What Canadians Need to Know About Dividend Growth Investing

If you are of those who want to pick stocks rather than invest in a basket of ETFs, you need a clear plan. You can’t just pick stocks you “like”. This article suggests an approach which I believe makes sense for many retail investors.

As the title suggest, I am a dividend growth investor. While I was studying finance at HEC Montreal and preparing level 1s of both the CFA and CAIA accreditations, I helped my father create his dividend growth portfolio.

Throughout the next few months, we polished our method and developed the S.A.F.E. framework for investing in dividend growth stocks.

What is dividend growth investing?

Dividend growth investing is an investing strategy which involves investing in companies which pay dividends and who increase their dividend payouts yearly.

Let’s decompose this further. The first clear choice which is made is to reduce your investment world to stocks which pay dividends. This excludes loads of stocks in the tech sector who don’t pay any dividends and probably never will.

Despite excluding some minor caveats, this strategy still makes sense, at least as far as returns go. According to CPA Canada, no matter what time period you choose, dividends have contributed to about 1/3 of the TSX total return. What this means is that for every 2% return you get in capital gains by investing in a TSX ETF, you would get a 1% return in cold hard cash, in the form of a dividend.

Interesting, don’t you think? Over the last 50 years the TSX has returned a compound annual growth (CAGR) of 6.05% versus 9.05% when you include dividends. That’s an extra 3% of return just due to dividends.

This 3% is about the average dividend yield of the TSX. Dividend yield is simply the value of the dividends you will receive in a 12-month period divided by the price of the stock. It measures the return from dividends as a percentage of the price.

Since a third of returns are due to dividends, it sounds like a smart idea to invest in stocks that pay dividends, right? And why not focus on those who have higher than 3% dividend yield so you are getting only stocks which pay out more dividends relative to their price than the average?

That is the basic premise. But it was taken a step further. Some savvy investors realized that several companies increased their dividends on a consistent basis, maybe once a year. Some of them have been doing so for decades; it has become somewhat of a tradition. There are lists which track these “dividend champions” both for Canada and the US. In Canada, Canadian Utilities has been increasing their dividend for the last 45 years, and they are currently yielding 4%.

And here is the trick. If you invest in a stock which pays $1 in dividends a year and costs $25, it means it yields 4% at the time you buy it (dividend yield on cost). If the company increases its dividend 10 cents every year, in 10 years those same stocks which you bought for $25 will be paying out $2 in dividends, an outstanding 8% yield on cost. Not bad, hey?

But it gets sweeter. Assume you bought 25 units of this $25 stock. Also, assume the stock price doesn’t move over the course of the next year (bear with me for the example), then in a year’s time you will have received 25*$1 in dividends, which will allow you to buy another share of the company. Which means that two years from now you will be receiving not 25*$1.10 but 26*$1.10 dollars thanks to that extra share.

This is called the power of compounding. If you reinvest your dividends, instead of a 10% increase in payouts next year, you get a 14.4% increase in payouts. Even if you start with a small amount of capital, those reinvested dividends could provide you with enough income to live through retirement.

Sound appealing to you yet? We sure thought it was.

Who do we think dividend growth investing is for?

First, it is for investors who want to get more involved in managing their portfolios. While you can still invest in dividend growth stocks with quite a low level of involvement, it will be more time intensive than just investing in a basket of ETFs. If you go down this route you will realize that you will quickly become accustomed with basic valuation concepts, financial performance ratios and so on.

Second, it can be for both investors who need income now from their portfolio as well as those who don’t need income yet. Obviously the further you are away from retiring, the less money you need to start. Finally, it is for investors who have a certain appreciation that high-quality stocks will lead to high-quality returns.

Without further ado, let’s move on to the exciting bit: a list of tips and tricks to help you get started with dividend growth investing.

My tips and tricks for dividend growth investing

• If you didn’t before, you now know what dividend yield is. You also understand the concept of a dividend growth streak. But you want to look at average dividend yields for individual stocks. How is a certain stock yielding compared to what it has historically yielded? What about the average dividend yield of the sector? Of the index? This will give you more perspective.
  
Keep in mind that really high yields could be traps where companies are about to slash their dividend because it is no longer sustainable. The payout ratio is also important. It is the proportion of net income which is used by the company to pay dividends to the shareholders. A low payout ratio means that the dividend is somewhat sheltered from a decrease in earnings. It also means that, given constant earnings, the dividend has room to grow. Make sure you diversify properly across sectors. The TSX is overexposed to a few cyclical industries (commodities and banking, notably). You will want to have more exposure and you probably won’t be able to attain that in Canada alone.
• But you can also invest in U.S. dividend growth stocks. As long as you put them in a retirement account (RRSP, RRIF), there is no U.S. withholding tax thanks to the tax treaty between the United States and Canada.
However, don’t put U.S. dividend stocks in a TFSA; you will loose 15% to the US withholding tax on your dividends. You don’t want that. You know earlier we were discussing the power of compounding. There is a simple rule of thumb to know how long it will take to double your dividend income from a stock, including reinvesting dividends. It is called the rule of 72. It works with non-extreme values. Here is the drill: by dividing 72 by the dividends growth rate you get the amount of years it takes to double your income. If you divide 72 by the amount of years in which you want your income to have doubled, you get the required growth in dividend payouts. For example, earlier we talked about a fictitious stock which grew its dividend payouts by about 10% every year. According to the rule of 72, you would double your income in 72/10= 7.2 years. Nifty, right?
• Don’t invest in hype; you pay a premium for it and ultimately this premium is paid for in the form of lower future performance.