Canadian dividend investing: a strategy not without risks

Sector concentration and the prevailing low-yield environment present unique challenges to dividend investors who want to focus on the home market.

Shehryar Khan, CFA 24 July, 2015 | 5:00PM

Focusing on stocks that can pay and sustain a dividend has been an enduring theme among investors -- it's no coincidence that RBC Canadian Dividend is the largest mutual fund in the country -- and has been hailed by many as a way to outperform the market in the long term.

In the wake of the 2008 financial crisis, investors flocked to income-oriented strategies due to the safety they were perceived to provide. After all, in 2008, funds in the Canadian Dividend and Income Equity category lost 24% -- much less than the 33% decline posted by the S&P/TSX Composite Index. And indeed, in 2011 when the TSX lost over 8%, the average fund in the category lost a mere 0.8%. Since 2008, the dividend-oriented funds have done remarkably well at protecting investors' capital when markets decline, capturing just 65% of down markets.

Not only have these funds proved themselves sturdy in market declines, they've kept up when the good times roll as well, capturing 75% of market rallies. Overall, from January 2008 to June 2015, the category has outpaced the broad market, delivering an annualized 4.7% return versus 3.7% for the TSX.

Given the success dividend-paying funds have had over pure equity Canadian equity funds, it's worth asking whether the fun can last. And dividend investing is certainly not without its risks.

The struggles of the global economy are a double-edged sword for Canadian dividend-oriented investors. On the one hand, the longer interest rates stay low, the longer dividend stocks will continue to bear the fruits of providing income-starved investors with much-needed yield. The flip side is that given the importance of oil to the Canadian economy, the price of crude remaining at current low levels could serve to prolong the time until we see higher rates; such a low growth environment would make it harder for firms to grow their earnings, and therefore their dividends.

Moreover, valuations of safer dividend-paying stocks have been steadily rising since the 2008 financial crisis, as investors viewed dividend-paying strategies as a safe haven after the markets collapsed. Using price/earnings (P/E) ratio as our gauge, we see that the average price levels for funds in the Canadian Dividend and Income Equity category are at post-crisis highs, as is the broad market. Valuations looked cheap relative to the broad market going into the 2008 financial crisis and the 2011 slump -- two relatively strong periods for dividend-oriented stocks. However, on average, the category holds stocks at market-like valuations, meaning the category could enter any potential down spell without the margin of safety that has served it well in the past.

The higher valuations of dividend-paying stocks may make sense, though, given the low interest rate environment. Low bond yields make higher-yielding stocks look attractive by comparison. This scenario could prevail for some time. The Bank of Canada has signaled a strong bias toward low rates as long as Canada's economic weakness and low oil prices persist. Were interest rates to rise, though, these stocks would likely take a hit, as bonds will offer greater safety and higher yields.

In Canada, dividends mean doubling down

Focusing on higher-yielding stocks in Canadian equities means you'll be doubling down on already-large weightings in the index, especially in financials.

The TSX sectors with the highest dividend yields at the end of June 2015 were energy, telecommunications, utilities and financials. Those four sectors account for over 60% of the index, with energy and financials accounting for the overwhelming majority of that exposure. The funds in the category, whose holdings yielded an average of 3.9% at the end of June 2015, had an average exposure of 70% to those sectors, with close to 39% allocated to the financials sector and 20% in energy.

Given the current market environment, this high exposure to energy and financials should give investors pause. Oil prices plummeted in 2014, putting significant pressure on the balance sheets of firms in the energy sector and resulting in many of them having to curb spending, delay new projects and cut jobs. Though firms in the energy services industry have generally fared better, the largest stocks in the sector are those of the exploration firms, which have been the hardest hit. Although funds in the Canadian Dividend and Income Equity category are invested primarily in the exploration industry, their largest stakes tend to be in names like  Suncor (SU),  TransCanada (TRP) and  Enbridge (ENB), that have reliably paid and even grown their dividends over the long term. Not all are immune however;  Canadian Oil Sands (COS) cut its dividend by 75% in January and is on shakier ground.

The financial sector, which is dominated by the large Canadian banks, accounts for a third of the Canadian market but more than 50% of the Dow Jones Canada Select Dividend Index. Some investors such as Brandon Snow, manager of Bronze-rated CI Cambridge Canadian Equity, worry about the headwinds banks face from slowing economic growth in Canada and high levels of consumer debt. These concerns could get in the way of banks' ability to increase their dividends, though bulls like Kim Shannon, manager of Silver-rated Sionna Canadian Equity, point to opportunities outside of Canada and the less-competitive nature of the industry, which should encourage stability.

Given higher valuations and the fact that dividend investing can lead to a higher concentration of financial and energy stocks -- a symptom of focusing on the domestic market -- income-oriented investors should ensure their overall portfolio is appropriately diversified as well as meeting their income needs.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Enbridge Inc47.36 CAD0.83
Suncor Energy Inc39.58 CAD-0.45
TC Energy Corp67.56 CAD-0.15

About Author

Shehryar Khan, CFA

Shehryar Khan, CFA  Shehryar Khan, CFA, is a senior investment analyst for Morningstar’s Investment Management group.