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People walk past a Toronto-Dominion Bank branch in Ottawa (CHRIS WATTIE/REUTERS)
People walk past a Toronto-Dominion Bank branch in Ottawa (CHRIS WATTIE/REUTERS)

Portfolio Strategy

With economy in limbo, dividends become key Add to ...

The North American economy is addicted to growth. Every three months investors pore over corporate earnings hoping the companies they own made more quarter over quarter and that new profits top the previous year's.

Because stock performance depends on growth, it's the key to most investment strategies. But recently Peter Gibson, the head of portfolio strategy and quantitative research at CIBC World Markets, has imagined a future without growth.

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The U.S. economy is in limbo, he wrote in a report this week, so "equity returns are likely to remain low over the next two to five years." Without stable growth, stock prices won't rise, and without price appreciation, investors earn little return - capital gains - on their investments.

Mr. Gibson now fixates on dividends. Equity markets may have rebounded from their March, 2009, lows, but "it's going to be supercritical to start focusing on yield," he said in an interview.

Nothing puts this into perspective better than the S&P 500's performance over the past 12 years. This exchange gauges Americans' wealth and in July, 1998, it hit 1,125. Today, it hovers around 1,100. That means many U.S. investors are no better off than they were a decade ago.

Canadians have been more fortunate. Global demand for resources buoyed the Toronto Stock Exchange over the past 10 years, but it, too, has stalled of late. The TSX is stuck in a rut and remains far below its all-time high.

"How much longer will the market trade in a range?" Mr. Gibson wonders.

The uncertainty convinced him that dividends are the way to go. Now he looks for "sustainably high-dividend-yielding" stocks. If equity prices move sideways and bond yields stay low, Mr. Gibson wants to get some sort of return from his equity portfolio.

The world has also changed, he says. Between 1980 and 1998, price appreciation made up 79 per cent of total return; since, it's accounted for 28 per cent. That means dividends and dividend re-investment accounted for almost three-quarters of total equity returns over the past 12 years.



Read more about dividend stocks:

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Traders don't buy and hold

Mr. Gibson is particularly worried about market volatility. "Traders may profit from this environment, but buy-and-hold people need to rethink their strategy," he wrote.

Since 1998, the S&P 500 has seen big swings, including rallies and collapses (consecutively, from peaks to lows) of plus-65 per cent, minus-50 per cent, plus-101 per cent, minus-57 per cent and, most recently, plus-80 per cent. Through all that, the average total return (that means including dividends) came in just under 3 per cent annually.

The big picture: Traders made massive profits (and absorbed some losses), but the average buy-and-hold investor made negligible gains.

These market fluctuations persist. In just over two months this spring the TSX lost about 10 per cent of its value stemming from fears about Europe, just after it gained the same percentage in the three months prior.

This volatility is best depicted by the VIX index, which peaked above 80 when banks started failing in the fall of 2008. After plummeting to below 20 earlier this year, it quickly doubled when the European debt crisis broke out.

Because stock prices fall in these environments, it's easy to find high-dividend yields because their payout as a percentage of stock price increases. However, Mr. Gibson says the best dividend stocks always pay well.

Not only are their dividends more stable, they also reward investors more equitably than risky companies.

The reasoning is simple: Finance is built on higher returns for greater risks. Yet since 1973 the TSX hasn't outperformed government of Canada 10-year bonds, according to Mr. Gibson's calculations. For high-dividend stocks, "as long as its good-quality yield, then I can do better than the bond portfolio alternative," he said.

Now, he isn't saying every investor should dump their bonds. Asset allocation changes over the course of a lifetime and the elderly typically need guaranteed bond returns. But for those who own stocks and aren't being compensated for higher risk, why not look for high dividend yields?

Mr. Gibson's historical analysis lends even more reason. Looking back 160 years, he found that bond yields and stock prices rarely fell in tandem - most notably during the long depression in the late 1800s, and the Great Depression.

Since 1998, this anomaly has been seen again (which is why he uses that year in his analysis). "The behaviour between stocks and bonds has been consistent with depression-like scenarios," he said.



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YIELD-FOR-NOW V. SUSTAINABLE YIELD

What stocks should investors buy? The answer isn't so straightforward, Mr. Gibson said. It depends on their risk preference.

If they think the current lull is temporary, he suggest a "yield for now" portfolio that targets stocks with temporarily high dividend yields; if they think the market will move sideways for a while, he suggests a "sustainable yield" portfolio comprising companies that always pay out.

Personally, he thinks yield-for-now is appropriate because the economy isn't too shattered. "As long as we're stable, oil prices will stay high," he said, which means many TSX companies won't cut dividends.

His analysis confirmed his suspicions. A number of oil and gas stocks made his list of suitable stocks, including Inter Pipeline Fund (current dividend yield 7 per cent) and Fort Chicago Energy Partners LP (9.3 per cent). Real estate players were also common, including RioCan REIT (6.9 per cent).

That compares with a median yield of 1.8 per cent for the TSX and 1.45 per cent for the S&P 500, according to Mr. Gibson's calculations.

Things could quickly change if the economy doesn't gain ground. "If interest rates are going to stay low," Mr. Gibson said, "does it make sense for a company to maintain such a high dividend yield?"

In that scenario he switches to sustainable yield. The list of companies that qualify is much shorter because they are put under "difficult, demanding tests" that emphasize return on equity.

Companies that make the cut include: BCE Inc. (5.3 per cent), Toronto-Dominion Bank (3.3 per cent) and Corus Entertainment Inc. (3.1 per cent).

"I think yield-for-now is fine because the environment appears to be stable," Mr. Gibson said. But "if the Federal Reserve loses control of the system and the crisis deepens around the world, a lot of stocks that you thought had high yields will get into a lot of trouble."

If the economy continues to sputter, capital gains will be negligible, says Peter Gibson, head of portfolio strategy at CIBC World Markets. To pick the right dividend stocks, he created two categories: "yield-for-now" and "sustainable yield." Yield-for-now's high dividend shares are appropriate for the time being, he says, but he will turn to companies that have historically paid out if the economy does not grow. Below, examples from each group:

Select stocks from Peter Gibson's yield-for-now portfolio

Ticker

Company Name

Forward yield (%)

Return on equity (%)

IPL.UN

Inter Pipeline Fund

7.4

12.2

FCE.UN

Fort Chicago Energy Partners LP

9.6

11.8

HSE

Husky Energy Inc.

4.5

8.9

REI.UN

RioCan Real Estate Investment

7.0

6.5

SJR.B

Shaw Communications Inc.

4.4

23.3

Select stocks from Peter Gibson's sustainable portfolio

Ticker

Company Name

Forward yield (%)

Return on equity (%)

TD

Toronto-Dominion Bank

3.5

13.9

BCE

BCE Inc.

5.5

14.1

GWO

Great-West Lifeco Inc.

5.2

15.1

CJR.B

Corus Entertainment Inc.

3.2

13.7

BMO

Bank of Montreal

4.6

14.0

Note: Forward yield based on analyst expectations.

Cat:e528746c-3414-401a-b14b-50247e3bdf01Forum:d0fa4e14-88d2-41f9-8a19-896bdff9544b

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