Friday, June 01, 2007

Dividend Investing

Many investors think of dividend-paying companies as boring, low-return investment opportunities. Compared to high-flying small-cap companies in hot industries, whose explosive nature can be pretty exciting, dividend-paying stocks are usually more established and predictable. Though this may be boring for some, the combination of a consistent and increasing dividend with an increasing stock price can offer a potential return potent enough to get interested in.

This chart tracks the value of 1000 shares in a major Canadian Bank. The Canadian banks and insurance companies have been great dividend payers and growers in the past. The bank highlighted, like all of the banks, has grown its dividend payout over the past 10 years by more than triple and its share prices has also risen substantially by more than 12 times the original value over the past 10 years. The original $5500 investment has grown into $69,000.



I'll be the first to admit this might not be the most ‘sophisticated’ investment strategy out there. On the contrary, it is quite simple, but over the long run, investing in companies with a strong earnings, solid balance sheet and a sustainable and growing dividend payout is a proven strategy to earn exceptional investment returns. In fact, the bank highlighted in this example has returned a compounded annual rate of return, including reinvesting dividends, of 23.5%. Pretty good show for a boring strategy.

If you are not into picking stocks and prefer someone else to do the stock picking for you, every bank and mutual fund company in Canada has a decent dividend fund. Some of my favorites are the AGF Canadian Large Cap Dividend Fund and the TD Dividend Growth Fund. As always you should consult your financial advisor before making any investment decisions and you should ensure that any investment chosen meets your risk tolerance and investment objectives.

22 comments:

johnnyrent said...

Mohican

VHB had some data which showed historical RE price run-up and correction data. Specifically, the length of the run-up, the length of the correction, the size of the run-up and the size of the correction.

Do you have this data or can you refer me to where I might find it?

Thanks, JR

mohican said...

Check this link out johnnyrent. Let me know if that is what you want.

I'll dig around for some other info.

the pope said...

thanks for this post mohican - I'm guessing you don't want to get into recommending any specific stock, but are you seeing any stocks out there with a good dividend that look like a decent buy right now?

johnnyrent said...

Thanks Mohican but no, I was referring to a table VHB developed. Maybe he'll be lurking around and can dig it up. Thanks for your help. JR

mohican said...

Johnnyrent - I know the one you are talking about now. I have it and this is what it says:

1981 Nominal Price High Q1 $233k with 16 quarters to a nominal price low of $154k for a nominal price drop of -33.8% and 17 more quarters to recover the Q1 1981 Price.

1990 Q2 Nominal Price High $324k with 3 quarters to low -12.3% and 5 more quarters to recover.

1995 Q1 Nominal Price High $418k and 16 quarters to new price low of $356k for a total drop of 14.7% and another 14 quarters to recover the 1995 Q1 nominal price.

VHB also had the 'real' inflation adjusted numbers too but I don't have them handy right now.

johnnyrent said...

Thanks Mohican

I seem to recall that the average correction was cited by VHB as 28%, over four corrections, with the last one being around 20%. Is there a correction missing here (freudian slip). JR

mohican said...

You are right johnnyrent - VHB used the inflation adjusted numbers in his table and that produced larger % declines. I just don't have that data with me right now.

Seems like we are missing a correction! Maybe it will be 16 quarters from now that we are hitting bottom.

RentingSucks said...

Can you address the whole MER situation? I noticed when Sauder released there "Are Renters Left Behind" report (http://cuer.sauder.ubc.ca/index.html).
They speicify on page 2 that to be better off you have to attain the total return of the TSE without significant management costs. So any fund you choose has to beat the TSX by at least it's MER to be worthwhile. However most funds in the long term get hauled down to the mean anyway doesn't this suggest that low MER index funds are the best way to go? In that case why recommend a fund that isn't an index fund?

RentingSucks said...

Can you address the whole MER situation? I noticed when Sauder released there "Are Renters Left Behind" report (http://cuer.sauder.ubc.ca/index.html).
They speicify on page 2 that to be better off you have to attain the total return of the TSE without significant management costs. So any fund you choose has to beat the TSX by at least it's MER to be worthwhile. However most funds in the long term get hauled down to the mean anyway doesn't this suggest that low MER index funds are the best way to go? In that case why recommend a fund that isn't an index fund?

mohican said...

rentingsucks - there are some interesting points in that study and also some unfair comparisons.

I hate high MERs as much as the next guy but I think its a distraction from the study's methadology.

