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5 Advantages of the Dividend Investing Strategy

Some readers have emailed me about the dividend investing strategy, and specifically, why I follow it.  Personally, I’m a believer of both index investing and dividend investing where both have their merits.

I use index investing for the accounts that are mostly hands off, like the RESP accounts for my children, and I even have a portion of my RRSP indexed. I use the dividend growth strategy through Canadian dividend stocks for my leveraged Smith Manoeuvre portfolio, U.S. dividend stocks in my RRSP, and recently have been purchasing REITs for our TFSAs.  I have also started growing my non-registered account with Canadian dividend stocks.

So why dividend stocks? I’m an advocate for the dividend investing strategy for a number of reasons, these include:

1. Produces a Passive Income Stream for Life, and with Raises!

Passive income for life is a pretty optimistic statement but for good reason. There are a number of dividend companies that have a long history of paying dividends.  For example, Coca-Cola (KO) has paid a dividend since 1893 – that’s right for 120 years!  Not only have they paid a dividend for well over a century, they have increased their dividend for 50 years straight.  They give raises to their investors just for holding onto their shares.

Relying on a company to keep paying their dividend may sound risky, but it’s simply a management priority of a company with consistent and predictable earnings. If a company like KO ran into financial difficulties, I’m willing to bet that they would do everything in their power to maintain their dividend.

2. Encourages Buying and Holding for the Long Term

The stock market has proven to increase in value over the long term, however, the problem is that most investors are their own worst enemies in selling during market lows and buying when the media tells us to buy during market tops.  In order to benefit from the market over the long term, an investor must buy and hold.  However, it can be tricky during the emotional swings of the market.

Dividend investors buy and hold (ideally forever) for the income (and raises) that the stock produces.  If buying value (when the dividend stock valuation is attractive), dividend investors are basically paid to wait for their investment to turn around.

3. Helps Create a Market Bottom

When the broad markets decline or if interest rates are raised considerably, dividend stock prices may start to decline however  dividend yields will increase. Providing that the business fundamentals are still strong and earnings/cash flow are enough to cover the dividend, the higher yield will likely attract income investors potentially creating a bottom, or even igniting a rally.

However, note that sometimes yields can get extremely high, which is a warning that the market may be pricing the stock in preparation for a dividend cut.

4. Dividends are Tax Efficient

Publicly traded Canadian dividend stocks are extremely tax efficient. So efficient, in fact, that an investor (in most provinces) can earn up to $45,000 in eligible dividends and pay $0 income tax (assuming no other income).

How is this possible?  Canadian corporations pay corporate tax and pay dividends with after tax earnings. To prevent double taxation, investors get a dividend tax credit on dividends received within a non-registered account.  If you’re interested, more detailed information on the dividend tax credit here.

5. Reduces Risk of Selling at Market Bottom for Capital

I follow the philosophy of nurturing the goose that lays the golden eggs.  In this case, the eggs are the dividends received and the goose is the portfolio of dividend stocks.  The goal for many dividend investors is to maintain the portfolio while spending dividends to cover monthly expenses.

It is a common strategy to sell portions of the portfolio to fund retirement. A pitfall in this strategy is if markets are down and cash is needed, the investor will end up selling at the bottom.  This can cause damage, and may introduce sustainability issues, to the portfolio.

Back to you, are you a dividend investor?  Why or why not?

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 24 comments… add one }
  • abraxas August 12, 2013, 10:24 am

    My very serious concern with buying dividend stocks right now is that when the low yield on treasuries starts to rise those stocks will be the ones to suffer the brunt of the decline. Witness the massacre of Canadian utility stocks and preferred shares in the last couple of months. Good deals on dividend stocks appear to be in the future.

    Additionally, when going gets tough dividend payers do cut dividends. Many companies did this in 2008. Now, they yields went up that year but only because stock prices fell even more.

  • FrugalTrader FrugalTrader August 12, 2013, 11:39 am

    @abraxas, that is a very good point, however, I would argue that the mentioned concerns are short term concerns. If you are a long term investor, sell offs are a good thing. For example, utilities (and REITs) are on my watch list right now.

