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Don't Give Up on Dividend Stocks

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The yield on widely held dividend stocks can be nearly three times better than bond yields on an after-tax basis.

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The whole-grain goodness of blue-chip dividend stocks has its limits.

Utility stocks, consumer staples, pipelines, telecoms, and REITs have all lost ground over the past month, even while the broader market has been flat. With the bond market signaling an expectation of rising interest rates, the five-year rally for steady blue-chip dividend payers has stalled.

Should you be scared if you own a lot of these stocks, either directly or through mutual funds or ETFs? David Baskin, president of Baskin Financial Services, has a two-pronged answer: Keep your top-quality dividend stocks, but be prepared to follow his firm's example in trimming holdings in stocks such as TransCanada (NYSE:TRP), Keyera (TSE:KEY), and Pembina Pipeline (NYSE:PBA).

Let's have Baskin run us through his thinking on dividend stocks, which are a big part of the portfolios his firm puts together for clients. A mini-manifesto for the managers at his firm: "We like low-beta stocks, we like a nice yield, and we like a history of raising dividends." Low beta means less volatility than the broader stock market.

Dividend stocks have had an amazing run in the past few years, and far outperformed the broader stock market. They've helped investors panicked by the 2008-2009 crash make friends with stocks again, and they've helped ease the mind of income-seeking investors appalled at how little bonds and guaranteed investment certificates pay.

But no theme in investing is successful all the time. You can see this in the way dividend stocks have been manhandled by investors looking ahead to market conditions where growing revenues and profits become more important than steady dividends. As of late this week, the Canadian S&P/TSX REIT, utilities, and telecom indexes had one-month losses of 7.6%, 7.1%, and 2.5%, respectively.

Baskin believes the sell-off of dividend stocks was excessive, but unsurprising at a time when bond yields have surged higher. The simple explanation of the interplay between bonds and dividend stocks is that higher yields on the kind of low-risk bonds issued by governments and blue-chip corporations make the yields on higher-risk stocks look less attractive.

In Canada, the yield on the five-year Government of Canada bond has gone from 1.15% on May 1 to 1.44% late this week, a very significant jump by the standards of the bond market.

Baskin points out that the 50-year average yield for the five-year Canada bond is 5%, which is a reminder that we are still at historically low levels for bond yields. So low, in fact, that yields from blue chip dividend stocks continue to be a lot more generous, and that's not even considering the benefits of the dividend tax credit in non-registered accounts.

According to Baskin's data, the dividend yield on the S&P/TSX composite index is 2.8%. Except for the past few years, where interest rates have been at historical lows thanks to the global financial crisis and recession, five-year bond yields have been higher than dividend yields every year since the 1950s.

Today, Baskin estimates that the yield on widely held dividend stocks can be nearly three times better than bond yields on an after-tax basis. That's one reason for not being hasty about dumping dividend stocks.

Another is the potential for dividend growth, which in practical terms means a rising stream of income. Already this year, there have been dividend hikes from the big telecom companies, banks, and some REITs.

"Right now, we're in a golden age of dividend increases," Baskin said. "It's not just the yields you're getting today, it's the yield you'll get in the future as dividends get increased."

Finally, Baskin believes central banks in Canada and the United States will be very cautious about allowing interest rates to move higher, given lingering questions about the strength of the economy. He said short-term interest rates won't increase by more than one percentage point in the next two years, though longer-term rates may rise more.

Don't give up on dividend stocks, but don't be complacent about them, either. Many of these companies have performed brilliantly in the past five years and have now become expensive.

Take Keyera, a provider of services to the oil and gas industry whose stock has risen a cumulative 165% in the past five years, and now yields 3.6%. "We trimmed a quarter of our holdings in Keyera when it got over $60," Baskin said. "It's a good stock and we love the yield, but it's really expensive."

Similarly scrutinized stocks in Baskin Financial client portfolios include Pembina and TransCanada. The stocks were reduced by roughly one-third or one-quarter, not sold outright.

"People have this thing in their mind that it's either buy a stock or sell it," Baskin said. "There's no reason why you can't sell a quarter of it or a third of it. We do it all the time."

Money pulled out of dividend stocks held in Baskin Financial accounts has for the most part been invested in US stocks. In fact, the firm has more US stocks in its portfolios than at any time since 2006.

Some of the most recent buys include Goldman Sachs (NYSE:GS), JPMorgan Chase (NYSE:JPM), Energizer Holdings (NYSE:ENR), Dr. Pepper Snapple Group (NYSE:DPS) and Bed Bath & Beyond, Inc. (NASDAQ:BBBY). (However, one rule the firm has for buying US stocks is that the Canadian dollar has to be worth more than 95 US cents.)

While dividend-heavy sectors such as utilities and telecom were falling in the past month, economically sensitive sectors like materials, energy, and industrials were on the rise. Baskin said his firm owns some Magna International (NYSE:MG) and some lumber companies to participate in the US housing rebound. But he's not moving into resource stocks in a big way until it's much clearer that the economy is strong.

In any case, Baskin said he doesn't like the volatility and low yields of commodity stocks. You don't have those issues with REITs and utility, telecom, and pipeline stocks, even if they have been roughed up lately.

Editor's Note: This article was written by Rob Carrick, reporter and columnist for The Globe and Mail.

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