Big, fat dividends

There was a time when dividend-paying stocks were considered low-risk investments. If you were a cautious, conservative investor, you bought shares in a bank, or an insurance company, or a utility, then you went to sleep. While you snoozed, dividend cheques dropped through your mail slot every three months and your shares gradually increased in value.

Dividend investing worked so well because banks, insurance companies and utilities made it a priority to maintain the stream of dividends that they paid to you. These companies knew that you bought them for the steady flow of cash they delivered. Management knew it had no room for playing with your expectations.

Both companies and investors prospered under this arrangement — until financial wizards south of the border became too smart by half. They engineered the greatest housing boom of all time, built on a foundation of shaky debt. The result is the recession we see around us.

The recession has smacked dividend stocks, especially stocks in the financial sector. No longer are these stocks praised as relatively safe havens; now they’re scorned as risky gambles. Why? Because investors worry that banks and insurance companies will no longer be able to continue paying their current dividends.

The easiest way to measure the level of investors’ fear is to look at what has happened to dividend yields — the annual amount of a stock’s dividends divided by its stock price. The average dividend yield on Canadian financial stocks now stands at a whopping 6.5%. That is almost double the historical average. It is, by any standard, an extremely attractive yield.

So does that mean that these stocks are a good investment? Assuming that the world will eventually return to normal, dividend yields will one day revert back to their historical mean. For that to happen, one of two scenarios has to occur — either banks will have to cut their dividends, or stock prices will have to rise to the point that dividend yields fall back to the normal level of 3% or so.

In my view, the latter scenario has a much higher probability of prevailing than the former. So I think these stocks are likely to do very well in the years ahead.

Before you get carried away, let me explain the risks involved. Dividends, as you may know, have to be declared every quarter at the discretion of a corporation’s management. No corporation has a legal obligation to pay dividends. A firm is allowed to cut dividends if times get tough.

If a company pays $3 of dividends per share, and the stock price is $50, the dividend yield to investors is 6%. If the stock price goes up, or if management cuts the dividend, the yield goes down.

In the U.S., dividends have been going down, down, down. The subprime mortgage crisis has hammered large U.S. banks and those banks have slashed their dividends to conserve cash.

In Canada, investors fear that our banks will do the same. This is why the high yields on their shares aren’t attracting buyers the way they once would have.

I can understand the fear. We have yet to see the full impact of the recession on the credit quality of Canadian banks. If people stop paying their mortgages and credit cards, then banks will suffer and they will cut their dividends.

I think, though, that fears of a dividend cut are overblown. Unlike their U.S. counterparts, Canadian banks have not experienced devastating losses from subprime mortgages. Yes, their earnings have declined, but, by my calculations, both their earnings and capital remain sufficient to sustain current dividends. In fact, in March there were reports that Canadian banks have started to refuse the government’s offer to buy illiquid mortgage assets. This refusal strikes me as a clear sign that the banks have no liquidity issues. If they can turn down government’s helping hand, they must be doing all right.

While banks look tempting, there is an equally bullish case for Canadian insurance companies. Their dividend yields are now higher than those of bank stocks, which is a rare occurrence. The yields have soared because investors are worried about a recent falloff in underwriting revenues and the degree to which stock market losses have hurt insurance companies’ portfolios. But while the short-term outlook remains bleak, it’s hard to imagine that recent losses could be large enough to permanently impair those big firms. I believe that in 10 years we will look back at today’s prices as the buying opportunity of a lifetime.

All of this means that financial stocks could be a bargain. As always, though, I urge you to invest with restraint. Rather than putting all your eggs into one or two stocks, consider buying a mutual fund that invests in dividend-paying stocks. Those dividend funds typically invest between 40% and 50% of their portfolio in financial stocks. The rest of the portfolio is usually diversified into sectors such as telecommunications, utilities and pharmaceuticals, or into some lower-risk asset classes, such as income trusts and preferred shares.

I’ve compiled a list of my favorite choices for dividend, which you can see below. In creating the list, I have tried to pick true dividend funds. I have avoided managers who have a tendency to stray away from their mandate in search of a quick buck. This tendency is more common than you may think. During the now defunct bull market, many dividend fund managers invested heavily in commodity stocks while reducing their exposure to high-yield equities. As a result, those funds distributed lower dividends than expected. During the bear market, their losses exceeded those of the typical dividend fund.

*Source: Fundata Canada Inc., February 2009
The funds I’ve chosen have stuck to their core mandates. While it’s difficult to estimate their yields going forward, I have tried to estimate the dividend yields of their top holdings (net of expenses) based on the most recent disclosure of each fund. The estimated yields are almost double what they were a year ago.

I think these funds are good investments but keep your expectations in check. Prices won’t rebound to last year’s level anytime soon. The economic crisis may not have hit bottom. Even if it has, investors have been hurt and will take time to regain confidence in stocks.

My advice is to invest in these funds in small increments. Never use money that you may need in the next few years. After all, the longest bear market in history lasted three years and took away 85% of equity values. We are only a year and change into this bear market, with losses of 50% or so. So proceed cautiously.