Since transaction costs are minimal and taxes a wash, you should be indifferent as to whether you are paid a dividend or manufacture a dividend (by selling shares). In theory, a dividend simply takes something that is already yours (cash on the corporate balance sheet) and places it in your personal bank account.
Reality is quite different – there are great reasons to invest in dividend stocks.
At the corporate level, there are a number of arguments as to why some companies should pay dividends. Perhaps the biggest is that dividends enforce discipline on company management by restricting cash flow. This forces managers to limit projects to those with a higher IRR (Internal Rate of Return).
In contrast, cash-rich companies that don’t give cash back to shareholders are more likely to waste money on low IRR projects or acquisitions that only serve to bolster executive pay. Instead, these companies should be giving cash back to shareholders who can then re-allocate to companies with higher return projects.
Dividend policy can also signal insiders’ confidence in the future. The current economic crisis is a perfect example. While some companies have recently cut their dividend (e.g. Wells Fargo) to free up cash in a collapsing environment, others have actually raised dividends. A company that raises its dividend during an economic depression signals to the market the resilience of its cash flows. In today’s environment, I’m much more comfortable giving my hard-earned cash to companies that are still raising dividends.
At a more personal level, I like dividends because they help me stay disciplined. A stock with a 5% dividend yield at the time of purchase provides me a 5% return regardless of the stock price. Knowing this, I’m less likely to make emotional buy and sell decisions. It’s purely psychological, but a known cash return that accumulates in my account beats an unknown potential return that sits in a company’s account (or is tied up in other corporate assets).
While I can manufacture those cash dividend returns by selling shares as they increase in value, this requires more intervention on my part. Do I systematically sell each quarter? Or only sell when share prices rise to crystallize some of my gains? Do I sell a fixed percentage or dollar amount? Do I stop selling when prices fall?
While these questions can be answered and a systematic process created, the emotional gyrations of the market could make me change the process at the worst time. In contrast, if a stock declines but I know I’ll continue to receive my 5% dividend I’ll be more inclined to hold on.
If you’re like me, activity is detrimental to your investing returns. The more I sit tight, the better I do. So any investing strategy that helps me avoid unnecessary activity is helpful.
Because any management team that has the conviction to raise a dividend during an economic depression is confident in their company’s ability to pay that dividend in perpetuity. They have every excuse to not raise the dividend, yet they made the explicit choice to do so. This level of conviction from company insiders gives me – the investor – greater confidence in the viability of the business and its ability to pay its bills while generating enough free cashflow for stockholders.
Here are a few Canadian (TSX-listed) companies that have recently raised their dividends. This isn’t necessarily a recommendation to buy, but use this information as part of your mosaic of research into dividend paying stocks.
These announcements all happened between June and August 2020:
Declared a dividend of 8c (US$) / share, a 14% increase on the previous quarter’s dividend.
Ritchie Brothers Auctioneers
Increased dividends by 10% to $0.22.
Increased dividend by 6% to $0.70 per common share.
Increased quarterly dividend by 25% to C$0.05 per common share.
Capital Power Corp
Declared a quarterly dividend of $0.5125 per common share compared to the previous $0.48 dividend represents a 6.8% increase, and an annualized dividend of $2.05 per common share.
Increased its annual dividend by a further 12% to $0.07 per share.
Increased dividends by 14.5% to $0.95.
Empire Company Ltd
Declared a quarterly dividend of $0.13 per share, an increase in the annualized dividend rate of 8.3%.
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A reader recently asked me about the TSX-listed iShares S&P/TSX Composite High Dividend ETF (XEI). XEI invests in a range of dividend paying Canadian companies and features a 6.26% distribution yield (June 30, 2020). The ETF pays roughly $0.075 to $0.091 per share on a monthly basis providing an attractive income stream. XEI’s management fee is 20bps.
Is XEI too good to be true? Or is it a great income provider?
