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Not all dividends are equal

Why the right kind of dividend matters.

With persistently low global bond yields and an increasing number of Canadians who are approaching retirement age, dividends have been brought into acute focus.

As governments and central banks continue to provide stimulus to expand economic growth, the amount of global negative-yielding debt has reached approximately US$13.4 trillion as of March 31, 2021[1].

This chart compares the 10-year government bond yields for several countries, from 2014 to the present. The countries shown are Canada, the United States, the United Kingdom, Japan, and Germany. The chart shows all five countries yields have decreased to below 1%.

In the next 10 years, every baby boomer will be at least 65 years of age. When you add the fact that people are living longer, the issues become very clear; it’s going to be a challenge to fund a longer retirement in a low-yield environment.

Dividends are different

With fixed income, we know that the current yield of a bond provides the annual return that can be expected for the life of a bond. If we assume a 2 per cent rate of inflation and a 40 per cent tax rate, a 3.3 per cent annual rate of return is needed just to maintain purchasing power. The current yield on a lot of government debt is just around 0.95 per cent. If you couple that with the potential for rising inflation this year (which would push bond yields higher), many bond funds could be facing negative returns.

Bonds come with certain guarantees of income, in the form of coupon and principal payments, but for the most part, they also come with a guarantee that an investor will never receive more income than the coupon states (assuming no capital gains have been earned). But dividends are different. While there are no guarantees, companies that pay the dividend may have some pricing power in the market, allowing them to adjust payouts to keep pace with inflation. So, why not just look for companies with the highest dividend yield and call it a day?

Diagram: It's a (yield) trap! The hidden reasons behind very high dividends. Unpredictable payouts, Debt-funded payouts, High payout limits future growth, High dividend yield due to stock price drop.

For illustration purposes only.

“We know that dividends are a significant driver of long-term equity performance. But we don’t want to fall into the dividend yield trap; you don’t just want to go out and buy the highest-yielding dividend stocks because they actually tend to underperform the dividend universe itself."

– Philip Petursson, Head of Capital Markets Research, Manulife Investment Management

Not all dividends are created equal. A company may attract investors through its substantial dividend offering, but what happens if the company falls on hard times? Is the dividend cut to preserve cash and manage the rough patch, or does the company take on debt to sustain the dividend and potentially the investment capital of those who may sell the stock if the dividend is suspended? This is a dividend value trap. Investors buy the stock for the unsustainable dividend and the company continues to add debt to the balance sheets to pay that dividend.

What about the flip side? There are plenty of companies that can maintain and grow their dividends. A good rule of thumb to help determine whether a company can continue to sustain the dividend is if the company has a payout ratio of under 70 per cent.  A lower payout ratio suggests that a company has available excess capital to reinvest in the business, grow its business and over time potentially grow its dividend.

Let's consider Company X:  •	It has a dividend yield of 2.5 per cent today. •	If Company X increases its dividend at an annual rate of 12 per cent, the yield on cost will double to 5 per cent in six years. Many companies fall into this category. In fact, it isn't difficult to find companies that have paid dividends consistently for more than 100 years and grown annually for over 25 years.

“Digging a little deeper, our research has uncovered that companies that have grown their dividends faster than median have outperformed the broad market over the long term.”

– Philip Petursson, Head of Capital Markets Research, Manulife Investment Management

This chart compares our dividend growth model to the S&P/TSX Composite Index cumulative return, from 2010 to 2020. There’s a strong correlation between the direction of both, and both show an overall year-over-year increase from 2011 to 2020.

The growth model

The Capital Markets Strategy team at Manulife Investment Management developed a dividend growth model to identify the dividend growers in the market. The performance of these companies is compelling. While it would seem obvious to just buy and hold the screened model, some discretion is required due to liquidity, diversification, and valuation. The model currently only has 24 companies, with a median market cap of approximately CAD 4 billion. Dividend growth combined with appropriate payout ratios is a good way to identify quality businesses; however, attention must also be paid to valuation and liquidity. The search for yield has driven valuation for some companies to levels that no longer offer attractive entry points. Paying attention to the price you pay, as well as exit points, remains equally important as buying quality businesses.

A market solution

Just like picking bonds, finding the right kind of companies at a reasonable price would be very difficult for the average investor. That’s why this method has been applied to two ETFs in Manulife’s line-up: the Manulife Smart Dividend ETF (CDIV) and Manulife Smart U.S. Dividend ETF (UDIV), Canadian and U.S.-based dividend growth model ETFs.

“If you focus on companies that can grow their dividend at an above average rate, think about it this way: you’re getting a raise for doing nothing each year. And they can do that through operations of the business (organically) … and we measure that through a lower payout ratio. This represents a good quality company.”

– Philip Petursson, Head of Capital Markets Research, Manulife Investment Management


That’s all well and good, but is it investable, especially when we consider the size and depth of the Canadian market? Creating an ETF based solely on the dividend growth model would move the markets when growing to any reasonable size. So how was the model made investable? Brett Hryb, Head of Beta Management at Manulife Investment Management, used their expertise and research to enhance the simple dividend growth model and develop it into a robust potfolio that captures the benefits of dividend growers while focusing on high quality factors.  Hryb says, “We look at these portfolios in the same way as an active manager, we just do it in a more systematic fashion. For example, we have a very high active share, especially in the Canadian portfolio, so that means very active bets on specific stocks. But we do it in a systematic manner — quarterly rebalancing, an efficient way to trade this as cheaply as possible and with really low turnover.”

So, by adding a strategic beta backbone to the dividend growth model, the Manulife Smart Dividend ETF (CDIV) and Manulife Smart U.S. Dividend ETF (UDIV) were launched in November of last year. To learn more about how Philip and Brett came up with and developed these ETFs, listen to episode 51 of Investments Unplugged.

Even though fixed income will face some challenges this year, it still has a place in portfolios. It can be especially formidable when it comes to rebalancing and taking advantage of depressed assets. In the current environment and with the challenges retirees will face over the coming years, dividends from stable, growing companies may offer an alternative solution for income-oriented investors.

[1] Souce: Manulife Investment Management, Bloomberg, as of March 31st, 2021

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