There has been a lot of investor interest in dividend-producing investments for some time now, and I still get questions on it. I believe it’s partially from the DIY investor revolution. There is more analyst research available, and more investor comfort with recognizable names, which are common traits of large dividend producers. In addition there was a lot of yield-chasing as investors lost favor with low-interest fixed income investments and set about to seek greener pastures. And finally I think (hope?) it’s a bit of an awakening, as people become more interested in finance, start talking more, and start asking questions.
But choosing a strategy that focuses towards dividend-paying companies is not as straight forward a decision as it may appear. First we need to look into what dividends are, and why a company would be a dividend-payor.
A dividend in its most basic form is excess corporate income that the company doesn’t want to pay tax on. When you have a large corporation and they have excess income, it often doesn’t make sense for them to just sit on this income and get bigger. Especially, and this is key, if they don’t think they can use it to grow. So, rather than paying tax on their income and then not putting it to any effective use, they kick a dividend out to shareholders. The taxation is actually a bit more complex than that, but the point is that most often corporations pay dividends to investors if they don’t think they can use the money more effectively.
Dividends are based on income, so they can fluctuate with income (note that many companies have been known to borrow money just so that they can continue paying dividends. It’s actually frightening how common this is). In 2008 we had a severe recession, and many companies ended up slashing or eliminating their dividends. Now we’re back into it again, and as revenue slows, something’s got to give. Encana is a recent news example, cutting their dividend by 79 per cent.
I really don’t have anything against dividend funds as a category, but I don’t think focusing on that category alone forms the premise for a sound investment strategy.
The folly is that dividends are not guaranteed. They are one way for a company to deal with their excess income. Another way is for the company to grow and expand. From a corporate point of view growth is preferred, which is why most companies don’t start issuing dividends until they’re saturated in their market space. Growth is preferred from an investor taxation point of view as well, because capital gains are deferred until disposition, and dividends are taxed on an accrual basis.
The stability in dividend-payors is a result of this market saturation, however that’s also what limits their growth. While smaller companies can be hit quite hard during recessions, they also outperform large-cap dividend payers 84% of the time (looking at 10 year rolling periods). When we look at 20 year rolling periods, small cap investments have always outperformed large-cap dividend payors. If your goal is stability with some growth, then dividend payors may add value to your overall strategy. If your goal is income OR growth, then dividend payors will not be ideal.
Most theories touting dividend-paying investments are comparing dividend funds to fixed income. They say that dividends are yielding 4% to 6%, when GICs and bonds are only yielding 2% to 4%. While this is true, it is a totally inappropriate comparison. Dividends are equities, and equities fluctuate with the projected future valuation of a company (which is hopefully mostly in the upward direction). GICs and bonds are designed for income and protection. If you consider it from a micro perspective, other than the size of a company there is really very little difference between taking a dividend from a company in order to create an income stream, and selling some shares in a non-dividend payor in order to create an income stream– the latter of which nobody ever recommends. At least nobody who believes in the sequence of returns.
Turning dividend-payors into a popular income strategy gives me three main worries.
First, it created an overbalance of demand. With supply as our constant, price became the variable. Since this strategy’s emphasis is on the income dividends produce, not the price to buy the asset, many dividend-producers became overvalued in a big way. Some of that shock is being felt now, with both the market value and the dividends of these companies being torn apart by the same storm. I mentioned before that I don’t really have anything against dividends funds as a category, and that’s true. But I do have something against buying expensive investments just because everyone else is doing it.
Secondly, the emotional desire to include dividends can obscure other planning goals. For instance, in a non-registered account dividend income can have punitive taxation results since the value of dividends are grossed-up on your tax return in order to calculate net income. The higher net income could potentially be enough to result in OAS being clawed back unnecessarily. In this case, preference for dividends can cause more damage than benefit. Alternatively, the use of dividend payors inside a Tax Free Savings Account to produce a tax-free income stream may seem like an optimal solution, but not unless it considers the impact of international tax treaties. Mutual fund investments should be fine, but if a dividend strategy inside of a TFSA includes diversifying with individual securities from American companies your “tax-free” dividends will actually have American tax consequences since the US does not formally recognize TFSAs as a tax shelter.
And finally, now that we’re in the midst of a correction, the third and most pressing issue is that dividend paying securities tend to struggle around the time of a rate hike. By “around the time”, I mean 12 months before and 12 months after. Beyond that, they historically have recovered some ground, but that’s assuming that there isn’t another rate hike pending.
This is a generalization on an already generalized sector, but the point is that rates going up is not good for stocks who’s dividends are constantly being compared to interest rates. We’re scraping the bottom of the barrel for interest rates already, and so as rates eventually begin their return to a normal cycle, it’s likely to create a challenging headwind for dividend investments.
Dividend-producing investments receive a lot of attention in DIY strategies, but that does not excuse a portfolio from needing in-depth analysis, diversification, or a structured rebalancing plan. If you have questions on how to determine if dividends are a suitable investment option for you, or for more information on creating diversified long-term portfolios, speak with a Certified Financial Planner today.
Written by Meagan S. Balaneski, CFP, R.F.P.
Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER® Advantage Insurance & Investment Advisors Investment Funds Representative Manulife Securities Investment Services Inc.
The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.