The Globe and Mail, Report on Business
Published November 12, 2011
By Tom Bradley
I recently watched a promotional video that outlined the reasons for owning dividend-paying stocks – tax-efficient income, lower volatility and you get paid to wait for markets to recover. I agreed with all the fund manager’s points, but he failed to mention that investors tend to get sloppy when it comes to income and dividends. The level of analysis and discipline that goes into buying tech or industrial stocks isn’t always evident when higher-yielding stocks (and structured products) are involved. Too many decisions are made for the wrong reasons. Here are a few of them.
For income investors, one number takes on disproportionate importance – yield. If I invest X dollars, how much regular income will I receive? Is it 4 per cent, 5 per cent, 6 per cent?
It’s perfectly appropriate to build a portfolio from a subset of securities that have a yield above a certain level, but once a stock qualifies on that basis, it’s time to determine what it’s worth. Is the price reflective of the company’s assets and growth prospects? Can the underlying business support the dividend payments over the long run?
The early days of income trusts provide a great example of when current yields unduly influenced purchase decisions. Trusts were a burgeoning area of the market and, as a result, the analysts tended to be less experienced. Too many of them were valuing trusts based on the yield spread above government bonds, instead of determining what the businesses were worth. Incredibly, interest rates were perceived to be a bigger risk factor than revenues and profits.
Return of capital
Today, the wealth management industry has embraced an exciting not-so-new tax deferral strategy. It’s called “return of capital” and it works like this. A product has an advertised yield of 6 per cent, but is earning only 3 per cent from interest, dividends and capital gains (after fees). The investors’ capital is used to cover the rest of the distribution. It’s a marketer’s dream. The client makes up the shortfall and it’s positioned as a selling feature. “Buy now and you’ll receive a tax-efficient 6 per cent yield.”
There are investment products where return of capital is part of the design and is communicated as such. There are too many others, however, that aren’t quite so forthcoming.
I have a friend whose parents live in Ireland. For years they invested most of their savings in Irish banks and insurers. When the financial crisis hit in 2008, they lost virtually everything. I tell this story because Canadian investors love their banks too. Layered throughout their portfolios are bonds, preferreds and common shares issued by the Big Five.
Now, I’m not here to bash the banks. They’re some of the best in the world and play a significant role in my portfolio. But that doesn’t get around the fact that they’re highly leveraged businesses and are all driven by the same economic factors. Income investing isn’t an excuse to not be diversified across different types of companies and asset classes.
In poor markets, it’s easier to hold on to a stock that’s paying an attractive dividend. As long as the income stream is secure, it’s a good thing. Conversely, that same dividend can cause an investor to hold onto a stock when it gets expensive. “I don’t care if it goes down … I’ll get my dividend.”
But consider the following example. You hold 100 shares of Company A priced at $10. It’s yielding 4 per cent, but your adviser thinks it’s getting overpriced. You decide to sell A and buy 100 shares of Company B, which is also $10, but looks considerably cheaper. Over the next year, A goes down to $8, while B rises to $12. At that point, you reverse the trade and find yourself with 50 per cent more shares in A and 50 per cent more income.
This trade is a favourable example for sure (and transaction costs and taxes have not been accounted for), but it’s meant to reinforce the point that there’s a cost to holding an overpriced stock, dividend or no dividend.
When it comes to income investing, yield and tax efficiency are important, but they have to take a back seat to diversification and valuation. Sometimes the best strategy is to accept a lower current yield and own a broader range of securities.