Canada’s top dividend stocks for Q3

Global dividends grew 2.8% on a headline basis to a third-quarter record of US$355.3bn, up 5.3% in underlying terms, the report said. The Janus Henderson Global Dividend Index rose to 193.1, a new record.

Canadian banks and energy beat U.S. bonuses
Growth in Canada beat its US counterpart for the ninth consecutive quarter driven by strong results from energy companies and banks. Here’s the list of the top 10 dividend payers in Canada, according to the Janus Henderson Index:

“Dividend stocks are highly linked to interest rates; investors tend to forget that. Using dividend stocks to replace bonds can be a part of an income strategy – but not the whole strategy. It scares me when people use dividend stocks as the whole strategy,” Tom Bradley, the co-founder of Steadyhand said.

Dividends aren’t bonded
While this might make sense as a part of an overall income strategy, investors shouldn’t use dividend stocks as a total substitute for bonds.Shoemake noted that with interest rates at their current low levels, equities will continue to provide a valuable source of income for investors.

Bonds typically perform four functions in a portfolio – returns, income, diversification and downside protection. Dividend stocks don’t cover all four functions.

It always makes sense to invest with a fixed goal and with an investment plan. When evaluating stocks, it doesn’t pay to see dividends as a single point screen.

When considering dividend stocks, investors should look beyond the headline dividend yield to how sustainable the dividends and growth of dividends are, and the total payouts, which include the effects of share repurchases, says Morningstar Canada’s head of investment management Michael Keaveney. “Indeed, in the long run, our research indicates that the cash flows that corporations supply, including payouts in the form of buybacks as well as dividends, are the ultimate drivers of stock returns,” he says.

How do you pick stocks that might make sense?

Selecting the right dividend stocks
When we look for stocks, we look for a competitive advantage, a margin of safety, and valuation. So, we looked for stocks that have an economic moat, or a sustainable competitive advantage. We also added in our “Morningstar Rating for Stocks”, popularly known as the "Star Rating". The rating is determined by three factors: a stock's current price, Morningstar's estimate of the stock's fair value, and the uncertainty rating of the fair value. The bigger the discount, the higher the star rating.

In addition to our ratings, we use the dividend payout ratio, which measures how much of a company’s annual earnings are used to pay dividends. A ratio of 1:1 indicates that a firm is giving back all its profits to shareholders. We also look at the historic yield (trailing 12 months) and compare that with the forward yield.

Here’s a look at the top 10 S&P/TSX Composite stocks in our coverage universe, with the highest historic yield, that also have a wide or narrow Economic Moat:

Promising dividend pipeline from Enbridge
Only three of these stocks are undervalued – Peyto Exploration & Development (PEY) Enbridge (ENB), and CIBC (CM). Of these three, only one is a rare triple-threat: high yield, wide moat, and undervalued share price.

Morningstar analyst Joe Gemino sees a 35% upside in Enbridge, coupled with a 6.3% dividend yield. He also expects Enbridge to generate significant free cash flow and grow its dividend at 10% next year with annual increases of 3% thereafter. “Even though the Line 3 Replacement Project has suffered some delays, we still expect the pipeline to be built. The market has also expressed concerns over the future of Enbridge's Line 5 pipeline, which has been subject to some legal challenges. However, we do expect the pipeline to remain in service in its full capacity,” he added.

CIBC continues to be the most undervalued Canadian bank under our coverage universe. “I think if you're going to consider CIBC, you have to keep in mind, they are the most exposed to the housing market. They did very poorly during the last downturn. And this is a bank that paid a fairly high premium for their PrivateBancorp acquisition to expand in the U.S. and this is a management team that's openly admitted they'd like to grow the U.S. business even more. So, if you can get comfortable with those risks, I don't think the valuation is very demanding on the name. They don't have to do much right to deserve a higher valuation,” Morningstar analyst Eric Compton says.