    Yes, some strong dividend payers do cut (like MFC), but the majority do not. I believe that out of all of my dividend payers, only MFC cut their dividend.

  • abraxas August 12, 2013, 12:09 pm

    FT, to your point regarding the dividend tax credit. I think that is a huge advantage of having Canadian dividend payers in a non-registered account. On the flipside, if Ottawa ever changes its mind about the dividend tax credit it will smash Canadian dividend stocks just as much as the income trust debacle hit income trusts.

    Having said, all that, I agree that you can do much worse in the stock market than buying dividend stocks. I’m just not comfortable at this juncture to have most of my money in divvy stocks. Too much downside potential for them given the abnormally low returns on treasuries.

  • FrugalTrader FrugalTrader August 12, 2013, 1:26 pm

    @abraxas, I agree with you, I would find it difficult to start a dividend portfolio at this point with markets reaching all time highs. About the dividend tax credit, the tax credit has been decreasing over the years b/c Ottawa has reduced corporate tax. If Ottawa decides to eliminate corporate tax, then the dividend tax credit could potentially be eliminated. But investors would see the benefit in earnings growth of the company, and potentially higher yields.

  • Richard August 12, 2013, 1:39 pm

    Dividend investing is a solid and reliable strategy if followed consistently, just like indexing. A couple of the advantages are shared by index funds even if they didn’t pay any dividends:

    #3: Earnings yields go up just the same as dividend yields and lure investors in to support prices (although I would rather see prices crash and pick up some stocks at a super-low P/E mysefl). The earnings aren’t returned to investors immediately but they can be used to buy other profitable companies, invest to grow the business, or the company may be acquired itself. Falling prices benefit all long-term investors.

    #4: Dividends paid to an individual stockholder get a tax credit because the corporation has already paid taxes on that income. If the company invests to grow earnings instead, it can pay less taxes. Dividend taxes are also inflexible as they have to paid every year (cutting into compounding) and are liable to many cross-border taxation issues which can increase taxes or restrict investors to a very small market here in Canada. Capital gains taxes only have to be paid once on a sale, and have a lot less international withholding rules. This boosts the effective after-tax return from capital gains.

  • Bernie August 12, 2013, 4:37 pm

    Coca Cola’s dividend history is impressive but pales against Bank of Montreal (BMO). They been paying uninterrupted dividends since 1829.

  • SV August 12, 2013, 7:16 pm

    Hi FT,

    In reference to Bernie’s comment regarding BMO’s payout:

    I think buying the big five banks as a long term hold for the income (and capital gains) is an acceptable conservative investing strategy. After all, they’ve weathered wars, depressions, recessions, etc. Also, the onging chenanigans of US banks and EU turmoil (just to name two global issues) makes Canadian banks a relatively safe place for foreign and domestic wealth to park their money.

    But of course you have to accept volatility and adding solid monthly dividend payers (e.g. Riocan, Altagas) can help to soften the downturns.

    I’ve found that as my dividend yield increases, so does my tolerance for market swings.

  • Ed Rempel August 14, 2013, 11:14 am

    Hey FT. Are you concerned about home country bias? Do you believe in dividend investing for investing globally?

    Ed

  • Peter August 14, 2013, 11:15 am

    Hi,
    I have a question about this article. If I buy ETFs, am I not benefiting from dividends? if so, how is buying a “couch potato” ETF portfolio so different than dividend investing?

    thank you

    Peter

  • FrugalTrader FrugalTrader August 14, 2013, 11:42 am

    @Ed, I hold U.S dividend stocks in my RRSP along with an international ETF for global coverage.

    @Peter, most index ETFs will have a dividend portion, but it may not be significant. Couch potato investing is basically index investing (owning the whole market with holdings weighed by how big the company is by market cap). Dividend investing is owning specific companies that have a long history of paying dividends. Although, you can also own ETFs that hold strong dividend payers (CDZ, XDV, VIG etc)

  • Bernie August 14, 2013, 11:55 am

    @Peter
    You can take that one step further with “dividend growth investing”. This is owning companies that have a long history of growing their dividends. You don’t get this with ETFs. I like this strategy as dividend growth stocks tend to raise their dividends at a higher rate than inflation. It’s worked well for me!

