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A warning for dividend lovers Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

The stock market recently took a tumble after the U.S. Federal Reserve mused it might taper its quantitative easing program should the economy continue to grow. It wasn’t a particularity apocalyptic portent, but even suggesting the flow of money might dry up was enough to unnerve investors.

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In times of turmoil I like to pause and get a better sense of the lay of the land. It might be impossible to predict the future with any accuracy but we can at least see where we stand today.

That’s why I decided to survey the yields offered by the large Canadian stocks that make up the S&P/TSX Composite index.

At first glance, the picture is pretty bright for dividend investors. The accompanying graph shows the distribution of stocks by dividend yield in the index. As you can see, there are more than a few stocks with juicy yields out there.

The graph is based on data from S&P Capital IQ and Globeinvestor.com. To create it, the stocks in the index were sorted by yield into half-percentage-point wide bins and then added up. The bin on the far left contains the most stocks and represents non-dividend payers. The second most popular yield bin is the one centred around 4.5 per cent (between 4.25 per cent and 4.75 per cent) and contains 20 stocks.

Notice that there are two bumps in the distribution with a peak near 2 per cent and another near 4.5 per cent. More conservative income investors should focus their attention on stocks near the second one.

In addition, several stocks sport extreme yields north of 9 per cent, which should raise alarm bells. Those with the highest yields, like Just Energy and Lightstream Resources, tend to be risky and deserve extra scrutiny.

On the whole, the average dividend yield for the stocks in the index is 3.2 per cent. If you just focus on dividend payers, the average climbs to 4.0 per cent.

But a few stocks with very high yields can skew the average which is why I also like to consider median yields. A median represents the point at which half the readings are higher and half are lower. In this case, the median dividend yield is 2.9 per cent and it rises to 3.8 per cent when non-dividend payers are excluded.

Dividends are lovely but they have to be backed up by earnings to be sustainable. That’s why the second graph shows the distribution of the same stocks by earnings yield. It is formed in much the same way as the first graph but it also includes negative readings and opts for 1 percentage point wide bins.

Earnings yield is the mirror image of the P/E ratio. Think of it as the E/P ratio expressed as a percentage. It’s a little more intuitive than the P/E ratio and it can be easily compared to dividend yields. For instance, if a stock’s earnings yield is less than its dividend yield then it’s a sign the dividend might be at risk.

The average earnings yield for stocks in the index is 3.7 per cent and the median yield is 5.2 per cent. The much higher median reflects the outsized impact that a few stocks with huge losses have on the average.

Unfortunately, the earnings figures are uncomfortably small in my view. They leave little margin for safety should the economy hit a difficult patch.

I was also fascinated to note that roughly a third of the dividend-paying stocks in the index didn’t earn enough, over the past 12 months, to fully pay for the dividends they paid. That doesn’t mean we’re about to see a massive wave of dividend cuts. But it’s not an entirely comfortable situation for income investors either.

As a result, even a little bad news has the potential to go a long way. Should rising interest rates slow the economy down, it’s fairly easy to envision the possibility of much lower stock prices and more than a few dividend cuts along the way.

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