As seen in Financial Post: FP Answers on November 24, 2023
Q:What role do dividends play in a balanced portfolio? What are some dividend-investing approaches or strategies? And is there ever a time when dividend investing doesn’t make sense for an individual equity investor? — Simon
A: It may come as a surprise to learn that, historically, dividends do much of the heavy lifting regarding long-term equity returns. Using data from the United States stock market from 1900 to 2016, research shows capital gains supplied only a third of total returns while reinvested dividends supplied the rest.
A more recent study found that over a 123-year period, one U.S. dollar invested in the stock market with dividends reinvested would have grown 2,024 times in terms of purchasing power, well above the 35-fold rise in prices during this period.
As you can see, dividends can play a major role in a balanced portfolio for several key reasons:
- Income generation: Dividends provide a consistent stream of income to investors that may be especially important for retirees or those seeking regular cash flows from their investments.
- Risk management: Dividend-paying stocks, particularly those from established and financially stable companies, can be less volatile than non-dividend-paying stocks. A regular and growing dividend along with a strong balance sheet clearly demonstrate a company’s ability to generate cash from operations. The steady income from dividends can help offset losses during market downturns.
- Dividend growth: Some companies have a history of increasing their dividends over time. Investing in these companies can provide a growing stream of income that can help investors maintain their purchasing power in the face of inflation.
- Tax efficiency: In Canada, dividends are taxed at a lower rate than other types of income because the profits being paid out as dividends have already been subject to Canadian corporate income tax.
- Total return: The return from an investment in stocks consists of capital appreciation (change in the stock’s price) and dividend income. The latter can significantly boost total returns over time.
In terms of dividend strategies, a balanced portfolio should include dividend-paying stocks from different sectors and industries to diversify risk and potentially reduce the impact of poor performance in any one sector.
For example, in the Pender Small-Mid-Cap Dividend Fund that I manage, we target a fund yield (income generated by stocks held in the portfolio) of anywhere between two per cent and three per cent versus the indicated dividend yield of 1.83 per cent for the S&P SmallCap 600 index as of Aug. 31, 2023.
It’s important to pay very close attention to a company’s ability to pay a dividend as well as grow it over time. Companies that pay a very high proportion of their net income as dividends are scrutinized very carefully as it may not be sustainable, and a dividend cut is not looked at favourably by the markets.
It’s also important to select companies with strong balance sheets, a history of profitability and robust free-cash-flow generation.
A Canadian example (and portfolio holding) is Premium Brands Holding Corp. It has grown its dividend at a compounded annual growth rate (CAGR) of nine per cent over the 10 years ending 2022. An investor could have bought the stock for $8.60 at the end of December 2003 and collected total dividends of $29.09 per share over the following 20 years. Dividends on the stock account for almost a third of the total annualized return of 19.6 per cent over that time.
The ability of a company to pay a dividend may be influenced by the stage in its lifecycle. Some younger, fast-growing companies require capital to reinvest in the business to fund growth. For such companies, equity investors may be better off if the company defers return of capital to shareholders and reinvests it in the business instead. However, this capital allocation should be done to further a sustainable competitive advantage that will create economic value and higher rates of return in the future.
Another example (and portfolio holding) is Trisura Group Ltd., a growing and profitable speciality insurer. It does not pay a dividend as it has been reinvesting capital to support growth in the business. With an equity base of $530 million at the end of the second quarter and generating an operating return on equity of around 20 per cent, we expect the company to be able to grow its book value to $1 billion by 2027 and see it as an attractive, high-growth business with the ability to reinvest capital at high rates of return.
Do not let the dividend tail wag the dog when it comes to dividend investing. An investor’s primary job is to identify good quality businesses that pay sustainable and growing dividends and where the value of the company increases over time. Fortunately, compared to the United States, Canadian companies, on the whole, are more generous dividend payers.
Aman Budhwar, CFA, portfolio manager, Pender Small/Mid Cap Dividend Fund