Think dividends! For income and growth

You are likely familiar with the fable about the race between the tortoise and the hare. At the start of the race the hare, with its great speed quickly takes the lead. Once ahead, the hare becomes overconfident and, before reaching the finish line, takes a nap. Meanwhile the tortoise with its slow-and-steady pace ends up crossing the finish line first. The moral of the story: Over-confidence and taking unnecessary risks can quickly undermine the chances of achieving your goals.

In the real world, this lesson can be applied to investing as well. History shows that taking a conservative, long-term approach often proves to be the most rewarding choice. Chasing highflying investments may seem attractive at first but rarely prove sustainable over the long run. Remember technology stocks from a few years ago?

If you are saving for retirement, the idea of investing in conservative, dividend-paying securities may not immediately come to mind. But recent years of market volatility now provide us with a unique vantage point from which to judge how this asset class performs. The verdict: The benefits of investing in dividend-paying stocks have stood the test of time.

What is a dividend?
A dividend is a cash payment made to stockholders using net profits from a company's day-to-day operations. Companies that pay their shareholders dividends are typically large, established businesses that reside in mature sectors of the economy (e.g. banks). The biggest advantage of owning a dividend-paying investment, however, is that it will pay out regular cash distributions that can add up over time.

Dividends provide tax-advantaged income
In addition to the benefits of owning a security that pays out a regular income stream, dividends also enjoy favourable tax benefits. Because dividends represent an after-tax payout of earnings from the company, an income tax credit known as the ‘dividend tax credit' is available to Canadian investors who earn dividend income through investments in the shares of Canadian corporations.

For those individuals not concerned by clawbacks of government benefits and other tax credits that are income tested¹, this can be a considerable benefit when compared with interest payments made from other income-paying investments like bonds and GICs. By including dividend investments in a diversified portfolio, you can benefit from the income the dividends provide as well as potential capital appreciation.

Over the long term, dividends pay off
Since 1956, the dividend component from Canadian equity markets has accounted for approximately 60 per cent of total market returns. In addition, Canadian dividend-paying stocks have outpaced companies that offer no dividend-yield. In U.S. markets, the monthly returns on dividend-yielding stocks have outperformed those that did not pay dividends by an annualized 3.7 per cent over the last 30 years.

Even more rewarding to investors than a steady stream of dividend income is a growing one. Analysis shows that the stocks of companies that have consistently raised their dividends have clearly outperformed the market, as can be observed in Chart 1.

Why dividends now?
In the current market environment, yield (the return on the interest-bearing investment) is a scarce and desired commodity. Bond yields remain low and investors are looking to high dividend-paying stocks to find attractive yields. The average yield of the top 10 yielding stocks of the TSX has actually surpassed the yield on 5-year Government of Canada bonds (Chart 2).

It only makes sense that companies that are able to continually pay steady or increasing dividends year after year tend to be disciplined, well-run companies. When building a diversified portfolio, it is important to do your homework to find investments with solid earnings, a strong balance sheet and a management team committed to paying a consistent dividend stream to investors.

Leveraging² the benefits of dividends
If you are looking to maximize returns from your portfolio, the strategy of borrowing to invest, or leveraging, may be one way of accomplishing this goal. Leveraging allows you to potentially magnify investment gains.

Assume you have $10,000 to invest and you borrow an additional $10,000. You invest the entire $20,000 in a mutual fund at $10 per unit. If the Net Asset Value (NAV) increases to $12 per unit, you have a nice profit of $4,000, less the cost of interest.

That's almost a 40 per cent return versus a 20 per cent return that you would have achieved had you invested only $10,000. Also, instead of receiving a dividend payment on 1,000 units you now receive it on 2,000 units, thereby increasing your income and potential rate of return. This amplified rate of return is the reason many investors are attracted to the strategy of leveraging investing. Keep in mind that while leveraging can magnify your returns, it can also magnify your losses – especially if the market is declining.

Generally, when you borrow funds to invest, the interest paid on the loan is tax-deductible, as long as it has the potential to produce income such as interest or dividends in a non-registered plan. Dividend-paying securities can provide you with a double benefit when you use a leveraging strategy.

First, you benefit from a larger lump-sum investment that can provide a larger dividend payout, resulting in an increased after-tax return.

Second, the interest paid on the loan is deductible. When you can deduct interest paid on your investment, this essentially lowers the rate of return the investment must earn to be profitable.

Under current tax rules, an investor who incurs expenses to produce income can deduct the expense. Even if your expenses are greater than the income in a particular year, you can still benefit by deducting the expense from other income. However, this rule does not apply for Quebec tax purposes. In Quebec, when you borrow money to invest, you can only deduct the interest against other investment income. The amount you deduct in any particular year is limited to the total amount of investment income reported on your Quebec tax return for that year. Since the dividend income reported on your tax return is grossed-up by 125 per cent, Quebec residents can deduct $1.25 of interest for every $1 of dividends received. This makes dividend-producing investments particularly attractive for Quebec residents.

Investing in dividend-paying stocks made easy
If you are considering investing in dividend-paying stocks, mutual funds are an ideal way to get involved. In the not-so- distant past, investors throughout Canada often built their own small portfolios of dividend-paying stocks to capture income and the potential for capital gains. And while these investors often benefited from their conservative approach to equity investing, the small number of individual securities did expose them to unnecessary risks.

Today's mutual fund investors not only benefit from the expertise of a professional money manager, they can also easily access a diversified portfolio of dividend-paying investments. Because there are many factors that can affect the price of a dividend-paying stock, an investment in these securities will benefit from the advantages that diversification can provide. By purchasing a mutual fund that holds a diversified portfolio of these securities, you can reduce the impact on your investment when an individual security fails to perform.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

¹ Dividends are included in income at 125 per cent of the actual dividends received and then receive preferential tax treatment through a tax credit. However, because the grossed-up amount of the dividend is reported for income purposes, they will have a greater impact on income-tested benefits such as Old Age Security (OAS) and tax credits such as the Age credit.
² Borrowing to invest is suitable only for investors with higher risk tolerance. You should be fully aware of the risks and benefits associated with investment loans since losses as well as gains may be magnified. Preferred candidates are those willing to invest for the long term and not averse to increased risk. The value of your investment will vary and is not guaranteed. However, you must meet your loan and income tax obligations and repay your loan in full. Please read the terms of your loan.