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Dividend-paying investments mute the swings but careful choices needed to win the race

by Wayne Cheveldayoff, 2003-08-18

Investors in dividend-paying stocks and mutual funds can be excused for wondering if they have the right investment strategy.

The non-dividend-paying NASDAQ led the way higher from March into this summerís highs.

In addition, a recent study found that the 131 non-dividend-paying stocks in the S&P 500 index outperformed dividend-paying stocks by a huge margin in the first seven months of 2003. Non-dividend-paying stocks were up an average 34.8 per cent versus a gain of 12.6 per cent for the overall index.

However, rather than discrediting the strategy, the numbers simply illustrate the less-volatile performance profile for dividend-payers: they hold up better than the overall market in a downturn but donít rebound as much when the market recovers.

The lower volatility was certainly evident in the performance of dividend mutual funds during the recent bear market. According to Morningstar Canada, the average dividend mutual fund gained nearly 6 per cent in the three years to June 30, 2003, compared with a 5 per cent decline for the average Canadian equity fund.

This better performance conforms to the historical evidence that dividends are an important element in total return. The compounded return from reinvested dividends accounted for more than 60 per cent of the total return from Toronto Stock Exchange index over the past 47 years.

But a strategy of investing in dividend-payers wonít necessarily win the race in the longer term.

Like most investment strategies, performance depends on choosing the right stocks (or mutual funds).

Some stocks have high dividends because the market collectively thinks the company is having trouble, causing the share price to lag (and the dividend yield to seem high) on the expectation that the company will falter or cut the dividend. If that happens, the total return, taking into account both price and dividend, could be negative.

Also, while preferred shares pay good-sized dividends, very little, if any, capital appreciation can be expected. The reason preferred shares have higher dividends than most common shares is because they donít share in any upside for the company that issued them. Investors get the dividend and their money back but that is all.

While perhaps okay for those who need nothing but income, a portfolio made up mainly of high-dividend-paying stocks and preferred shares is unlikely to bring the longer-run total returns that most would need to build a healthy nest egg.

Rather, the key is choosing dividend-paying companies that are on a solid growth path and have a history of increasing their dividends, so that the stockís value will rise over time.

This requires research. While it is possible to do this yourself, it is very time consuming. Most people, especially those with little time to spare, would require the help of an investment advisor who would have access to a proprietary list prepared by a research department.

The wrong choice could be expensive. The above-mentioned study of the S&P 500 index found that investors suffered if companies cut or eliminated their dividends. In the January to July period, the nine companies that reduced their dividend payouts saw their stocks rise an average of only 1 per cent, while the four that stopped paying dividends experienced an average 13 per cent decline.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

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©2003 Wayne Cheveldayoff