  • FrugalTrader FrugalTrader August 14, 2013, 11:59 am

    @Bernie, which are your favorite holdings? Do you focus on Canadian or US stocks or a mix?

  • Bernie August 14, 2013, 7:07 pm

    I focus on both with my RRSP. I only hold Canadian in my non-registered account & TFSA.

    My RRSP holdings and/or watch list include:
    CDN – AD BCE BDT BIP.UN BNS CEU CJR.B CMG CTY ENB GLN IPL.UN KEY NA
    U.S. – CBRL CVX DRI DPS GIS HAS JNJ KO LMT MCD OHI OXY PG TCAP WAG WEC

  • Michael August 14, 2013, 7:22 pm

    Hi FT,

    I am interested in Horizons HSX ETF for exposure to international dividend stock. The advantage with this ETF is that it avoids the 15% withholding tax associated with US dividend stocks. I have never seen you mention the withholding tax on your top US dividend stock picks or elsewhere so I was wondering how you deal with it?

    Do you just accept the 15% tax because you want greater control over your US holdings? The HSX seems to yield pretty well and the effective “MER” is about .045 which I think is much better than the effective .15 from the withholding tax.

    Also am I right in assuming that Canadian Dividend paying stocks won’t generate a dividend tax credit if they are held in a TFSA? If so where should I hold them? RRSP? Currently I am planning to hold the HSX ETFs in my TFSA to avoid the Capital gains tax as-well as the withholding tax. I can always pull the HSX ETFs out of the TFSA if I want to put a less tax advantaged investment in.

    Please let me know what you think.

  • SV August 14, 2013, 9:41 pm

    FT,
    Do you own XTR in any of your portfolios?
    Also, do you have a strategy when it comes to the amount you are investing in a particular stock/ETF (e.g. buying a $3,000 position vs $30,000 one)?

    One personal observation:
    I remember after the ABCD market meltdown, BMO was trading around $24 with a yield of 8+% at one point. It sticks in my mind because I was wavering about making a purchase at the time.

  • My Own Advisor August 15, 2013, 8:00 am

    Solid post FT. I enjoy these articles.

    I’m a fan of dividend investing (and likely stick to it), because dividends are tangible whereas capital gains are not. I see the dividends flow in, money creating more money. Capital gains are tough to see on that front. The psychology of seeing the money contribute to wealth is positive and reinforces my strategy.

    I have a post about that coming up, I believe it’s point #3 why dividends matter :)

    I hope to have that guy published next week.

    Keep up the good stuff,
    Mark

  • KrissyFair August 15, 2013, 5:29 pm

    Kevin O’Leary often says this about his dividends-only strategy: “My money is like a chicken on a spit dripping cash”

    :)

  • FrugalTrader FrugalTrader August 15, 2013, 9:22 pm

    @Bernie, Thanks for the list, I also own a lot of your holdings.

    @Michael, HSX i’m seeing as an SP500 ETF, which is basically an index ETF, not a dividend ETF. If you are interested in US coverage, check out VTI, it is a very cheap way to get US coverage. About withholding tax, US dividends do not face withholding tax within an RRSP, which is where I hold my US dividends. About your other tax questions, this article will help clear things up: http://www.milliondollarjourney.com/portfolio-allocation-rrsps-tfsas-and-taxable-accounts.htm

    @SV, I can see XTR being a cheap replacement to the bank monthly income funds (bonds and equities). I wouldn’t own it in a non-registered account due to the complexity of the distrubution. http://ca.ishares.com/product_info/fund/distributions/XTR.htm. With regards to position sizing, I try not to let any one position grow larger than 5% of my portfolio.

    @my own advisor, thanks for the feedback! In your dividend updates, have you considered disclosing your holdings?

    @krissyfair, Mr. O’Leary is good with his imagery, but I like my golden egg analogy better. :)

  • SST August 17, 2013, 3:27 pm

    re: #16 “I’m a fan of dividend investing (and likely stick to it), because dividends are tangible whereas capital gains are not.”

    With that in mind, any plans on adding any private equity dividends to your investment strategy, FT et al? If private equity is stable, risk-adverse, and profitable enough for the CPPIB to be a major player in the market, it might be worth your investigations (see summary below).

