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Can We Trust Dividend Stocks To Continue Performing?

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Dividend stocks, especially ones with above average yields, have been excellent performers for the past few years.

But with uncertainty dominating the broader economy and stock markets, a growing number of investors have raised the question of whether the good times can and will continue.

As a refresher, a common stock dividend is the distribution of a portion of a company's earnings, decided on by its board of directors, to shareholders of its common shares. Dividends can be issued as cash payments, as shares of stock, or as other property.

Typically in North America, dividends are handed out quarterly, which allows investors to regularly receive cash for their shares. International companies, more often than not, pay their dividends annually or semi-annually.

Dividend-paying stocks have long been considered a smart buy for obvious reasons: Combined with regular distributions and long-term stock price appreciation, dividend-paying stocks as a whole tend to outperform their non-dividend paying counterparts over the long-term.

More importantly, "dividend growers" -- companies that steadily increase their dividends over time -- tend to do better than those that simply pay out a distribution, but never or rarely increase that distribution rate.

And when total return (dividend yield plus capital gain) is looked at (as it should as that is what investors actually earn), dividends tend to make up over half of that return over the long-term.

Additionally, in taxable accounts, dividends from Canadian corporations have quite a tax advantage over dividends from foreign corporations on interest earned. For example, for 2016, residents of Ontario pay tax at a rate of 39.34 per cent for eligible Canadian dividends while they pay 45.3 per cent for non-eligible dividends and 53.35 per cent for interest income.

Companies that pay hefty dividends have seen a spike in popularity over the past few years as central banks around the world have instituted near-zero interest rate policies (ZIRP), some even imposing negative interest rates (NIRP).

Utilities and REITs have been the biggest beneficiaries of this funds flow. Technically, REITs pay distributions, not dividends, as their payouts are generally a combination of a return of capital and earnings. Investors, however, seem to treat their payouts similar to how they treat dividends in their search for yield.

As a rule, we like to invest in companies that not only pay dividends, but are "dividend growers." We will almost always choose a company with a low but consistently growing dividend over one that has a high but static dividend.

An excellent example is Canadian label producer CCL Industries (CCL.B-T). It currently yields a very modest 0.8 per cent based on an annual dividend of $2.00 per share. Just five years ago, however, the annual dividend was $0.70 per share (a then-yield of two per cent) and the share price was one-seventh of where it is today.

Had you bought CCL in 2011 at $35, the yield on your original purchase would be 5.7 per cent today (and your capital gain 640 per cent), and you could expect the dividend to keep growing.

Investors often make the mistake of chasing companies with high absolute yield rather than buying companies with low but growing yield. Companies with high, static yields are quite often problem-laden companies whose dividend payments are quite often at risk, whereas companies with growing dividends are usually companies whose earnings and fortunes are improving.

A lesson learned the hard way over the past year has been that not all dividend payouts are safe. I am referring here to dividends from highly cyclical or resource-based companies. These are companies whose fortunes are tied either to the price of the commodity it produces or are heavily reliant on the ups and downs of economic cycles.

In no uncertain terms can these dividends be considered safe, especially when compared to dividends from most consumer, financial or industrial companies. These companies are price and volume takers, and for the most part are unable to control much of their own destinies.

It's easy to become enamored with these companies' generous yields when times are good, but always remember, in the back of your mind, that their dividend payments will become suspect once their fortunes begin to turn.

And besides, all companies will tell you their dividend payouts are safe until the moment they tell you that they are being cut or eliminated.

One thing dividend chasers should be aware of is that the shares of companies with above-average dividend yields are currently quite expensive, due mainly to the ZIRP mentioned above, as investors continue to search out and chase yield.

An ever-present risk associated with high-dividend yielding stocks is that they tend to fall as interest rates rise. This hasn't been much of an issue since the early 1980s as interest rates have pretty much only gone down since then. However, with interest rates currently on either side of zero, eventually rates will begin to increase, putting the valuations of these stocks somewhat at risk.

As always, the best advice I can give is to have a broadly diversified portfolio, one that contains stocks from many industries and countries as usually not all stocks go up and down at the same time. This is how we manage our clients' portfolios and how I recommend you manage yours.

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