Dividend critics offer myriad reasons for their aversion to watching free money pile up in their accounts.Nuthawut Somsuk/iStockPhoto / Getty Images
I hope you’re sitting down, because I have some shocking news to share:
Not everyone loves dividends.
I know, crazy, right? Who could possibly be against receiving regular cash payments for doing absolutely nothing to earn them?
Dividend critics offer myriad reasons for their aversion to watching free money pile up in their accounts. Dividend companies are slow-growing dinosaurs, they say. Dividends stick investors with unnecessary taxes. Dividends don’t necessarily create wealth but simply return investors’ own capital.
Some critics have even gone so far as to label dividend investing a cult. Today, I’m going to respond to these and other criticisms of my favourite investing strategy, starting with that last allegation.
Is dividend investing a cult?
Okay, I admit it. Dividend investors believe in doomsday prophecies and engage in animal sacrifices. Who doesn’t? But that’s where the cultish behaviour ends.
Unlike in an actual cult, we don’t demand slavish devotion to a person or doctrine. Dividend investors are free to hold other asset classes such as growth stocks and fixed-income securities. We believe in diversification because we know that dividend investing has worked very well at times, but less well at other times.
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That’s why I always remind investors to supplement their dividend holdings with index exchange-traded funds. ETFs that track the S&P 500, for example, provide exposure to sectors such as technology that don’t generally pay big dividends but have produced outstanding capital gains.
As much as I love dividends, l also believe in having a well-rounded portfolio.
Have dividend returns really lagged that much?
It depends on what time period you’re looking at.
Let’s compare two exchange-traded funds, the iShares Canadian Select Dividend Index ETF (XDV) and the iShares Core S&P/TSX Capped Composite Index ETF (XIC).
For the three years ended June 30, XDV posted a total annualized return, including dividends, of about 12.9 per cent, lagging XIC’s return of 16 per cent.
This shouldn’t be surprising, given that interest rates rose sharply over that period as central banks tried to tame inflation. Rising rates typically compresses dividend stock valuations.
But the picture changes dramatically if we look at just the past year, when interest rates were no longer rising, but falling. The dividend ETF came out on top with a total return of 32.5 per cent, compared with 26.2 per cent for the benchmark index ETF.
There have been plenty of other periods when dividend stocks outperformed the broader market, and there will probably be more in the future.
Are dividends just a return of my own capital?
Critics point out – correctly – that when a dividend is paid (or, more accurately, when the dividend record date arrives), the stock’s value adjusts downward by an equal amount to reflect the fact that money has gone out the door. It rarely works out precisely that way, because lots of other factors affect stock prices.
But does this mean the company is simply returning your own capital to you? No.
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Return of capital (ROC) has a specific meaning in investing. It refers to a distribution that does not consist of income such as dividends, interest or realized capital gains. A dividend, by definition, is not a return of capital. Rather, it is paid out of a company’s earnings.
In other words, when a company sends you a dividend, it is sharing a portion of its profits with you. This is your reward for being a part-owner of the business. With growth stocks that pay no dividends, on the other hand, you’ll need to sell shares to generate cash – something not everyone is comfortable doing.
If you don’t need the cash from dividends, you can always enroll your shares in a dividend reinvestment plan so your money continues to compound, or you can manually reinvest your dividends elsewhere.
Do dividends create additional taxes?
Yes, if you hold dividend stocks in a non-registered account, you’ll likely have to pay some tax, which you could avoid if you invested in a growth company that reinvested all of its cash internally instead. The good news is that dividends are taxed at favourable rates thanks to the dividend tax credit (DTC).
If your income is low enough, you’ll pay very little, if any, tax on dividends. In many provinces, the tax rate on dividends is actually negative in the lowest income brackets. Because the DTC is a non-refundable tax credit, the government won’t send you a cheque for the negative tax. But you can use the credit to offset your other taxes owing.
Is it even realistic to avoid dividends?
Dividends are almost as old as capitalism itself. The practice goes all the way back to the early 1600s, when the Dutch East India Company paid the first dividend – initially in spices, and later in cash – under pressure from investors who complained about the company’s poor allocation of capital.
Nowadays, dividends are virtually impossible to avoid. The vast majority of the biggest companies on the S&P/TSX Composite Index – including banks, pipelines, railways, energy producers and insurers – pay dividends. If these companies suddenly stopped paying them, shareholders would revolt.
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Investors want dividends, not just for financial reasons, but for the psychological benefits as well.
During periods of extreme volatility, receiving a regular flow of dividend income can help investors resist the urge to sell, which could sabotage their long-term financial goals. Adding to investors’ peace of mind, dividend-paying companies are “typically well-established, soundly managed companies with stable businesses,” RBC Global Asset Management said in a report.
“Moreover, many companies are able to grow their earnings and reward investors by increasing their dividend payouts, which can lead to share-price gains and help income investors stay ahead of inflation.”
Finally, companies that increase their dividends regularly – which is the holy grail for dividend investors – have also outperformed the broader stock market over long periods, with lower volatility, RBC said.
With that, I raise my glass to dividends. And, for the record, it isn’t filled with cyanide-laced Kool-Aid.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.