Dividend Investing: Easily Beat the Market?

Edited Photo. Source: Flickr - daveynin

There is an advantage to purchasing Canadian companies in Cash/Margin accounts. Presumably to entice money flow into local stocks, the Government of Canada provides very favourable tax rates for Canucks who invest in Canadian companies who pay dividends.

This has led to a massive dividend investor following in Canada. Every so often a news article will come out declaring that any Canadian can earn $50,000 a year tax free... or something to that effect.

But should you join the party?

What are Dividends?

Dividends are basically payments made by companies to their shareholders, typically on a regular basis. It's basically profit sharing--a way of rewarding shareholders for their investment.

Most companies pay dividends from their profits instead of reinvesting those earnings back into the business. Therefore dividends are more typically seen in established, slower growing sectors.

Some companies which are unprofitable pay dividends as well (with borrowed money). To be safe, dividend investors often look for companies with a healthy dividend payout ratio: where dividend payments per share are much lower than net earnings share.

Forms of Dividend Investing

Dividend investing comes in two primary styles: dividend growth investing or dividend income investing.

The appeal of dividend growth investing appears very valid. Instead of focusing intently on company valuations, or blindly indexing, you purchase a portfolio of companies who reward their investors with growing regular distributions and hold them forever. The historical returns of this strategy have been pretty good.

The iShares Canadian Dividend Aristocrats ETF (CDZ.TO) is a good, broad measure for this strategy. It has returned 6.33% annually over the past ten years, solidly beating the iShares TSX Capped Composite ETF (XIC.TO) which returned just 4.49% annually.

Dividend income investing follows a slightly different logic. Investors choose larger companies with high yields, but adjust for payout ratio safety. The best long-term ETF capturing this strategy is the iShares Canadian Select Dividend ETF (XDV.TO) which returned 5.30% annually over the last decade. Again nicely outperforming XIC.TO.

A Bigger Picture

Dividend investors love to brag about the easy, passive dividend payments earned each month, or quarter. But many ignore total returns, diversification, and valuations.

I often see dividend investors concentrated in a few "old economy" sectors: financials, pipelines, utilities, telecoms, grocers, and REITs.

This strategy ignores some of the best performers on the Canadian market not noted for their dividends: Constellation Software, CGI Group, Shopify, Brookfield Asset Management, Canadian National, Canadian Pacific, and Fairfax Financial. You get all of these companies when you buy XIC.TO, and you get a growing share of them as they form larger parts of the total index.

While I can't argue about the past performance of these strategies compared to the overall Canadian index, I am sceptical of their future performance.

Future of Dividend Investing

One of my biggest qualms against pursuing this strategy is the inherent concentration is these so-called "safe sectors", which already form a large chunk of the broader Canadian stock market.

Since the financial crisis in 2008-2009, interest rates have been chopped and kept extremely low. This means "old economy", capital intensive industries have done very well as their borrowing costs dropped substantially.

This has prompted a huge increase in borrowing and fueled growth in assets and earnings per share.

In addition, the retail investing community still has a distrust of the stock market after two massive crashes in less than 10 years. When buying stocks in recent years, retail investors have gravitated to sectors which have been traditionally held for their stability: Canadian banks, utilities, grocers, etc. This is a big change from the 90s when money dumped into wobbly tech stocks--causing massive overvaluation there.

However, as a result of this money pouring in, the value of these slower growing, capital intensive sectors has exploded beyond comprehension relative to their growth prospects.

Loblaws (L.TO), the boring owner of Superstore and Shoppers Drug Mart, trades hands at a massive 31x last year's earnings! That's the same multiple given to fast-growing, capital light Google.

Emera (EMA.TO), an electric utility operator focused on the eastern seaboard, also trades at 31x earnings while carrying an ever growing debt pile.

Another dividend favourite, Enbridge (ENB.TO), trades at a similar multiple of 29x. All it does is transport goop through a massive network of pipes while carrying $40B of growing debt on its books. Great when interest rates are low, but those are destined to go up.

Our infallible banks are tied to the fat and happy Canadian housing market where young, impressionable, uneducated, and greedy buyers foolishly fight for wildly overpriced real estate they can't actually afford. The value of mortgages on our "safe" banks' books has rocketed higher with our housing boom.

When house prices correct to historical norms the effects will be devastating. Seeing how the U.S. and Irish housing crashes impacted their banks, I can imagine what a correction will do to ours... if it happens.

I'm Not Dividend Investing

If you choose to be a dividend focused investor, be very mindful of the risks going forward with this strategy. With the value of dividend favourite "safe" sectors bid up so high, I have good reason to believe dividend investing is going to substantially underperform my RM Balanced Portfolio in the years ahead.

Personally I'm staying clear, instead looking at the entire global stock market, sectors that grow, and my total returns. Many wise investors get burned by lack of diversification--don't be one of them.

Come back Friday as we dive into Step 3 of the Moose-approved Smith Manoeuvre.

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