The main points I would bring up are:
- the study's treatment of leverage
- the chosen start and end dates
- limiting investment opportunities to only TSE

1 - Leverage is a powerful financial tool and can bring immense benefits or financial destruction. None of these complexities are really dealt with in the study.
2 - the dates chosen have a big effect on the result - I'd love to see numbers run for starting at a market top like 1981 or 1995 or now
3 - global markets are also available investment vehicles and have had higher returns than canadian markets historically

e said...

hi Mohican,

interesting post. i was graphing bmo, td, ry, to, bns, and they all only showed a 175-300% gain over the past 10 years -- so i'm just curious how you derived your high gains (i'm not including dividends here, but your values "without dividends" is much much higher!

mohican said...

e - good question - I downloaded the data from Yahoo Finance Canada to Excel and I used the month end adjusted close stock price from August 1996 to May 2007. I hope that explains it.

You can't use the unadjusted price because all of the bank stocks have had stock splits since 1996. I think this is why you are getting the discrepancy.

e said...

Mohican,
Thanks for the explanation.
it is split adjusted already
http://finance.yahoo.com/charts#chart3:symbol=bmo.to;range=19960801,20070528;compare=ry.to+cm.to+td.to+bns.to;indicator=split+volume;charttype=line;crosshair=on;logscale=on;source=undefined

however, I see a 300-600% increase over that time period for any of these major banks (i was only looking 10 year, but I have now expanded it for august 96 as you have used). however your chart shows a 1200-1300% increase over that time period (for "excluding dividends").

i guess what i'm trying to get at is the example you have given may not have been mainstream (as all of the other major banks have not pulled that kind of return). only a lucky pick would have? (i.e. even CWB was 950%).

mohican said...

I stand corrected e. You have sharper eyes than me. Thank you.

It appears I misread the meaning of Yahoo's "Adjusted Close" it is not only adjusted for splits but also for Dividends. This is my mistake and I apologize if this misled anyone. I have corrected the chart.

freako said...

"It appears I misread the meaning of Yahoo's "Adjusted Close" it is not only adjusted for splits but also for Dividends."

Easy to do. Since some stocks have hefty dividends, it can be tricky to get apples to apples. For example, does the S&P500 include dividends?

My two cents?

1. In theory, the dividend decision should not make any difference. We have discussed Miller-Modigliani before. The underlying value remains unchanged. And in either case, an efficient market would level the playing field back to comparable Sharp ratios (risk-adjusted returns)

2. However, markets are not perfectly efficient. Companies that pay dividends are not random sample. In order to pay a dividend, a company needs to have steady cashflow. Earnings can be manipulated, but not cashflow. You are essentially excluding speculative high PE stocks, and all the issues associated with such.

4. On the other hand, we'd expect these stocks to have less risk, and therefore lower returns. Could it be that the returns are skewed by a recent love affair with high yield stocks in a low interest rate environment?

5. Or are their hidden risks to the income stream that the market fails to account for. I definitely think that is the case for REITS.

Going back to 2 for a second, I read some very interesting research by an academic. It proved something I had suspected for some time.

Sorry, I can't remember the name or the details, but here is the gist of what I consider the best active investment strategy of all time:

He ranked companies on how aggressive their accounting was (ie. how hard they pushed within gap). Given a long enough time horizon, those stocks with conservative accounting methodology had far superior returns to those who were aggressive. Why? Probably because it tells you something about the attitudes of management. Aggressive accounting pleases short term investors because it pops the stock. But management who chose this route are planning to look good in the near term (presumably to unload their options at high prices) and are neglecting the long term value of the company. Thus, such management would forego golden opportunities if the payoff is too long. And they would impose long term costs by for example cutting back on maintenance in return for short term profitability.

I think aiming for accomplishes something along these lines, because by paying a high dividend, management has less room to play games. Of course one concern with the conservative GAAP investing was that the theory had become so popular that selfish management would cook the numbers the other way to get flagged as conservative. The same could apply to dividend stocks. Maybe they too have gotten a little too much good coverage?

mohican said...

freako - I know warren buffett is renowned for being extremely critical of aggressive accounting and this is one of his top 2 - 3 things he looks at when examining investment opportunities. I have even heard him speak on the subject. It appears to be one of his hobby horses that he likes to ride along with excessive executive compensation.

You may disagree, but I feel most laypersons are not well trained to spot such aggressive accounting techniques and thus should likely rely on a sound money manager to make these observations for them.

freako said...

