EQUITIES COMMENT - Dividend Stocks - What's Not to Like?
The accompanying charts provide a two year view of the TSX Composite, the S&P 500 and Canadian and U.S. 10 year bond yields. You can see the decline that took place in stocks during the third quarter. It was triggered in large part by the rise in10 year bond yields. On a more positive note, the TSX and S&P 500 are up 10% and 20% respectively over the past year. Stocks have been stuck in a trading range for the past two years. They are still below the levels reached in the early part of 2022. The increase in bond yields is putting downward pressure on stocks including those with high dividend yields.
Looking at sector performance, the laggard is now Utilities. The rise in bond yields combined with strength in the economy has made this non-cyclical, above average dividend paying sector less attractive to investors. Technology is still the leader thanks to the potential for artificial intelligence. In the U.S., Consumer Discretionary and Communications sectors are also up substantially due to strong performance from Tech-like stocks such as Amazon and Google. Among Financials, higher interest rates are raising concerns about more bank loans going sour and this is causing bank stocks to decline. In our view, the shares are already reflecting a lot of this potential bad news. As long as unemployment remains low, loan losses should remain manageable. During the quarter, Energy was the strongest sector thanks to the rise in oil prices.
The following graph shows the performance of the TSX Composite with stock prices only (purple line) and the TSX Composite Total Return (orange line) which includes stock prices and dividends. You can see that dividends have accounted for more than half of the increase in the Total Return Index. This is one of the reasons why we favour dividend paying stocks.
Dividend paying stocks have been under pressure this year due to competition from increased bond yields. Some investors with a low risk tolerance bought dividend paying stocks to earn income in recent years because of the paltry rates available on bonds. Now that rates have increased, these investors can sell stocks and buy bonds for a similar yield. This trade looks good now however, when the bonds mature, investors could be facing lower rates if inflation declines. Also, when tax time comes, depending on the investor’s marginal tax rate, after tax income from bonds could be significantly lower than stocks.
One of the attractions of dividends is that they grow over time. This provides a hedge against inflation. The accompanying graph shows the annual growth rate of dividends over the last ten years for some of our favourite stocks. You can see that banks have had the fastest rate of growth while the less cyclical companies have had more modest increases.
At the current time, the majority of these stocks have a dividend yield greater than 5%. This is calculated by taking the dividend paid per year divided by the share price. Yields on the selected stocks below are attractive even in the current rate environment. In addition, there is potential for dividend increases and capital appreciation over the next 3-5 years.
The near term prospects for the TSX and S&P 500 are being dampened by higher bond yields. Stocks could remain within the two year trading range for another year. A recession brought on by restrictive monetary policies in Canada and the U.S. or an oil price spike related to the war in Israel could push stocks to the bottom of the trading range. Lower inflation and rate cuts could allow stocks to move to the top of the range. Our research indicates Canadian stocks have a more favourable risk reward trade-off in the near term than U.S. stocks due to a lower valuation. Longer term we expect faster earnings growth from U.S. stocks.