Dividend-paying equities have a reputation for being boring relative to growth stocks. This is understandable given that telling your neighbour you bought Current Thing Corp. at $20 last year and it now trades at $30 is more impressive than bragging about that boring pipeline you have owned forever that just increased its dividend from $2 to $2.10.
To quote Bohdi Sanders, the Martial Arts Hall of Fame inductee: “Your reputation is what others think of you; your character is what you truly are. Reputations can be manipulated; character can only be developed and maintained.” The analogy speaks to the dividend-versus-growth question. Growth stocks discount the collective forecast market participants have on the future earnings of the company. Dividend payers maintain enough profitability to provide consistent, growing quarterly payouts.
When discussing the long-term efficacy of investing in dividend-paying stocks versus those companies that choose to retain all earnings, it is important to be aware of the confirmation biases of both schools. Proponents of dividend investing correctly point out that, over the long run, most investor gains will come from dividends rather than capital gains. A US$10,000 investment in 1960 in the S&P 500 would be worth more than US$4-million now, with more than 80 per cent of that gain from dividends (assuming reinvestment) and 20 per cent from capital gains.
Fund managers who eschew dividend payers point out that in the past few decades dividends have been less of a factor in total return. This is true. There is a marketing aspect to this: The riskier and more glamorous the asset, the more a fund company can charge in fees in general. In bull markets, especially ones financed by artificially low interest rates, riskier assets do well and short-term performance sells funds.
Given the relentless competition among portfolio managers, underperforming a hot market because you took less risk is a recipe for career termination. “Superstars” are handsomely rewarded during bull markets. When the inevitable bear market occurs, underperformers, like zebras in herds hunted by hungry lions, try to go unnoticed and hope their brethren will satiate the beasts. Nor does management forget that, even though the high performer’s fund blew up, their aggressiveness attracted money into the fund.
Before the secular bull market that started in 1982, dividends were a far more vital component than capital gains. This makes sense, intuitively. A company makes money for its shareholders. Current and growing dividends should be important. Future company growth is important, but a dollar today is worth more than a potential capital gain in the future. Not all stocks that do not pay dividends are the next Facebook. From the 1940s through the 1970s, the percentage of gains due to dividends ranged from 73 per cent in the 1970s to a low of 30 per cent in the 1950s. In the 2010s and 1990s dividends accounted for only 16 per cent to 17 per cent of returns. The 2000s are difficult to assess fairly since we had two brutal cyclical bear markets in 2000 and 2008. Obviously, dividends offset some of the losses of downturns.
Dividend stocks perform well relative to other stocks – far better than their critics would have one believe. If one looks at return relative to risk, they look even better. However, during sharp and quick bear markets they will lose more in price than their fans may have expected. Eventually they recover, since the dividend supports the stock price. They provide excellent opportunities after crashes.
I believe we have entered a more historically normal period that will be marked by higher interest rates. Avoid recency bias. The era of cheap capital costs and malinvestment is over. Dividends will be far more important than in the past. Giant, mature companies with lower growth potential should start returning more capital to investors in the form of dividends, in part because alternatives such as bonds will have more competitive yields. Their cost of capital will be higher, and growth will not be turbocharged by artificially low rates.
Dividend stocks are attractive, but not all are the same. The most attractive firms are in good businesses with great management that can consistently increase dividends. Also, we have mature companies such as utilities and pipelines that have little business risk, even if they do not have many growth opportunities. They usually have regulatory protection. Avoid companies that consistently pay higher dividends than they make in earnings. This strategy is mathematically unsustainable and artificially keeps the stock price from imploding. It is a sign of a failing company.
There are many solid dividend stocks right now in Canada. Intrepid contrarians should have a good look at the banks and other financial services. Everyone knows the banking system is facing some headwinds owing to rising interest rates and credit quality deterioration. However, we must always remind ourselves that this is already understood – the market anticipates the future. Royal Bank RY-T sells at $122.37, down around 15 per cent from its high. At a yield of 4.4 per cent, the investor is well compensated. Canadian Tire CTC-A-T also merits a look at $152.46. The stock has a dividend yield of 4.5 per cent. It is about 25 per cent off its highs and has a strong balance sheet. Imperial Oil IMO-T, at $78.10, has a dividend of 2.5 per cent and gives the investor exposure to higher petroleum prices. It also has a strong balance sheet.
Low-fee exchange-traded funds provide a diversified way of gaining exposure to dividend stocks and are typically a better approach than buying higher-fee mutual funds. There is no point in buying stocks that pay dividends if you are going to give up a portion of your cash flows by paying large fees to active managers, most of whom, if you believe the empirical evidence, do not add any value over the long run.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.
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