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I am now approaching three months into my young blogging career and I want to thank everyone who has taken the time to reach out to me with feedback and suggestions. I have received a number of requests for information on several different topics and I will do my best to accommodate everyone. This feedback and enthusiasm confirms that you are hungry for information and are engaged in your financial future and for that I am grateful.
Today’s entry will be part 1 of a 3 part series on dividend investing and more specifically dividend growth investing within the Canadian and US equity markets. In the last two weeks alone, I have received requests from four clients to address this concept and today I will focus on basic terms and fundamentals specific to dividends generated from common shares of publicly traded companies as well as the case for dividend income given today’s slower growth economic environment and persistently low interest rates.
Dividend Fundamentals and Glossary
Dividend income is defined as a distribution of a portion of a company’s earnings, decided by a board of directors, to a class of shareholders. The amount of the dividend is quoted in terms of the dollar amount each share receives (Dividends per share) and is often quoted as a percentage of the current stock price or Current Yield.
Yield on Cost is calculated by dividing the most recent annual dividend payment by the cost per share. The goal over time is to increase this yield by investing in shares of dividend growers. This yield will grow as dividends are increased while the original cost of the shares is fixed. This is an important concept that I will spend more time on in part 2 of the series.
Dividend Payout Ratio is simply the percentage of earnings paid to common shareholders in dividends and may be calculated as dividends per share/earnings per share or total dividends/net income. The payout ratio provides an idea of how well earnings support dividend payments. Generally speaking, more mature less cyclical dividend paying businesses tend to have a higher payout ratio than more capital intensive or cyclical businesses. Most dividend paying companies try to achieve a stable dividend level and many companies will specify target payout ratio ranges. For example, most of the major Canadian banks have a stated target payout range of 40%-50% of earnings with the exception of BMO at 45%-55% and TD at 35%-45%.
These ranges are just guidelines and the payout ratio may exceed the range for short periods of time. For example, a majority of the Canadian banks had dividend payout ratios above their target range during the 2008-2009 financial crisis. Generally speaking the lower the payout ratio, the safer the dividend and the more room for dividend growth.
The Dividend Payout Ratio is only one tool in evaluating a company’s ability to sustain its dividend. When comparing dividend payout ratios between two companies or sectors, here are a few other items to consider:
North American Dividend Landscape
In a slow growth and low interest rate environment where equity markets have for the most part moved sideways over the last 10+ years, investors are demanding more dividend income. This is true not only of individual investors living on a fixed income or looking to build their portfolios for use during retirement but is also true of institutional investors such as large pension funds who have less flexibility with their fixed income investments than retail investors and are using long-term return assumptions of between 7% to 8%. Historically dividend income accounts for approximately 60% of North American market returns over long-term periods of at least 20 years. However over the last 10 years in a sideways market dividends have accounted for approximately 90% of the returns produced by the S&P500 and 75% of the returns of the TSX60.
While dividends earned from Canadian companies qualify for the dividend tax credit and are taxed much lower than dividends from foreign companies, building a well diversified portfolio of large cap Canadian companies is challenging to say the least. When examining the constituents of the TSX60, an index of the largest Canadian companies by market capitalization, it doesn’t take one long to conclude that over half of the 60 companies are either in the resource sector or in cyclical capital intensive businesses outside the resource sector. Many of the former royalty trust gas funds that recently converted to Canadian corporations have had to reduce their dividends by as much as 50% recently due to persistently low natural gas prices. Not what you want to see when you are relying on the income to fund your retirement.
Remembering our checklist for dividend sustainability from above, the safest and most consistent dividend payers tend to come from more stable and less economically sensitive sectors such as the consumer packaged goods, pharmaceutical industries and more recently mature technology companies, three sectors that are not well represented in the Canadian market. Even the Canadian banking sector, which produced double digit compounded dividend growth over a 15 year period, got stopped in its tracks in 2008 and froze dividends until mid 2011.
The scarcity of high quality non cyclical dividend paying companies is creating an insatiable demand for the handful of these companies that are liquid enough to attract large pools of capital. This demand/supply imbalance is causing these stocks to trade at a significant premium to the rest of the Canadian market and their US brethren. To illustrate this phenomenon let’s take a look at Enbridge. Enbridge is a well run energy storage and transportation company with a good dividend growth track record that currently trades at a substantial premium to the market at 25x earnings with a 3% dividend yield and an expected compound earnings growth rate of 7 to 10% over the next 3 years. Contrast this with a company like Johnson and Johnson, which has increased dividends every year for the last 49 years and trades at 12x earnings with a higher 3 year forecasted rate of earnings growth than Enbridge. At half the valuation of Enbridge, I would much rather own Johnson and Johnson.
With a focus on not only earning a high current yield from dividend paying stocks but also on growth of dividends, I have a healthy weighting of US stocks in client portfolios. There are many large well run businesses with sound balance sheets and long-term track records of profit and dividend growth domiciled in the US . Many of these companies are probably well represented in your grocery cart or at the Home Depot (incidentally a company that has grown its dividends at an 18.7% clip over the last 10 years!). We expect continued dividend growth from these companies but also capital appreciation given that many trade at a discount to the market and their long-term historical valuations.
