As a Canadian, why should I pay more to buy a U.S. stock?

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Question: I read your recent article on the spice maker McCormick & Co. Could you please explain to me how you can keep recommending U.S. stocks that I, as a Canadian, must purchase at about a 33-per-cent premium in price (because of the currency exchange rate) before I earn dividends that my wife and I need to survive in retirement? And then I get hit again with U.S. withholding taxes. I simply cannot get over the reality of handing over $1.33 to receive $1 in spendable value where I live.

Answer: First, let me address your comment about U.S. withholding tax. If you hold your U.S. dividend stocks in a an account that is specifically for retirement purposes - such as a registered retirement savings plan or registered retirement income fund - you will be exempt from withholding tax under the Canada-U.S. tax treaty. Be careful, though, because U.S. shares held in a tax-free savings account or registered education savings plan are not exempt from withholding tax.

Now, let me respond to your objection with respect to the currency. Your contention that a Canadian investor has to "hand over $1.33 to receive $1.00 in spendable value" is incorrect and appears to be based on a misunderstanding of how the exchange rate affects the value of a U.S. investment.

I'll illustrate my point using McCormick (MKC-N) as an example.

MKC recently traded at $98.43 (U.S.) and it pays an annual dividend of $1.88 (U.S.). The yield is therefore 1.91 per cent ($1.88/$98.43) (I'll come back to the yield in a moment).

At the current exchange rate $1 (Canadian) = 75 cents (U.S.), as a Canadian if you want to purchase 100 shares of MKC it will cost you $9,843 (U.S.) or $13,124 (Canadian).

Say you later decide to sell your 100 MKC shares. Assuming the value of the Canadian dollar and the price of MKC have not changed, you could sell your MKC shares for $9,843 (U.S.) and receive $13,124 (Canadian) - which is exactly what you paid for them. (I'm ignoring currency conversion costs here to keep things simple, but they would amount to about 2 to 3 per cent in total over the two trades.)

So, apart from the currency conversion cost, you would not have lost anything, because you are not actually "handing over $1.33 to receive $1 in spendable value". You are handing over approximately $1.33 (Canadian) for an investment worth $1 (U.S.), but again, you can convert that $1 (U.S.) back to $1.33 (Canadian) at any time and come out (roughly) even.

Now, if you were going on a trip to the U.S., then yes, you would have to pay $1.33 (Canadian) for every $1 (U.S.) that you spend there, but even then it does not necessarily mean that you would be paying 33 per cent more for everything, because $1 (U.S.) and $1 (Canadian) do not necessarily have the same purchasing power in their respective countries. What's more, buying a U.S. investment and paying for a U.S. hotel room are two very different things. You can always sell the U.S. investment and recoup the value in Canadian dollars, but the money spent on a hotel room is gone.

Now let's look at MKC's dividend.

On 100 shares of MKC you will receive $188 (U.S.) in dividends. If you take your dividends in Canadian dollars, you will receive $250.67 (Canadian), minus currency conversion costs.

Your yield in Canadian dollars would therefore be the dividend of $250.67 (Canadian) divided by the purchase price of $13,124 (Canadian), which equals 1.91 per cent. Notice that this is exactly the same yield that a U.S. investor would make. The fact that the Canadian dollar trades at $0.75 (U.S.) does not change the yield you would get.

Don't get me wrong. I agree that there are legitimate reasons to think twice before investing in a U.S. stock. Currency conversion costs are one factor to consider. Future movements in the exchange rate are another. If the Canadian dollar rises after you buy the U.S. shares, then the value of your U.S. investment - and the value of the U.S. dividend it pays - will both fall when converted to Canadian dollars. That would obviously be bad for you.

On the other hand, if the Canadian dollar falls after you buy the U.S. shares, the value of your U.S. investment - and the U.S. dividend - will both rise in Canadian dollars. That would be good for you.

But if the Canadian dollar remains at its current level, the currency will not affect the value of your U.S. investment or the U.S. dividend when converted to Canadian dollars.

Bottom line: The fact that the Canadian dollar trades below par with the U.S. dollar does not, in and of itself, put you at a disadvantage.