If you’re one of those investors who likes stocks that are solid and steady, it’s easy to feel left behind by the last few months.
While the stock market has recovered much of the lost ground from the meltdown in March, the biggest rebound has been in volatile sectors like technology and gold.
But there is a bright spot. Solid, blue-chip, Canadian dividend-paying stocks that have lagged the hot sectors can be bought at reasonably attractive valuations, with relatively reliable and juicy dividends.
You can find these stocks in sectors like banking, insurance, telecommunications, pipelines, utilities, industrials and real estate. To be sure, like any equity investment, they come with significant risk. But many of them pay out dividends of four per cent to six per cent or more that you can pretty much count on, with good prospects for moderate dividend growth long-term.
“You’d have to go back to 2008 or 2009 in the Great Financial Crisis to get comparable yields,” says Oscar Belaiche, a dividend stock portfolio manager and head of the equity-income team at Dynamic Funds, owned by Scotiabank.
If you add in some dividend growth stocks with less yield but higher expected growth, you should be able to attain a combined yield of three per cent to five per cent with decent long-term growth prospects.
For retired investors in particular, that generates a lot more income than they now get from ultra-low yields on the fixed-income side of their portfolios, plus they can expect some dividend growth on top of that.
“If you’re clipping somewhere between three per cent and five per cent dividend yield … it’s a pretty good place to sit, versus a 10-year government bond earning you less than one per cent,” says Don Newman, a dividend stock portfolio manager with Fidelity Investment Canada.
For conservative investors, many of these Canadian blue-chip dividend stocks offer an attractive middle ground in the stock market. On the one hand, these quality dividend stocks are on far more solid ground than less steady companies often found in restaurants, hospitality, airlines, and oil and gas — sectors that have been devastated during the pandemic. Dividend cuts have become common for these susceptible businesses.
On the other hand, many of these blue chip dividend-payers have been impacted by the COVID crisis to a degree, and have been left behind by rocketing technology stocks that are seen as COVID winners but have soared to nosebleed valuations.
“Many dividend stocks are looked on as COVID losers,” says Newman. “As we return to normal, I think there is an opportunity for some of the dividend stocks to play catchup in terms of earnings and multiples.”
Belaiche and Newman look for quality companies at reasonable prices that generate lots of steady cash flow which ideally is also growing, and strong balance sheets without too much debt. “Invest in the best of the best and strongest of the strong,” is the way Belaiche looks at it.
They look to make sure that the proportion of profit devoted to dividends (the “payout ratio”) leaves plenty of money that can be reinvested profitably to grow the business and increase future dividends. A moderate payout ratio also provides a buffer to help get through recessions without dividend cuts.
These quality stocks should be in a good position to sustain their dividends through a severe recession like the one we’re in now with only a few exceptions, although a number of them will likely put dividend increases on hold for a while until conditions improve. (Of course, even blue-chip stocks come with substantial risk, and more widespread dividend cuts are always possible, particularly if the recession turns out to be far deeper and longer than expected.)
So far this year, the portfolios co-managed by Belaiche and Newman have each had only a single stock cut its dividend. (In both cases it was Suncor, which has many blue-chip characteristics but is in the oil and gas industry, which has suffered a steep drop in oil prices.)
If you’re hunting for dividend-paying stocks on your own, avoid the extremes of “ignoring yield” and “chasing yield.” In the search for income, many investors overlook attractive dividend growth stocks which may provide meagre yields of around two per cent or three per cent now, but come with strong growth prospects that drive future increases in the stock price and dividends. At the other extreme, investors often become overly enamoured by exceptionally high dividend yields, often a “red flag” that the dividend is at risk and growth prospects are poor.
Valuations for Canadian blue-chips look relatively attractive compared to other stocks, as shown by metrics like the price-earnings ratio (the “P/E” ratio, and calculated by taking the share price and dividing by earnings per share). Newman says that the P/E ratio for his portfolios is around 16 to 16.5, which is close to the long-term ratio for the market at around 15 to 16. Meanwhile, he compares that to a P/E ratio close to 23 for the S&P 500 index of large U.S. stocks, and a P/E ratio well over 30 for the technology-heavy NASDAQ composite index.
While Canadian investors are often most comfortable investing in dividend stocks from Canada, it’s a good idea to add foreign stocks to diversify by sector and country. Many Canadian dividend mutual funds (including those co-managed by Belaiche and Newman) include some U.S. and international stocks in sectors where quality Canadian stocks are lacking.
Quality dividend-payers undoubtedly give you downside protection relative to other stocks, but there is also reason to expect decent long-term total returns (which combine dividends and capital gains) from a starting point like today where valuations are fairly reasonable. Financial principles tell us to expect a tradeoff between risk and reward, so that the downside protection from reliable-dividend payers should lead you to expect lower returns over the long term, relative to riskier types of stocks.
But the historical evidence suggests returns for dividend stocks have done just fine, particularly in Canada. Research by RBC Capital Markets found that Canadian dividend-payers outperformed the broad S&P/TSX Composite Index by just over three percentage points a year in the period from October 1986 to July 2020. Dividend growers did even better, outperforming by just over five percentage points a year.
Meanwhile, a study using U.S. data from 1962 to 2014 found that moderately high-yielding dividend stocks reduced risk broadly across different styles and sizes of stocks. There was no general evidence of lowered returns (and in fact there were higher returns for dividend-payers in mostly non-blue-chip categories like growth, small-cap, and mid-cap). “Our results suggest that over the long term, at the very least, dividends reduce risk for all style and size portfolios, and sometimes increase return,” wrote Mitchell Conover, a finance professor and one of the authors of the 2016 study, “What Difference Do Dividends Make?”
If you aren’t buying individual stocks, your main choices for a ready-made dividend portfolio are exchange-traded funds (ETFs) versus mutual funds. There is plenty of evidence that most mutual funds don’t add enough value to offset their higher fees, so ETFs are usually the superior choice if you’re not confident you’ve found something better.
However, in my view, mutual funds can often still hold their own and sometimes add additional value to offset the higher fees if you choose them carefully and go with top-notch portfolio managers with proven track records.