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TORONTO (GlobeinvestorGOLD) — When equity markets rallied, investors rallied behind growth stocks. When the markets tanked, and interest rates trended down, we jumped on the bond-rally bandwagon. And now that rates have hit rock bottom and have no where to go but up, our last money-making refuge seems to be dividends. Dividends have become one of the more certain income streams in very uncertain times, though even rocks can begin to show cracks.
It's a good time to be a dividend investor. In late May, the Bank of Nova Scotia boosted its dividend by 20 per cent — its second increase in 2004. Canadian Imperial Bank of Commerce, Toronto-Dominion Bank, Bank of Montreal, and Royal Bank of Canada have also been raising their dividends to stay competitive. The move has paid off for the S&P/TSX capped financials sub-index, which has gained 5.6 per cent since the beginning of the year, compared with a broader market increase for the S&P/TSX composite index of 1.6 per cent — adding capital gains to income.
Energy and telecommunications companies have also been generous sectors when it comes to raising dividends because of their relatively fixed margins. Since the start of 2004, the list of companies rewarding their shareholders has included Encana Corp., Canadian Natural Resources Ltd., and Petro-Canada. Even Rogers Communications started paying out five per cent every second quarter last July.
In other sectors, blue chips such as George Weston Ltd., Canadian Tire Corp. and Canadian National Railway Co. are coughing up more of their earnings. In 2003, 90 per cent of financial services providers, 30 per cent of telecom companies, and 60 per cent of utilities raised their dividends.
Sensing this shift, traditional non-dividend paying companies have jumped on the bandwagon. BusinessWeek reports that Standard & Poor's expects companies in its stock index to pay out almost 14 per cent more in cash this year. Some are raising dividends and some are just starting to pay them. A slew of technology companies have joined the dividend club, including Microsoft and Intel.
There's no denying dividends have made a comeback. Since 1926, stocks have produced an average annual return of 10 per cent. Half of those returns were generated by dividends and the other half from capital gains. A CIBC World Markets study revealed that since 1956, 60 per cent of the TSX composite's returns were re-invested dividends. In the high-flying 1990s, stocks produced an average annual return of 18 per cent — but less than four per cent of those gains were generated by dividends. It was an unprecedented time of growth, and companies were using earnings to expand their businesses. Excess cash was used to buy back shares — artificially inflating their stock price and, in some cases, sweetening executive options packages.
Then came the technology tumble when dividend stocks once again showed their true worth. In the bear market of 2002, non-dividend paying stocks on the S&P 500 composite index dropped 30.3 per cent, while dividend-paying stocks fell only 13.3 per cent. In essence, dividend stocks are hedges in down markets. On the other side of the coin, they can be a drag in up markets. According to Globefund.com, as of April 30 of this year the average one-year return on a dividend fund was just over 19 per cent. That's pretty impressive, but it still lagged the overall S&P/TSX 60 by close to two percentage points.
While market growth could shift investors' attention away from dividends for the short term, the biggest dark cloud to appear over the dividend parade is the prospect of rising interest rates — making cash supply that much tighter. Juliette John, who manages the Bissett Dividend Income Fund, is bracing for the change. "The biggest factor where there is interest rate risk is the pipeline and utilities group because they are most bond-like", she says. Still, she's big on the big banks including Scotiabank and CIBC. "Banks tend to be strong earners and have been raising dividends as a result" she says.
The Bissett Dividend Income Fund has brought in a 17-per-cent return over the past year, but a year-to-date-return of 2.7 per cent could be a sign dividend stocks are losing steam. In a recent interview with Report on Business Television, Ms John said she believes the prominent role of dividends is here to stay — accounting for 20 to 30 per cent of overall returns in future. "I think we're probably in more of a balanced framework," she said.
Corporate earning have been trending up over the past two quarters but even the earnings picture has its own dark cloud. According to First Call/Thomson Financial, earnings for the S&P 500 are expected to soften in the second half of 2004. While year-over-year profit increased 27.5 per cent in the first quarter and 19.4 per cent in the second quarter, growth is expected to pull back to 13.3 per cent in the third quarter and 14.9 per cent in the fourth quarter.
Economics aside, dividend investors have some political heavyweights in their corner. In the United States, the maximum personal tax rate on dividends was recently reduced to 15 per cent from 38.6 per cent. In Canada we enjoy the dividend tax credit that gives an advantage over interest income. Still, dividends are subject to double taxation, prompting some heavy pressure on Ottawa to give the same breaks to companies who pay dividends. One break is already available for income-trust unit holders, where no corporate tax is levied.
The best yielding dividend stocks in Canada right now include tobacco giant Rothmans Inc. (6.2 per cent). Of course, nothing secures an income stream like having your customers physically addicted to your product. Other big dividend stocks include TransAlta Corp. (6.0 per cent), Manitoba Telecom Services Inc. (5.6 per cent), and Atlantic Canadian energy company Emera Inc. (5.1 per cent).
One drawback to the revival of the dividend stock is the difficulty startups could have meeting the needs of dividend-hungry investors. Many small companies need those earnings to invest in research and development or to expand. Investors could find themselves taking short-term gains and denying the birth of the next Microsoft Corp.
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.