For investors seeking income, the investment landscape has become an increasingly complicated one over the past several years. Two prevailing themes have been ‘yield compression’ and recurring volatility explosions.
Over the past decades, yields on traditional fixed income instruments have trended dramatically lower. This has pushed investors further out on the risk spectrum to earn meaningful yield. One major beneficiary of this change has been dividend paying stocks, which have risen in value as investors sought to augment their portfolio’s income stream.
More recently, equity markets have experienced significant and sudden events where stock prices crashed, and volatility soared. In most of these panics, stocks that pay a steady stream of distribution to shareholders have proven more resilient than the broader market, especially compared to the stocks of more speculative companies with less reliable cash flows.
Don’t Overlook the ‘Growth’ Element of Dividends
At Northwood, our response to persistent low fixed income yields over the past 10+ years has been to increase our allocation to dividend-paying stocks through the development and implementation of a Canadian Dividend Growth mandate. The key, and often overlooked, word here is ‘growth’. In constructing the mandate, we elected to forgo higher yielding stocks with a lower chance of increases in those dividends, and to invest instead in companies that paid decent dividends but also exhibited high potential to grow their dividends over time. These businesses generally produce strong and stable cash flows from operations, sufficient to comfortably pay sustainable, regular dividends, and to have enough surplus cash to opportunistically reinvest in additional growth or repurchase shares.
We originally sourced this mandate for our clients in 2010 and so we now have a meaningful history to analyze. One thing that has stood out to us is that while the current yield on the portfolio has not surprisingly come down as the value of the holdings has gone up, the decline in yield has not been as pronounced as with other income-producing asset classes. This can be attributed to the dividend growth element of the portfolio. By investing in companies that not only pay dividends, but also aim to grow them each year, the income earned on each original dollar invested has meaningfully increased since inception. The following chart helps to illustrate this point.
Current Yield vs. Yield on Original Investment
Had you invested $1,000,000 in the mandate at inception in 2010, the yield on that initial investment amount would now be approximately 9.8% or $98,000 in annual income. This is more than double the original 4.5% yield, and nearly triple the current 3.6% yield on the mandate, showing the benefit of holding companies that grow their dividends. Looking at it another way, an investor in this mandate in 2010 has seen both their portfolio rise from $1,000,000 to just under $2,500,000 as well as their annual income increase from $45,000 to $98,000.
For the tax-aware investor, it is also important to note that in Canada, domestic dividend income is taxed somewhat more favourably than other sources of income, which further enhances the after-tax return to the investor for this type of mandate.
Dividend Growth Could Help to Mitigate Interest Rate Risk
One of the more significant risks to income-producing asset classes is the potential for interest rates to rise. Of course, dividend-paying stocks will undoubtedly suffer as well as yields rise (i.e. prices fall). But given their ability to increase the cash dividends they pay, there is a good chance that dividend-paying companies will do a better job of protecting capital than fixed income securities, even as market rates rise.
Although dividend paying stocks now trade at higher valuations that they did 10 years ago, and, like all asset classes, the potential impact of rising rates should be taken into account, a dividend growth fund is a worthwhile consideration for most private client portfolios.
Why focus on picking dividend growth stocks? Why not just own the entire stock market?
It’s not easy to identify companies with the potential to deliver a growing stream of dividend payments over the long term. So wouldn’t it be easier and make more sense to take a passive approach and own a highly diversified market index? Performance during downturns shows us that passive investing isn’t always preferable. After several relatively crisis-free years since 2010, recent equity market experience has seen downturns becoming more frequent and volatility become much more pronounced. The stocks in the Canadian Dividend Growth Mandate won’t entirely escape downturns, but in quarters where the Canadian stock market declined, the portfolio has on average fallen by only 26.5% as much as the market (we call this measure “downside capture” and the lower the percentage, the more resilient the portfolio). That stability during downturns can provide investors the reassurance needed to help them calmly ride through the markets ups and downs without making emotional decisions that could lead to exiting the market at the least opportune time.
Where Dividend Growth fits in a Portfolio
Our experience over the last 10+ years has shown us that a portfolio of dividend growth stocks offers a more attractive, more tax-efficient stream of growing income payments than is possible from a fixed income portfolio. It can also offer comparable returns to a conventional equity portfolio, but with much lower volatility in downside capture. As such, the strategy fits neatly into the space between investment grade fixed income strategies, and value-oriented equity strategies. For this reason, the strategy is a staple for our clients whose goals depend on having a stable, reliable source of income that has the potential to grow over time.