    Take Coke (KO) in comparison to the first private equity oil play into which I invested (5-yr contract with an Alberta oil company).

    PE
    10.25% annual regular dividend
    1.75% annual special dividend
    w/DRIP = 16% annual return (80% total return)

    note: the company will sell it’s assets at the end of the contract at which time shareholders would be privy to any capital gains, which I have not taken into calculations. Thus far the valuation of the company has risen 200% annually, meaning my wind-up capital gains may ring in at a wonderful 1,000%. (I think of cap gains as deferred tangible cash ;) ).

    KO (1 share)
    2.08%/yr average annual dividend
    Total Div Income $5.67 (10.4% total return)
    w/DRIP = n/a (~1/10th of a share)
    note: your 2008/09 shares now pay 4%

    SUMMARY (5-yr)
    Dividends Annual
    PE = 16% (80% total)
    KO = 2% (10% total)

    Capital Gains Annual
    PE = 200%
    KO = 8.75%

    note: all calculations do NOT include taxation as those are account dependent.

    Further more, as a pure dividend stock, KO — the “ultimate” dividend stock — was even more ultimate pre-Regan era. The dividend increased 5.75% annually, the stock price increased 5% annually (split extrapolated). DRIPing would have netted you 0.75% more stock annually.

    Post-1982, the dividend increased 67% annually, the stock price increased 150% annually (splits extrapolated). DRIPing would have netted you 0.44% more stock annually.

    Loose monetary policy was great for gains of all types, but I highly doubt the market will again experience another 30-year environment of cheap-n-easy credit/leverage. If you think the games will continue, then your ONLY investment is to buy 2,000 shares of KO right now to cement your $45,000 of tax-free retirement income.

    Perhaps if KO dividend increases return to outperforming stock price increases I might buy, setting up for that passive income stream in retirement, but as demonstrated, there are better methods to putting tangible cash in your pocket.

  • FrugalTrader FrugalTrader August 21, 2013, 9:28 am

    @SST, are there any publicly traded companies that invest in private equity? Would Legg Mason count? On another note, anyone who contributes to CPP is invested in private equity.

  • SST August 21, 2013, 9:27 pm

    Hi FT, there are most definitely public companies invested in the private equity market. As a matter of fact, you own one of them (kind of) — Brookfield Properties (BPO).

    To clarify, BPO’s parent company, Brookfield Asset Management (BAM.A), has $10 billion invested in PE (~6% of total assets), ranging from energy to construction to retail.

    As stated: “…focus on business improvement and the adoption of changes that add value and strengthen fundamental earnings generating capabilities.”

    The above strategy, if carried out effectively, works wonders for bringing in big time returns which lead to ‘productive positive returns’ as opposed to ‘destructive positive returns’ gained from lay-offs, plant closures, stock buy backs, etc.

    Legg Mason is not invested in any private equity, even though it may seem as such.
    Other public all-private equity companies would Blackstone (BX), KKR & Co. (KKR), and the Carlyle Group (CG). As well, there are plenty of Private Equity funds floating around, but all the above are not quite the same as direct PE investment.

    :)

  • Jack @ Enwealthen September 11, 2013, 1:06 am

    Thanks for the writeup.

    I’ve been in dividend investing for a few years now, with great results. But that has been via retirement accounts.

    I’m getting ready to join a company’s DRIP program. Leaning towards 3M since they have had reasonable performance, but more importantly for my need, they allow automatic investments of as little as $5, and are a well known brand. Perfect for gifting to my nieces and nephews to start them on their DRIP journey.

  • Dan October 29, 2013, 4:46 pm

    FT, can you think of any examples of dividend paying companies that had to cut their dividend and how the markets reacted? I assume negatively but I’m curious to see how far they can fall with a div cut. Perhaps in 2008/09 ?

    • FrugalTrader FrugalTrader October 30, 2013, 8:55 am

      @Dan, the ones that come to top of mine is MFC and TCK.B. Check out their charts! Mind you, the market sometimes can foretell when a dividend cut is going to be made and pushes the price down. Once the cut is made, the stock can rally back.

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