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Slow and Steady Wins the Dividend Race
11/21/2012 8:30 am EST
Rather than focusing on short-term capital gains, savor reliable quarterly increases instead, writes Rob Carrick, reporter and columnist for The Globe and Mail.
The slow lane to investing success is where you'll find dividend enthusiast David McCaslin.
We live in an investing world where the capital gain is celebrated above all other investing outcomes. But McCaslin pays more attention to the money his stocks pay him each quarter.
Imagine a choice of having your stocks rise 15% over a short period of time, or receiving an average 7.5% increase in the dividends paid by your shares. The answer is a no-brainer for McCaslin, who retired in 2011 after spending 23 years as a Regina-based pension investment fund manager: "I'll take the 7.5% any day."
McCaslin contacted me earlier this month to share his thinking on dividend investing, which has become very popular lately because dividend-paying stocks have done so much better than the broader stock market lately. He offered some ideas not only on how to find good dividend stocks, but also on the mindset needed to prosper as an investor even when dividend stocks aren't market darlings. Let's further develop his thinking on the importance of the dividend, which he applies in bad times as well as good.
"My biggest concern is not whether companies I own are going to be up or down 15% next year," he said. "The most calamitous scenario that I can think of is that one of my stocks would reduce its dividend—or worse yet, eliminate its dividend."
Capital gains—where stocks rise above the price paid for them—are not immaterial to McCaslin. Ultimately, he seeks a total return based on capital gains and dividends together. But his main goal is long-term dividend growth, a preference that is out of sync with an investing world where stocks positioned to gain in price in the short term are best loved.
In his view, dividend investors must accept that their stocks will periodically be out of favor with both analysts and the broader markets. McCaslin said he recently looked up the stocks in his portfolio in a major survey of investment analysts' consensus recommendations. The result: 60% of his portfolio ranked as average or below average. He's okay with that because the survey zeroed in on stocks with big potential for capital gains in the 12 months ahead, and that's not his main investing goal.
"Over the long term, I'm looking for the same thing as everybody else, which is a very competitive total return," he said. "The difference is that I'm prepared at this point to be a lot more patient, and to take a significant part in dividend income."
McCaslin asked to keep his own investments private, but he did share some ideas on building a dividend portfolio. Off the top, he said a company should have a long history of paying dividends, ideally ten years or more for large companies.
He also seeks a record of not only paying a dividend consistently, but of increasing the payout on a regular basis. "Ideally, you'd like to see annual increases, but this is where some judgment has to come in."
The banks are a great example of this sort of judgment call. They were among the dividend-growth elite prior to the global financial crisis, then suspended dividend increases across the board for a few years.
Now, some of them are once again raising dividends on a regular basis. For example, Toronto-Dominion Bank (TD) has bumped up its quarterly cash payout four times in the past two years.
The fact that a company regularly increases its dividend is more important than the actual amount of the increase, McCaslin said. "If a company consistently increases its dividend, that itself says a lot. It speaks volumes to me about management."
With respect to dividend yield, he uses the S&P/TSX composite index as a benchmark, while also considering his cash-flow needs as a retiree. This week, the index yield was 3.2%.
In terms of individual stocks, he considers a yield of 6% or more a signal to avoid buying without doing substantial research on why the stock is out of favor with investors (a rising yield means a falling share price).
Another indicator McCaslin uses in selecting dividend stocks is the payout ratio, which looks at how much of a company's earnings are being paid out to shareholders in dividends. Standards vary from sector to sector, but generally he likes to see a ratio below 50% for most sectors, and no more than 80% for regulated industries such as electrical utilities and pipelines.
The extent to which dividend stocks have outperformed the broader market in recent years is striking. The S&P/TSX Canadian Dividend Aristocrats Index had a three-year cumulative gain of 22.5%, compared to 2.6% for the S&P/TSX composite index.
Dividend stocks like these have shown a clear ability to outperform the market in uncertain times, but what if the stock markets surge?
McCaslin said dividend stocks will underperform in the short term, and smaller, more speculative stocks will outperform. His advice for dividend investors: "Don't be distracted because the market is up 15% over the last month and you're only up 5%, or you're flat."
Successful dividend investors understand that rising dividends are a foundation for higher share prices, he added. They also understand that as much as dividend stocks are popular today, what investors mostly want is higher share prices.
"There's a pre-occupation with capital gains," he said. If you want to be a successful dividend investor, get past it.