Archive | January, 2011

Debunking Dividend Myths: Part 5

This post is the fifth in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

One of the most appealing aspects of dividend investing is the tax advantage: dividends from Canadian companies are eligible for a significant tax credit. This credit does not apply to US or international stocks, however—indeed, foreign dividends are taxed as regular income and are subject to withholding taxes. That’s why many dividend-focused investors hold only Canadian stocks in their portfolios.

Income from Canadian dividends is an important part of most retirement plans. But if you’re staking your whole future on a small number of domestic stocks, you should be aware that your investment strategy may be a lot riskier than you think.

Understanding risk

First, a little financial theory. All equity investors face systematic risk, which is simply the risk associated with the market as a whole. Systematic risk cannot be diversified away: even people who own index funds with thousands of stocks are not immune to a market crash.

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Debunking Dividend Myths: Part 4

This post is the fourth in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

I recently attended an investment show where one of the speakers (a well-known Canadian author) explained that his strategy was just common sense. It went something like this: “Think about the products and services you use every day. We all use toothpaste, cellphones, debit cards, oil and gas. So all you need to do is identify the best companies in these sectors: they should have strong brand recognition and a competitive advantage. Buy stocks in these companies, and then sit back and watch those dividends roll in.”

Peter Lynch was the pioneer of “buy what you know,” and here in Canada, Derek Foster has taken up the torch. I touched on this kind of folksy investing wisdom in a previous post back in November,

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Debunking Dividend Myths: Part 3

This post is the third in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

It’s awfully hard to get excited about fixed-income investments these days. During most periods in the past, bonds and GICs paid interest rates significantly higher than the average stock dividend. But not today: five-year GICs are now pulling down about 3%, while 10-year federal bonds are earning less than 3.5%. The dividend yield of the S&P/TSX Composite Index is about a point lower than that, but it’s easy enough to build a stock portfolio that pays 4% or more.

No wonder I frequently hear from investors who have ditched fixed-income investments altogether in favour of dividend-paying stocks. Indeed, some popular dividend gurus advocate throwing fixed income to the dogs altogether, no matter what market conditions happen to be. “I don’t understand why people switch to bonds in retirement,” writes Tom Connolly of the popular Dividend Growth website.

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Debunking Dividend Myths: Part 2

This post is the second in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Every morning Larry takes a brisk walk with his beloved German shepherd and then enjoys a Dole banana and a cup of nonfat Yoplait. He eats organic lunches at The Angry Vegan, and three times a week he visits The House of Pain, where he lifts weights, swims or does a spinning class. Larry follows this routine for decades (he goes through a few German shepherds) and remains spry and active into old age. One day, Larry’s great-grandson asks him for the secret to keeping so healthy. “It’s all about making good choices,” the old man replies. “Start by choosing a breed of dog that is strong and long-lived. Then buy only recognized brand names for your breakfast foods. Finally, always patronize restaurants and fitness clubs that are well managed and highly profitable.”

When I hear dividend investors talk about their success,

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Debunking Dividend Myths: Part 1

This post is the first in a series exploring common myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Many investors take it for granted that dividend-paying companies are superior to those that do not pay a yield. But this idea has been the subject of debate for decades, and many academics believe that it is irrational.

Let’s start with something everyone can agree on. Equity returns have two components: capital gains (price increases) and dividends. Add them together and you have the total return for a stock. Ignoring taxes and transactions costs, a stock that pays no dividend but increases in price by 6% provides precisely the same return as one whose share price rises 4% and pays a 2% dividend.

Dividends lead to a drop in share price

What many investors don’t grasp is the direct relationship between share prices and cash dividends. If a company’s stock is trading at $20 and it pays a $1 dividend,

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When Does a Dividend Strategy Make Sense?

My last couple of posts have dealt with stock picking and dividend-based indexes, and they’ve sparked some of spirited debate in the comments sections. Much of the feedback has come from dividend investors, and it’s prompted to me to finally write a series of posts that I’ve been researching for some time.

Dividend investing is perhaps more popular than it has ever been. There are two obvious reasons for its increased appeal. First, many people have lost faith in the growth prospects for equities and see dividend payouts as more reliable than share-price increases.  Second, the low rates on bonds and GICs have made dividend yields even more attractive to income investors. But if the emails and comments I’m receiving are any indication, many investors have flocked to dividend investing for the wrong reasons, without understanding the risk-reward trade-off.

When dividend investing may be best

Let me stress something before we go any further. I am not suggesting that building a portfolio of dividend stocks is a bad strategy. Many savvy investors have done so successfully for years, and it would be supremely arrogant for me or anyone else to tell them they’re wrong.

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The Tyranny of the Aristocrats

Last August, Rob Carrick of The Globe and Mail wrote a piece about Canadian dividend ETFs and he invited three bloggers — me, Canadian Capitalist and Million Dollar Journey — to offer our picks. My colleagues both chose the Claymore S&P/TSX Canadian Dividend ETF (CDZ), one of the more popular ETFs in Canada, with almost half a billion dollars in assets. I took a different view, suggesting that investors consider buying equal amounts of CDZ and the iShares Dow Jones Canada Select Dividend Index Fund (XDV).

My reason for that recommendation — explained in this August 2010 post — was that the ETFs track two very different indexes, and there was surprisingly little overlap in their holdings. Well, that’s even more true today. The S&P/TSX Canadian Dividend Aristocrats Index, the benchmark for CDZ, was reconstituted in December, and the changes were dramatic: the Claymore ETF now has zero exposure to banks and insurance companies. Its iShares competitor, meanwhile, is more than 51% financials: the Big Six banks alone make up almost 30% of XDV.

How to become an Aristocrat

To understand what’s going on here,

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What Investors Can Learn From Entrepreneurs

This post is the last in a series in which I share some insights from my recent interview with Meir Statman, one of the world’s leading scholars of behavioural finance. At the end of the post, I’ll tell you how you can win a copy of Prof. Statmans’s fascinating new book, What Investors Really Want.

It’s natural for human beings to be overly confident in our own abilities. You’ve probably heard about the famous famous study in which about four out of five people rated their own driving skill as above average.

This tendency to overrate our own skill is sometimes called the Lake Wobegon Effect, after radio personality Garrison Keillor’s fictional town where “all the women are strong, all the men are good-looking and all the children are above average.”

You can imagine that 100% of active fund managers are convinced that they can outperform the market. But this is impossible, since every invested dollar that beats the market must be balanced by another dollar that lags by an equal amount.

The idiot on the other side of the trade

Prof.

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There’s No Place Like Home

These are good times to be a Canadian equity investor. Not only have we enjoyed back-to-back banner years — the S&P/TSX Composite returned over 35% in 2009 and 17% last year— but Canadian stocks have dramatically outperformed both the US and international developed markets over the last decade.

Of course, even when Canadian stocks were lagging the rest of the world in the 1980s and 1990s, investors in this country still loaded up on them. Back then we didn’t have much choice: you weren’t allowed to have more than 20% of your RRSP in foreign holdings, and in any case, investing internationally through mutual funds was extremely expensive. Both hurdles have long since disappeared—indeed, thanks to ETFs from firms like Vanguard, investing internationally is in many ways cheaper than buying Canadian. Yet still our home bias remains.

Are companies safer because they’re more familiar?

In my recent interview with Meir Statman, author of What Investors Really Want, I asked the professor why we suffer from home bias. I suggested that perhaps we were confusing what is familiar with what is safe:

“That makes sense,

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