Currently, XEI remains about 26% below its February 20, 2020 peak before the Covid-19 market crash. In comparison, the S&P/TSX Composite Index only remains about 13% below it’s February 20th level. This divergence can mainly be explained by differences in the holdings. The S&P/TSX Composite Index, for example, holds gold miners and Shopify which have been performing very well since the March 23rd bottom. In contrast, XEI is heavy into financials and energy, both of which have lagged. As a dividend fund this makes sense.
XEI seeks to replicate the S&P/TSX Composite High Dividend Index. For this reason, the growth and momentum names that don’t pay dividends are excluded from the portfolio.
Effective June 13 2017, the fund’s name was changed from iShares Core S&P/TSX Composite High Dividend Index ETF to iShares S&P/TSX Composite High Dividend Index ETF.
To understand how XEI operates, one must look at the methodology of the underlying index. The S&P/TSX Composite High Dividend Index consists of 50 to 75 stocks selected from the S&P/TSX Composite focusing on dividend income. The index is market-capitalization weighted, with stocks capped at 5% and each sector capped at 30%. The index rebalances quarterly.
To be included in the index, a stock must be a member of the S&P/TSX Composite and have a non-zero indicated annual dividend yield. Selection is done step by step, as follows:
As of the reference date for the Composite rebalancing, S&P Dow Jones Indices determines the median indicated annual dividend yield of all stocks in the S&P/TSX Composite with non-zero indicated annual dividend yields.
The 75 stocks with the largest indicated annual dividend yield, from those stocks which have indicated annual dividend yields above the median calculated in step 1, are selected to form the index. Current index constituents are not removed unless their indicated annual dividend yield falls below the 85th position. Stocks that are not current index constituents with an indicated annual dividend yield ranking above the 65th position are automatically added to the index.
If step 2 yields fewer than 75 stocks but more than 50, stocks with indicated annual dividend yields greater than or equal to the median form the index. The buffer thresholds given in step 2 continue to be 10 ranking positions above and below the number of constituents.
If there are fewer than 50 stocks with indicated annual dividend yields above the median, stocks are added in descending order of indicated annual dividend yield below the median until a total of 50 stocks are included.
The index is market-capitalization weighted subject to a maximum weight of 5% for each stock and 30% for each GICS Sector. The caps are established at the quarterly rebalancing and are not revised until the next quarterly rebalancing.
Based on this methodology, the portfolio will provide exposure to the highest-yielding dividend stocks in the S&P/TSX Composite Index, regardless of quality. Unlike some other dividend ETFs, XEI doesn’t factor in dividend growth or longevity.
Since its April 2011 inception, on an annualized basis XEI has returned 3.09% (ending June 30, 2020). If you held until January 31, 2020 (thus avoiding the Covid-19 mess), you would have received an annualized 6.27%.
Looking back 5 years (ending June 30, 2020), XEI returned 1.23% annualized vs. S&P/TSX Capped Composite Index’s 4.45%.
For the 5 years ending January 31, 2020, XEI returned 5.62% annualized vs. S&P/TSX Capped Composite Index’s 6.53%.
While fees can explain some of the difference vs the broad benchmark, it is clear that the lack of growth names has caused total returns to lag somewhat – especially recently.
Why is the distribution yield so high?
XEI sports a 6.26% distribution yield. While total returns matter, many investors are attracted to this yield. The yield is based on the underlying components of the ETF, 49.08% of which is concentrated in the top 10 holdings.
The top 10 stocks held by XEI have dividend yields ranging between 4.74% and 8% (as of June 26, 2020). These ten holdings contribute to about half of XEI’s overall distribution.
Many funds top up their distributions by returning capital to investors. In contrast, XEI is mostly distributing dividends the fund receives from underlying holdings. In 2019 about 8% of the distribution was considered return of capital, whereas in 2018 and 2017 there was none. Most of XEI’s distribution is organic as opposed to manufactured.