"You may disagree, but I feel most laypersons are not well trained to spot such aggressive accounting techniques and thus should likely rely on a sound money manager to make these observations for them. "

I simply don't buy the concept that market beating informatin can be cost effectively acquired. Reminds me of one of those ads/auctions where you pay $50 to find out how to buy home electronics below dealer cost. I am sure that you also remember the old joke that ends with "Where Are the Customers' Yachts?".

Anyhow:

1. I don't expect laypeople to be able to beat the market.

2. I don't expect sound money managers to be able to beat the market.

3. Even if we assume that the market is totally efficient (it isn't), a sound money manager can create enormous value by directing the individual towards investments with appropriate levels of risk.

4. If nothing else, a sound money manager can prevent an individual from committing idiotic blunders. These range from: at best, grossly overpaying for investment services, to at worst getting caught up in some penny stock uranium play.

freako said...

A slightly different angle:

We can achieve returns that approximate that of the aggregate market by simply allowing for sufficent diversification. But how do we "beat" the market?

We have to realize that "beating the market" is a zero sum game. For you to beat the market, somebody else has to do worse. In other words, it is every man for himself.


Value investing can be fairly "boring", especially to investors with high expectations and short attention spans. These people are in fact what allows prudent long term value (and growth) investors to be beat the market. If people become more financially educated and conservative in the aggregate, there will be fewer mispricing for value investors to pounce on.

But that will never happen. Here is a parallel: One of my old finance profs, Ziemba had an interesting side gig. He wrote books on how to win at the race track. At first I laughed at the whole concept. His "system" didn't involve any special knowledge of horses or inside tips. I don't remember the details, but it was purely based on certain conditions, and unless the system indicated an edge, there was no betting. The gist of it was that favorites are underbet and longshots are overbet. Why might that be? Mostly because winning 1.5 to 1 is boring. We want to win the big one, 20 to 1, so we are reluctant to bet on 1.5 to 1 odds, even if those odds are too low.

His system takes advantage of this, and does indeed produce positive returns. So why don't people follow his system and in so doing, destroy the mispricing? Because it is damn boring to go to the race track and only bet on every fourth race. So the mispricing persists.

I suspect that dividend stocks may be in a similar situation. It is simply not sexy enough for the quick buck crowd, and as a result remain underpriced.

Warren said...

Good post. I'm a big fan of dividends as a part of one's overall investment or retirement strategy for 3 reasons:

1. Tax treatment for dividends from Canadian companies.

2. Its a constant and can be a very predictable source of cashflow. Good for the Smith Maneuver, or just plain spending money.

3. Enrollment in SPP/DRIP plans can be a perfect alternative (or addition) to regular RRSP or mutual fund contributions.

Ideally I'd like to have my portfolio split 1/3 each in real estate, RRSPs of various types, and dividend paying stocks.

freako said...

"Tax treatment for dividends from Canadian companies."

Well, from a tax perspective, dividends are a negative.

If dividends were not paid out, appreciation would be higher by an equal amount. Appreciation is taxed at the capital gains rate.

"2. Its a constant and can be a very predictable source of cashflow. Good for the Smith Maneuver, or just plain spending money."

It is indeed predictable cash flow, but first of all, do you really want the cash flow? If you don't you need it, why hassle with reinvesting it. And you could you not create your own cashflow by liquidating small portions of your portfolio?


"3. Enrollment in SPP/DRIP plans can be a perfect alternative (or addition) to regular RRSP or mutual fund contributions."

Yes, it is a great way of being able to buy small amounts without incurring direct transactions or management fees.

Warren said...

Well, from a tax perspective, dividends are a negative.

If dividends were not paid out, appreciation would be higher by an equal amount. Appreciation is taxed at the capital gains rate.


You are aware of how dividends from Canadian companies are taxed right? It is much better than capital gains for the $50k-$100k crowd, which is a pretty big one. I should say for BC in particular, results may vary in other provinces.

Buying and selling is a harder strategy, as when to to both is up for a lot of argument. A dividend paying company is typically something to hold for a long time.

It is indeed predictable cash flow, but first of all, do you really want the cash flow?

Well, I think of it like not having to worry about selling off pieces and when to do so, its just income, plain and simple. My thinking is probably altered by my desire to retire early, with perhaps a smaller income than some.

freako said...

"You are aware of how dividends from Canadian companies are taxed right? "

I forgot about the DTC for Canadian stocks. Though the deferal of unrealized capital gains also factors in.


"A dividend paying company is typically something to hold for a long time."

You could say the same thing about any company. Especially since capital gains are deferred until realized.

Again, nothing against high yield investments.

I think the key is not the dividend itself, but the types of companies that pay dividends. It is a quick, dirty but effective sorting mechanism.