It used to be that income-seeking investors could find decent yields in fixed income. Not so anymore. With bond payouts still near historic lows and slow global growth muting capital gains, there’s only one way for Canadians to get a decent total return: by buying dividend-paying stocks.
That’s been a blessing and a curse. While these stocks have helped investors generate decent returns, it’s also made many of these companies, and in particular the more stable, higher quality consumer goods, telecom, utilities and REIT operations, more expensive. For instance, the S&P 500 Utilities Index’s forward 12-month price-to-earnings ratio is 16.3, while its 10-year average is 14.6.
Unfortunately for price-conscious investors, the demand for dividends isn’t going to disappear anytime soon, says Jason Gibbs, a portfolio manager with 1832 Asset Management. There are several structural issues that will keep yield-producing companies in the spotlight, including prolonged low interest rates. While rates may rise somewhat over time—potentially causing interest rate-sensitive sectors to fall in the short-term—central banks can’t spike rates back to where they used to be without creating some sort of crisis, he says.
North America’s population is also getting older—the first baby boomers turned 70 in 2016—and aging investors have always loved dividend stocks. “They want to protect capital, save money and generate income,” he says. “They’re not interested in finding the next hot thing.”
Global debt-to-GDP ratios are at all-time highs as well, says Gibbs, which tends to result in lower growth and lower inflation. That then keeps investors focused on defensive operations that offer modest gains and dividends.
All that said, dividend-paying stocks can still add value to portfolios. If a stock can return about 3.5% in gains over time, and can pay a 3.5% annual dividend, then you’ve got a respectable 7% return. Investors, though, must pick their spots, says Gibbs.
Be careful about buying companies with too-high valuations or overly aggressive dividend yields. An extremely high yield could be sign that the stock is falling—yields rise when stock prices drop—while a company with an above average price-to-earnings ratio could fall harder than a more reasonably priced stock if the company runs into trouble. Check out MoneySense’s Canada’s Best Dividend Stocks for information on tickers with appropriate valuations, yields and price-to-earning ratios.
Gibbs is seeing value in some defensive sectors as investors have jumped into cyclical industries, such as industrials, since the U.S. election (many people now think that a Trump victory could be good for economic growth). That’s caused consumer staples, telecoms and utilities to take a time out, says Gibbs.
Most investors will hold dividend-paying companies even if they’re not specifically looking for income, says Gibbs. Many stocks do pay something and you can find yielding operations across all 11 sectors. When buying dividend payers, watch the payout ratio, which is the percentage of earnings a company pays out in dividends—it depends on the sector, but generally you don’t want the number to be too high compared to its peers, between 40% and 80% depending on the sector.
As well, look at free cash flow, how much debt a company is carrying—a debt-to-EBITDA ratio of three times is getting high, says Gibbs—and how they’re spending their money. It’s a good sign if a company has money left over after paying for capital expenditures and dividends. Stay away from businesses that are spending more than they take in. One of the worst things that can happen to a one of these companies is a dividend cut.
Ultimately, people need the money, just be careful about overpaying for it in today’s income-hungry market. “These are still good companies,” Gibbs says. “You just have to do your homework.”
How to buy dividend stocks
Investors have plenty of choice when it comes to buying dividend stocks. Which method is right for you?
There are myriad ways to buy dividend stocks, says Jason Gibbs, a portfolio manager with 1832 Asset Management. Any investor can buy a company directly and collect a quarterly dividend. There are also numerous dividend mutual funds, like Gibbs’ Scotia Canadian Dividend Fund, which has a 3% annual payout. In many cases, funds send a monthly cheque to investors, who can pocket the cash or reinvest. While every dividend fund varies, you’ll want one that’s diversified and requires its companies to increase its payments every year, says Gibbs.
Dividend-focused exchange-traded funds (ETFs), which are cheaper than mutual funds, are also an option and offer quick access to a diversified basket of payers. However, be sure that these ETFs, especially the Canadian ones, aren’t concentrated in too few sectors. The iShares S&P/TSX Canadian Dividend Aristocrats Index is relatively differentiated, with 23% in financials, 21% in energy, 18% in industrials plus holdings in consumer discretionary, real estate, utilities and more.
Even more important however is to make sure your fund is holding high-quality stocks. “There are a lot of good companies that have been around for a long time,” Gibbs says. “These are the ones I try and own.”