While XEI imposes a 30% cap on sector weights the fund is still quite concentrated. I would expect this, given the nature of how the ETF is constructed (essentially a sort and rank of dividend paying stocks). Naturally, XEI will have higher exposure to areas of the market that have higher dividend yields – financials, energy, utilities. 73% of the ETF is concentrated in these three sectors.
It is interesting to note XEI’s high portfolio turnover. Clearly this has to do with the construction and rebalancing methodology.
Compare XEI’s 2018 turnover of 49.86% to that of the FTSE Canadian High Dividend Yield Index ETF (VDY), which is just 22.90%. This may be a nothingburger, but higher turnover strategies tend to be indicative of higher costs. However, with XEI’s management fee of just 20bps this doesn’t appear to be much of a concern.
XEI will never hold high-flyers like Shopify or junior gold miners. So investors need to recognize that it might underperform the broad market during periods in which momentum or growth are favoured.
Given the construction methodology, it is expected that many names within XEI might have historically been poor performers. (Dividend yields rise as stock prices fall.) There is no discretion applied to what names are in XEI, so there inevitably will be a mix that could includes dogs at risk of dividend cuts. Luckily exposure to any single company is limited to 5% at the time of rebalancing.
There may also be companies with well-supported dividends that have simply underperformed (driving up the yield) for other reasons.
Conclusion: don’t buy XEI for the yield. Buy it because you like most of the companies it holds. If you think most of the underlying holdings will continue to pay their dividends and are good long-term holdings, then XEI is a convenient way to invest in those companies.
Corporate executives have an ability to send ‘signals’ to the market about the health of their organization. One such signal is dividend policy.
In particular, if a company increases its dividend – particularly in a bad economic environment – it signals management’s confidence in the company’s future prospects. It also indicates the company has the cash to continue paying its dividend.
If I’m going to invest in a company right now, I want to know that the company’s executives are confident. While I wouldn’t rely on this single factor to make an investing decision, I believe it provides good corroborating evidence for an investing thesis that might already exist.
May of 2020 was one of the worst months ever for the US economy. Yet there are a handful of large cap US companies that are increasing their dividends, which I have listed below:
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May Dividend Increases (US Companies with Market Cap >$10b)
I’ve met many people over the years who love their dividend stocks. They buy Canadian staples like Royal Bank, TD, BCE and Enbridge for their consistent, growing (usually) dividends.
If you’re an income investor, there’s nothing wrong with this for the equity portion of your portfolio. But there’s a way to get the fixed income side working harder – by using preferred shares.
Preferred shares are hybrid securities that pay dividends (often fixed). Preferred share dividends must be paid out before common share dividends, making them a more reliable source of income.
In the event of a dissolution or liquidation of the issuer, preferred shareholders’ claims on assets are senior to common shareholders but behind debt holders.
The share price of preferred shares can change significantly but tends to be more stable than common equities. This is a positive and a negative, depending on how you look at it. Preferred shares don’t participate in the upside profits from ownership of the company and usually have no voting rights unlike common shares. However, they might decline less than common equities from the same issuer in down markets.
Because preferred shares are often redeemable at a specified par value and pay a fixed dividend, they can have similar characteristics to bonds. Namely, they are more interest rate sensitive than common shares. Because of this, at times the prices of preferred shares can move in different directions to their common stock counterparts.
A big benefit over corporate bonds for Canadian investors using non-registered accounts is certain Canadian preferred shares are eligible for the dividend tax credit. (I.e. a 5% yield on an eligible Canadian preferred share is worth more after tax than 5% on a similar bond.) Another advantage over bonds is the higher pre-tax yield. Of course, this is because bonds are ranked higher in a company’s capital structure and tend to be less volatile.
As you can see, preferred shares are an asset class that belongs somewhere between stocks and bonds. As such, they can be used to fine tune a portfolio potentially replacing some of the equity or corporate bond portion, depending on an investor’s individual situation.
