November 11, 2011

Did you know …. all about dividends?

Filed under: Investments — Tags: , — MikeT @ 8:17 pm

Dividends have long been associated with stability and strength. After all, it is usually the strongest and most stable companies that can pay, maintain and even grow their dividends year in and year out. Given the current investment environment; slowing economic growth, a sovereign debt crisis, general economic uncertainty, there has never been a better time to focus on the strong and stable.

Typically defined as the regular payments that are paid out to investors out of a company’s profits, dividends also form an important role in the calculation of total investment return. From a historical perspective reinvested dividends have been responsible for approximately 40% of the investment return of the TSX/S&P over the past 10 years. Although this return representation is impressive domestically it is even more so globally, as dividends have contributed approximately 60% to the return of the MSCI World Index over the last 40 years.

More recently the effect that dividends have on return can also be seen. Over the past 10 years (period ending August 31/2011) the MSCI World Index has experienced a negative return of 10% (this is a simple return and is not compounded) vs. a return of 7% on the MSCI Total Return Index. Although these indexes are comprised of exactly the same stocks the return differential can be explained simply by dividends, which are assumed to be reinvested in any total return index.

While the investment rationale for investing in companies that pay a dividend is compelling, it is not without risks. Beyond the dividend payout, one must also consider the stability of the dividend. In other words, how likely is it that the company will be able to continue to pay their dividend going forward?  To their dismay many investors in Manulife Financial discovered this in the first quarter of 2009 when the company cut its dividend in half, with the share price following.

Manulife may be a high profile example of a dividend cut, however, the reality is that more often than not, many corporations actually increase their dividends. In fact, despite the slow pace of the economic recovery, numerous companies have recently raised their payouts. For example of the 60 companies listed on the S&P/TSX 60 index, 58 pay a dividend and approximately 35 of those companies have increased their dividend payout over the past year. Moreover up until 2008 the big six Canadian banks had all increased their dividends almost every year. In December of 2010 after a three year hiatus National Bank of Canada became the first of these big banks to raise its dividend since the financial crisis. Since then all of the big six with the exception of Bank of Montreal have followed suit.

Though the dividend payout ratio may be one aspect of the investment selection process, it is far from the only one. Traditionally companies with high payout ratios have experienced one of two events. They have either increased their payout or the valuation of their shares has fallen substantially.  Consideration should then be given to those companies with strong balance sheets, a history of growing their dividends and the ability to sustain them. With US non financial companies now holding nearly $2 trillion in cash on their balances sheets, a level that is the highest in about 50 years, the possibility of further dividend increases and shareholder reward certainly exists.

And really, who doesn’t love being rewarded? There is perhaps no better feeling. On this topic oil tycoon John D. Rockefeller once said “Do you know the only thing that gives me pleasure? It’s to see my dividends come in”. This also brings to mind the old proverb “a bird in hand is worth two in the bush”, as its lesson suggests that one should not be motivated by greed. As the adage implies if you already have a bird in your hand you will be well fed. However, if you let it go to pursue two birds that you see in the bush, you may catch neither, and as a result wind up hungry for the night. This proverb points out that by passing up pay- off for one with more promise you run the risk of losing both the pay-off as well as the promising possibility.