Why dividends could save you from years of meagre 3% returns

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Watch those falling profit margins. They could leave your retirement with a nasty bruise.

Pavilion Global Markets, the Montreal-based market research firm, says investors should expect to reap only a meagre 3 per cent annual return from stocks, in real terms, over the years ahead. The main culprit for those dismal returns, it says, is the inevitable decline in corporate profit margins.

In the United States, profit margins in the national accounts hit a 60-year high of 12.7 per cent in October, 2011, and have since slid to 12.4 per cent, according to Pavilion. It sees much more slippage ahead, as competition erodes profits, and expects margins to eventually revert to their historical norm of 9.5 per cent.

Falling levels of profitability may be offset by slightly higher price-to-earnings ratios and increased sales, but if you do the math – as Pavilion has – stocks seem set to produce only about half their level of historic returns, or 3 per cent a year in real terms.

That is not good news for anyone counting on big stock-market gains to fund their golden years. At 3 per cent a year, it will take nearly a quarter century to double your wealth.

The reality, though, is that there are no alternatives that offer an obviously better deal. Bonds at historic lows seem like a license to lose money; Canada's cooling real estate market isn't exactly a temptation either.

So what can you do to boost your returns? Pavilion suggest focusing on dividends. Companies are gradually beginning to distribute the vast amounts of cash on their balance sheets. Pavilion suggests this will be the main driver of stock prices over the year ahead.

Dividend investing isn't exactly a new notion, of course. But what is striking is how attractive a modest dividend can look if you expect stock market gains to be only a paltry 3 per cent a year.

By my count, there are 97 companies on the Toronto exchange with market capitalizations of more than $1-billion and dividend yields of more than 3 per cent. If Pavilion is right, you won't have to look far beyond these companies to produce market-beating results.