5 Reasons the Dividend Rally Has Legs

05/08/2013 10:15 am EST

Focus: DIVIDEND

Sure, dividend stocks have been on a tear, but they aren't headed toward a cliff. Here's why, writes John Heinzl, reporter and columnist for Globe Investor.

The doomsday dividend scenario goes something like this: Income-starved investors have pushed dividend stocks to unsustainable levels. As soon as interest rates rise, money will pour out of equities and into bonds, bringing the dividend party to an abrupt and painful end.

Scary narrative for sure, but it's not going to happen.

It's true that dividend stocks have been posting impressive gains: Even as the S&P/TSX composite index has gone basically nowhere in the past year, many classic dividend payers such as pipelines, telecoms, and consumer staples stocks have delivered double-digit returns.

It's also true that dividend investing, which fell out of fashion during the heady growth days of the 1990s, is very much back in vogue. In recent years, there's been an explosion of dividend-oriented financial products, investing blogs, and Web sites. Why, even some financial columnists regularly trumpet the glorious benefits of dividend investing.

But none of this means that dividend stocks are about to head over a cliff. Far from it. Here are five reasons that the dividend boom is here to stay.

1. Retirees Will Need Income
Over the next couple of decades, millions of boomers will retire, pushing the number of people age 65 and over to nearly 25% of the population, up from about 15% currently.

Retirees tend to be conservative, buy-and-hold investors who want a steady, predictable income stream. High-quality dividend stocks provide that. Plus, unlike bonds and guaranteed investment certificates, many dividend stocks increase their payments regularly, providing protection against inflation.

2. Companies Have Mountains of Cash
Companies are sitting on record amounts of cash—more than $1 trillion in the United States, according to some estimates—and investors are increasingly eager to get their hands on it.

Apple (AAPL) recently hiked its quarterly payment by 15%, becoming the biggest dividend payer in the world. Companies that can't find more productive uses for their cash will be under increasing pressure to return it to shareholders.

3. Payout Ratios are Poised to Rise
Three or four decades ago, companies on average paid out about half of their earnings as dividends. After investors started favoring capital gains in the 1980s, however, the payout ratio dropped to about 30%.

But with more US companies increasing or initiating dividends—there were 3,154 such "positive dividend events" in the 12 months ended March 31, up from 2,120 the year before, according to S&P Dow Jones Indices—the average payout ratio has risen to about 36%. And it may well head higher.

"The dividend cycle is solidly back on the upward track, with both investors and companies viewing them positively," said Howard Silverblatt, senior index analyst at S&P.

4. Dividends Have Tax Advantages
Thanks to the dividend tax credit (DTC), Canadian dividends are taxed at much lower rates than interest from bonds or GICs. At low-income levels, in particular, tax rates on dividends are tiny—and in some cases even negative.

In fact, in several provinces, an individual with no other sources of income can earn nearly $50,000 in dividends without paying any tax at all! Such tax advantages will make dividend stocks a compelling investment for a long time to come.

[Editor's Note: US dividends, in most cases, also have favorable tax treatment, despite the best efforts of some politicians.]

5. Dividend Stocks Aren't Expensive
True, some dividend stocks have shot up in price, but on the whole price-to-earnings ratios are not out of line.

The S&P/TSX Canadian Dividend Aristocrats Index Fund trades at a P/E of 16.7 based on trailing 12-month earnings, and the Dow Jones Canada Select Dividend Index Fund has a P/E of 12.7, according to iShares. That compares with a P/E of 15.5 for the broader S&P/TSX composite index.

Some dividend stocks still look cheap on a P/E basis: The Big Five Canadian banks, for example, are trading at P/Es of between ten and 12.

Read more from Globe Investor here...

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