trying to preserve assets or restructure. 

Instead, stocks that pay dividends tend to be large, "blue-chip" companies that enjoy sustainable competitive advantages and operate in mature industries. While their prices can fluctuate, dividend stocks are fundamentally more conservative investments than the high-risk, high-return stocks in which speculators tend to invest. 

Keep in mind that this is only a general rule. There are several outstanding, well-run businesses that do not pay dividends (Berkshire Hathaway; Cisco Systems). Conversely, there are companies operating in highly cyclical industries (Barrick Gold Corp., for example) which do. 

Dividends Don't Lie

Another benefit of dividend investing: dividends serve as a corporate "reality check." While a company could pump up its stock price by being aggressive with growth projections, overstating its income, hyping up a particular product or moving liabilities off of its balance sheet, you can't fake or hype a dividend. If no cash is coming through the door, it's tough to pay a dividend. 

Keep in mind, however, that a company's ability to pay a dividend can change dramatically in a short time. Over the past several years, many companies have had to cut or suspend their dividends in response to financial turmoil (U.S. bank stocks, for example). Many investors had put their money into such stocks, thinking that the underlying businesses would be profitable forever. It didn't turn out that way and dividend investors have been paying the price ever since. 

Looking For Income Growth 

Unlike income from GICs, bonds and other fixed-income investments, stock dividends often grow over time. This makes sense when you consider what a stock actually is: a small portion of an operating business. If the business is well-managed, it should grow, generating more and more cash. A portion of that cash should be reinvested in the business, helping it to sell new products or expand into new markets, leaving the remainder to flow through to shareholders in the form of steadily increasing dividends. 

This ability for dividends to grow over time is one of the major attractions of dividend investing. As dividends increase over the course of many years, the annual return which you receive on your original investment can expand dramatically. Alternatively, many companies allow you to automatically reinvest your dividends into additional shares, usually at a discounted rate. 

In this way, dividends are a built-in hedge against inflation. Even if a company increases its dividend by a nominal amount every year - say, by as little as three to five per cent - you will likely keep the purchasing power of your money intact. What's more, you don't have to sell, reinvest, restructure or reallocate your investment to enjoy the increases. It happens automatically, at no charge to you. 

Dividends and Taxation

Another major benefit of investing in dividend stocks is the preferential tax treatment which dividends receive. Although the exact rules differ according to where you live, in general, the tax man will take a smaller chunk of your dividends than he will take of the interest income that you receive from a bond or a GIC. In practical terms, this means that a dividend of, say, four per cent could actually leave you with more money in your pocket than an interest payment of five per cent from a government bond.

Keep in mind, however, that such tax breaks are typically only available to citizens of the country in which the dividend-paying company resides. So, for example, Canadian citizens enjoy a much lower rate of tax on dividends from Canadian corporations than do American citizens, and vice versa. 

Most countries have tax treaties that specify how dividends are taxed when held by non-citizens. For Canada and the U.S., cross-border investors must pay a 15% withholding tax on dividends payable to non-registered accounts. Investments inside RRSPs and RRIFs are exempt from such tax. 

Finding Dividend Stocks: What to Look For

So how do you find great dividend stocks? While every investor has different financial goals, there are several features of a good dividend-paying stock to which almost every dividend-focused investor pays attention:  

Payout Ratio

A measure of the percentage of a company's annual profit paid out as dividends. In general, the lower the percentage, the less of a hardship dividend payments are and the more flexibility a company has to maintain, or even raise its dividend in tough times. 

This is not to say that stocks with high payout ratios are necessarily "bad" dividend investments, however. But they are a lot less likely to increase their dividends—most of their profits are already flowing through to shareholders. 

Dividend yield

A measure of the annual return which an investor can expect from dividends, expressed as a percentage of the company's current share price. For example, a stock paying an annual dividend of $1 that currently trades for $10 a share has a dividend yield of 10%. From a dividend investor's perspective, the higher the yield, the more attractive the stock. 

Beware of exceptionally high yields, however; if a company's dividend yield gets much higher than seven per cent, it could be a sign that the stock market believes that the company's dividend is not stable, or that the company is in financial distress. 

Track Record of Earnings Growth

Always remember: dividends are paid out of corporate profits. Obviously, if a company's earnings are not growing, it's going to be tough for a company to increase its dividend. Conversely, a company that has increased its revenue over several years should have more cash on hand to allocate to dividends. 

History of Increasing Dividend Payments

An uninterrupted string of increasing dividends (even if the increases are small) is a sign of a healthy business. More importantly, it's a sign of dividend-friendly management. When a company management demonstrates its commitment to expanding its dividend over time, this is a good sign that management shares the "dividend mindset."

"Reasonable" Amount of Debt

It makes sense that a company which is using its cash to pay interest on debt will have a harder time paying a dividends. For this reason, it makes sense for dividend investors to focus on companies that don't require a lot of debt to fund their operations. 

Keep in mind that every industry has different debt requirements, however. A 100-year-old company selling soft drinks around the world needs a lot less debt than a company building a new multi-billion-dollar oil-and-gas pipeline, for example. Yet both Coca-Cola and TransCanada Corporation could be outstanding dividend stocks - you need to do your homework to find out. 

As attractive as they are, dividend-paying stocks should not be seen as a replacement for GICs, bonds or other fixed-income investments. Unlike GICs, the value of dividend-paying stocks can fluctuate. Unlike bonds, there is no guarantee that you will get your capital back. And, as many dividend investors discovered during the recent downturn, there is no law or rule that says a corporation must maintain its dividend. 

If you're interested in building a portfolio of dividend stocks, there are a number of online resources that can help. Check out www.thedivididendguyblog.com or www.thinkdividendsblog.com or specific information about dividend stocks. For those more interested in a general rationale for dividend investing, the Globe and Mail has a number of dividend-related articles available on its website www.globeandmail.com.

Use this as a starting point for your research, then follow up with a consultation with a qualified financial professional. Working together, you can start putting dividends to work in your portfolio, and realize why cash is indeed king.