Warning: Over the long-run you’d probably be better off NOT using preferred shares as an equity substitute. They don’t participate in the upside – that’s a big tradeoff for an investor with a long time horizon.
There is a lot to look for when buying individual preferred shares:
Yield to call/redemption
Term to maturity – perpetual vs retractable
Payment provisions – fixed, floating, re-settable
Dividend policy – cumulative vs. non-cumulative
Ideally, a portfolio of preferred shares is diversified by issuer and type. Quite frankly the dumb/lazy investor like myself has no time or energy for this kind of research and maintenance. Instead, I prefer to use an ETF.
Below I’ve listed 3 of the largest preferred share ETFs that are traded on the TSX:
iShares S&P/TSX Canadian Preferred Share ETF (CPD)
This ETF provides exposure to a diversified portfolio of Canadian preferred shares and can be used to diversify sources of income beyond traditional government bonds and GICs.
Key facts (as at May 25, 2020):
Yield: 6.05% (trailing 12mth distribution yield)
Distribution Frequency: Monthly
Top 3 Sectors: Banks (35.83%), Insurance (20.98%), Energy (15.67%)
Management Fee: 0.45%
RBC Canadian Preferred Share ETF (RPF)
This ETF provides access to a diversified portfolio of rate-reset preferreds in a single ETF. The ETF is actively managed by investment teams with expertise in company-level fundamental research, credit analysis and interest rate forecasting.
Key Facts (as at May 25, 2020):
Yield: 6.81% (dividend yield)
Distribution Frequency: Monthly
Top 3 Sectors: Financials (59.70%), Energy (22.60%), Utilities (14.80%)
Management Fee: 0.53%
BMO Laddered Preferred Share Index ETF (ZPR)
This ETF is designed for investors looking for higher income from their portfolios. The ETF invests in a diversified portfolio of rate reset preferred shares and has lower interest rate sensitivity than the full preferred share market.
Key Facts (as at May 15, 2020):
Yield: 6.81% (distribution yield)
Distribution Frequency: Monthly
Top 3 Sectors (May 25, 2020): Diversified Banks (39.17%), Oil & Gas Storage and Transportation (21.43%), Life & Health Insurance (7.53%)
If you’ve watched CNBC lately all you see is doom and gloom. If it bleeds it leads, so naturally media has a bias to publish scary stories. And there have been plenty over the past couple months.
Many of these recent stories included high profile dividend cuts at companies with big brand names: American Airlines, Expedia, Southwest Airlines, Walt Disney Company, Estee Lauder, General Motors, Hilton Worldwide, Boeing, Ford, Macy’s, Gap, Nordstrom…just to name several.
This is enough to make a dividend investor want to wait it out on the sidelines.
Despite the negative news about dividend cuts, the number of positive (increases) and negative (suspensions and decreases) dividend actions is surprisingly balanced.
The negative actions make sense and there are undoubtedly more cuts to come. But the increases?
Put yourself into a corporate executive’s shoes. The economic shit-storm is no longer a surprise to any executive choosing whether or not to pay dividends. Many corporate executives now have enough information to determine whether their company can continue to pay – or even raise – dividends. So many companies are indeed in a position to raise dividends.
Consequently, since March 1st 40 companies in the S&P 500 have voluntarily chosen to INCREASE their dividends. Some by significant amounts.
For those relying on a dividend for retirement or investment income, a dividend suspension can be quite a shock. However, if you’ve been following my suggestions you are properly diversified and fairly insulated from the negative shock from a single holding or sector.
But that’s in the past. Like the executives leading these corporations, what you need to do now is think about the future. Executives typically don’t raise dividends when the see a dark future for their company.
Which companies increased dividends? Below I’ve listed them in order of % dividend increase. The average increase was 7.44%, ranging from 0.36% to 78.57%. Personally, I think any company raising dividends by 5% or more in this environment has to be pretty confident about the future.
Note that one company initiated dividends in May (Otis Worldwide Corp).