Take the cash: The case for investing in Canadian dividend-paying companies
Do you know the only thing that gives me pleasure? It’s to see my dividends come in

- John D. Rockefeller

Investors love dividends, though let’s hope it’s not the only thing that gives them pleasure, as it did financier John Rockefeller, who was the wealthiest man in modern history.

Still, there’s nothing like getting a dividend cheque like clockwork to make one feel good about an investment. There are good reasons to own dividend-paying assets (whether in the form of shares in individual companies, or mutual funds or ETFs) — and some caveats, too. After all, no one type of investment is a slam dunk, otherwise we’d all be a Rockefeller.

What’s a dividend?

When you buy a share in a publicly traded company, you’ve bought a proportional share of the business. That entitles you to partake its growth. Companies that pay dividends send some of the cash they generate to their common shareholders, usually every three months. What you do with the cash is up to you. Some companies even pay special dividends—a one-time payment in addition to what you would normally receive—if they’re swimming in cash due to selling a business unit or winning a legal settlement, for example.

What’s so great about dividends?

Dividend-paying companies tend to share certain desirable characteristics. Here are some of them:

  • They tend to be successful businesses that generate positive cash flow;
  • They tend to be well-managed and financially sound because they know that the market (and investors) expect them to pay out regular dividends;
  • They tend to be large, well-established businesses in telecommunications, healthcare, consumer staples, banking, and utilities, that have been around a long time and will likely have a long future;
  • Their share prices are more stable than high-growth businesses.

For these reasons, investing in a basket of high-paying dividend companies has historically been very successful. A study by RBC Capital Markets that looked at 30-year returns from 1986 to 2016 showed that Canadian companies which paid dividends outperformed those that did not by a whopping 8.6 per cent (9.9 vs. 1.3%).

Companies which regularly raise their dividends are great inflation beaters. Even during periods of low interest rates, these firms may boost their payouts by double digits. How many workers get a 15 per cent raise every year?

The Canadian tax system favours income from dividends over interest or salary income. The Dividend Tax Credit means that investors who collect dividends from eligible companies will receive a non-refundable tax credit which can be applied against other taxable income, which will reduce the tax bill.

In addition to the direct financial benefits, investing in dividend paying companies comes with a psychological bonus. Even during market meltdowns, it’s much easier to avoid panicked selling when those cheques are rolling in. This income stability provides a buffer against the news headlines and helps investors stay the course and benefit from the fact that over the long term, markets always trend upwards.

Lastly, for those who reinvest their dividends or who participate in company programs called DRIPs (dividend reinvestment plans) which automatically purchase additional shares in lieu of cash payments, dividends are generated on top of dividends. This wealth compounding effect is very powerful over the long term.

But dividends do have a dark side

When interest rates and bond yields are at historical lows, the relatively more generous payments from dividends are very tempting. In fact, higher dividend-paying stocks, usually from telecommunication and utilities companies, are sometimes referred to as “bond proxies”. But make no mistake, equities are riskier than quality bonds. There is no guarantee that a company will not reduce or even cut its dividend, and equity prices bounce around a lot more, which some people may find stressful.

When investors “reach for yield” and rush to buy up dividend equities this causes their prices to rise—sometimes above fair value. Overpaying for an asset is a type of risk because it decreases the probability of future gains.

On a related theme, the prices of dividend-paying stocks are more sensitive to interest rates than those of non-payers. Here’s why: When interest rates are low, investors are more willing to take on equity risk to reach for a better return. However, as interest rates rise, bonds and other forms of fixed income start to look a lot more appealing. Investors may sell the stocks (causing their prices to fall) and replace them with safer bonds.

Diversification is a pillar of sound investing. If you only own dividend-paying companies, you’re also avoiding certain fast-growing industries, like high tech, for example, which typically don’t pay dividends but re-invest their earnings back into the business through research & development or acquisitions to fuel future growth.

While a very high yield is tempting, a savvy investor must determine whether such a high payout is sustainable. Some companies pay a high yield because their share prices are severely depressed. There may be a good reason why the market has assigned a low value to a company and this is a sign of caution. Also, a company may pay out more in dividends than they take in through business operations. Again, this could be a sign that the juicy dividend is at risk of being cut or eliminated.

And, lastly, unless dividends are received in a tax-sheltered (RRSP) or tax-free (TFSA) account, they’re subject to tax—whether you spend or reinvest them. In some cases, they can even bump you up to a higher tax bracket, especially due to the way the Dividend Tax Credit is calculated. If you receive means-tested government benefits, like Old Age Security, they could mean subject to clawbacks.

As in all things, balance is key. Dividends can be an important source of income but a well-diversified portfolio that is geared to total return, including capital gains and interest income, is the prudent choice for the long term.

Rita Silvan, CIM™️, is personal finance and investment writer and editor. She is the former editor-in-chief of ELLE Canada magazine and is an award-winning journalist and tv media personality. Rita is the editor-in-chief of Golden Girl Finance, an online magazine focusing on women’s financial success. When not writing about all things financial, Rita explores Toronto’s parks with her standard poodle.

Rita Silvan is a paid Sonnet spokesperson.

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