While its hard to prove, dividend investing seems to be more popular in Canada than in the U.S. and other countries. Certainly, there’s no shortage of media coverage, websites and mutual funds devoted to dividend-based investing strategies.
The popularity of dividend-focused approaches may reflect, at least in part, the special tax treatment Canadian dividends receive, or a home bias toward shares in Canada’s banks, telecoms, utilities and other blue-chip dividend payers.
Whatever the reason, the fascination of many Canadian investors with dividends betrays a misunderstanding of how equity returns work and exposes portfolios to higher risk.
Returns from equities are composed of capital gains (price increases) and dividends. As explained in this excellent article by our PWL colleague Dan Bortolotti, dividends and price appreciation are two sides of the same coin.
If a company pays a $1 per share in cash dividends from earnings, its shares become less valuable by that $1, in theory. As Dan explains: “This price drop will not be penny for penny, and it may even be washed out by the normal fluctuations in the daily markets. But there is always a trade-off. After all, when a company pays out, say, $10 million in dividends, it must be worth $10 million less.”
Therefore, it should make no difference to you whether your returns come from dividends or from capital appreciation (ignoring taxes and transaction costs).
However, the direct relationship between share price and dividends is clearly a difficult concept for many shareholders to grasp and that can lead to some risky investment bets. First among the risks is a serious loss of diversification to which dividend investors are prone.
A dividend focus excludes a large and growing number of companies that don’t pay dividends, despite earning high profits. One prominent example is Warren Buffett’s Berkshire Hathaway, which has never paid a dividend under his leadership. In fact, nearly half of all U.S. publicly listed companies paid no dividends between 1963 and 2019, according to this article.
The problem is compounded by the sector concentration of higher-yielding dividend paying stocks. This is particularly pronounced in Canada where dividend funds are dominated by a relatively small number financial, telecom, pipeline and energy stocks.
Then, there’s the danger that dividend payouts will be cut or eliminated during recessions. This was the case during both the 2008-09 financial crisis and the pandemic when one in five companies cut their payouts and one in eight eliminated them altogether.
Finally, investors often buy dividend stocks for the income, but this is less tax efficient than selling shares to generate cash.
The first months of 2021 have been kind to dividend investors as the market rotated from growth to value stocks, a group that includes many dividend-payers. The iShares Canadian Select Dividend ETF, the largest such fund in Canada, returned 12.99% in the first quarter, easily outpacing the broad-based iShares Core S&P/TSX Capped Composite Index ETF’s return of 8.11 %.
It was a very different story last year. Dividend boosters often claim these stocks hold up better in downturns, but that certainly wasn’t the case during the pandemic crash and recovery. ETFs focused on Canadian dividend stocks were “blown away” in 2020 by broad-based ETFs that track the S&P/TSX Composite Index. The iShares dividend ETF returned -0.51 versus +5.61 for the S&P/TSX Composite Index ETF.
The evidence is clear that the best way to build wealth over the long run is by diversifying as widely as possible within and across asset classes and geographies. Dividend investing not only fails the diversification test but also exposes your portfolio to the risk of not delivering the income you were counting on.
Certainly, dividends are an important part of overall stock market returns. However, when it comes to dividends, too much of a good thing can be bad for your financial health.