Divys

By Guest Blogger Ryan Lewenza

Upon completing my business degree from the illustrious University of Windsor (I joke but it actually had a decent business school), I packed up my 1987 Honda Prelude and moved up to the Big Smoke to begin my career in finance. After a few embarrassing setbacks (one job I interviewed for turned out to be a scam as instead of leading “exciting marketing strategies in the sports and entertainment industry” it actually involved selling two-for-one restaurant coupons door to door…definitely the low point in my early career), I was able to get a job working the phones in the fast-growing discount brokerage industry.

This was 1999 just months before the 2000 stock market peak and the ensuing tech crash. Like many others I got caught up in the mania and made some of my first stock investments in companies like Enron and WorldCom. Maybe you’ve heard of these beauties before. Well we know how that story ended (and my trading account at the time), and it was my first important investment lesson – don’t get caught up in the hype and mania of the time and don’t take high-quality companies that pay a consistent dividend for granted. Today I discuss why dividend-paying stocks are a must-have for long-term investors so hopefully you can avoid the hard lessons I’ve had to learn.

Let’s take a step back and discuss what dividends are and where they come from. Some entrepreneur comes up with a great new product or service and goes into business. The new product/service takes off with the business growing rapidly. At first any profits are plowed back into the business to fund even more growth in the business (e.g., adding new staff or building a new factory). As the business matures and it’s growing steadily it doesn’t require as much investment. Management and the board at this point might implement a new dividend policy. Over time, as the company continues to prosper, it increases the dividend paid to shareholders, effectively starting to pay investors back for initially investing in them through the IPO. So the dividends are a function of the underlying earnings stream. If there’s no earnings, generally there’s no dividend.

While dividend-paying stocks are not very sexy and are unlikely to make you a hit at your next dinner party, they sure do provide tasty returns for long-term investors. Below is a chart showing the impact of dividends on total returns, and in particular, the reinvesting of dividends. If an investor invested $100,000 in the S&P/TSX in 1988 and only received the price returns of the TSX, the investor today would have $510,870. Not bad but a fraction of the $1,142,935 the investor would have if they received and reinvested all the dividends back into additional units of the TSX. In fact, a 124% higher return due to the dividends and the compounding of those dividends. This clearly shows the impact of dividends and compounding returns.

Returns on $100,000 Invested in the S&P/TSX

Source: Bloomberg, Turner Investments

Now you just don’t want to focus on the highest dividend-yielding stocks, in fact, you generally want to avoid these like the plague. When investing in dividend stocks you want to focus your attention on the best dividend growing stocks. These are those companies that consistently increase their dividend year in and year out like the banks, pipelines and telcos. Why is that? If the company is consistently increasing the dividend then it generally means the company is steadily growing and management has confidence in the outlook of the business so it can justify increasing its dividend. Management knows that dividend cuts can torpedo the stock price so they generally are only increasing the dividend if they have confidence in their business and earnings outlook.

RBC did some great analysis a few years ago looking at different categories of stocks and their respective returns. For example, they examined the performance of “dividend growers” (companies that consistently grew dividends), “dividend payers” (those that paid a dividend but didn’t increase them), “dividend cutters” (self-explanatory) and “non-payers”. They found that the “dividend growers” provided the highest total returns of 11.7% annually, versus “dividend payers” at 9.9%, “dividend cutters” at 2% and “non-payers” at 1.3%.

Annual Total Returns from 1986 to 2016

Source: RBC Capital Markets

But it gets even better! Not only did dividend growing stocks in the TSX provide the best returns they also displayed the lowest volatility across the different categories. When looking at volatility or standard deviation of prices they found “dividend growers” had the lowest standard deviation of 13% versus the TSX at 16% and dividend cutters at 25%, for example.

So dividend growing stocks offer higher historical rates of return and with lower volatility – that’s the equivalent of a free lunch in investing!

Over and above the good returns from dividend stocks there are other factors that contribute to their attractiveness. These include:

• With our aging population and more and more boomers going into retirement, they will require income from their investments to fund their retirement spending needs. This could result in more investor demand for dividend-paying stocks and potentially higher prices over time.
• Related to that is the very low interest rate environment we’re in. With bond yields near historical lows this adds to the attractiveness of dividend stocks. Below I illustrate by this comparing the dividend yield of the TSX to the Government of Canada 10-year yield. Currently the TSX yield is 3% versus the GoC 10-year yield at 1.77%.
• Dividends can help to keep up with inflation as dividends rise with inflation (since earnings would continue to rise with inflation). Dividends can provide a hedge on inflation!
• Lastly is the preferential tax treatment of dividends, which are taxed at a lower rate than interest and other income. For example, an Ontario resident earning $75,000/year would pay a 8.92% tax rate on dividends and 31.48% on interest income.

TSX Dividend Yield vs GOC 10-year Yield (%)

Source: Bloomberg, Turner Investments

In summary we love dividend-paying stocks and it’s why they are an important part of client portfolios. Every one of our current equity ETF holdings in client portfolios pay a dividend and in fact we’ve been increasing exposure to dividend growers since that’s where you get the best bang for your buck. Like Tom Cruise said in Jerry Maguire: “show me the money!”

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.