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CASH FLOW

The downside of being addicted to dividends Add to ...

It’s like feuding over Grandma’s needlepoint.

Dividend investing has such a calm, folksy feel. Investors hold onto stocks that pay regular dividends and patiently reinvest those dividends over years, decades, even a lifetime.

So it’s surprising to see this strategy generate cautionary flags, even the ire of some.

Dividend investing attracts vociferous fans and equally adamant detractors. Proponents, especially investors with retirement in sight, like the cash flow and growth potential of stalwart stocks distributing payouts. Others warn of the risks of being drawn to dividends at the expense of other concerns.

Financial advisers usually support dividend investing, but they don’t recommend complete reliance. What’s important is to understand the risks, especially when these stocks look all the more tempting in a turbulent market. And especially when interest rates and bond yields are so low.

Yet it’s hard to ignore the attraction. Take the story of Grace Groner, who is said to have bought three special-issue, $60 (U.S.) shares of her employer, Abbott Laboratories in Illinois, in 1935. She reinvested the dividends over time and watched her investment grow into $7-million by the time she died in 2010.

But with luck comes risk. A company might discontinue paying dividends, or it might not be able to sustain its increase in the level of dividends it pays, and the stock’s price may drop severely as a result.

“What you are looking for is the consistency of the dividend over years,” said Lynn Williams, financial adviser and owner of the financial planning firm Lifestyle Protector in Vancouver. “And then, are they increasing the dividends over years?”

The hope is that a consistent dividend reflects efficiency and strong performance. But if the dividend decreases, it could be a warning sign, Ms. Williams said.

Investors should focus more on long-term trends and the larger picture rather than a stock’s current dividend amount, she added.

On the flip side, bond yields are so low that dividend stocks can be used as an alternative source of cash flow. “It seems when you look at the big picture that our only hope for any kind of return these days is to be in equities,” Ms. Williams said.

“It’s kind of weird times,” said Terry Willis, vice-president at T.E. Wealth in Toronto, “Typically in the past, when you wanted some stability and you wanted some income, you could go buy a GIC or a government bond. But now, you’re getting cash flow from equities.

But this phenomenon can cause investors’ portfolios to become more heavily weighted in stocks at a time when the stock market is volatile. Ultimately, it comes down to weighing one’s individual risk tolerances and cash-flow needs.

“Typically when you’re looking at dividend paying stocks, you’re looking at financial companies, you’re looking at energy companies,” Mr. Willis said. “And there are only so many of them in Canada.

“If the market turns and oil goes down to $30 [a barrel U.S.], it’s kind of a double whammy, where they might cut their dividends now, and you might have a depressed stock portfolio, too,” Mr. Willis said.

It also can be difficult to evaluate companies’ abilities to continue paying dividends or to increase their payments. This is worsened by the general lack of full transparency in companies’ financial statements, argued Al Rosen, head of forensic investigation at Accountability Research Corp. in Toronto. It’s like “having your seven-year-old child fill out his or her own report card,” he cautioned.

A long-time critic on the level of financial disclosure to investors, Mr. Rosen strikes a far more cautionary note than most. Companies may adjust their earnings statements to look healthier in terms of cash flow and their ability to pay dividends, he says.

The concern is that if companies are not reinvesting enough in their businesses and consequently suffer, they won’t be able to pay dividends in the future.

“That’s the main issue you have to get across,” Mr. Rosen said. Analysts must try to uncover the level of reinvestment within a company to see if a dividend is likely to continue, he said.

But even everyday investors – those who like a docile, buy-and-hold approach to retirement saving – should still understand that these risks exist.

With clients, “we figure out what their objectives are, their risk tolerance, their timeline. And we build a portfolio for them that’s going to be diversified among different asset classes. And one of those asset classes would probably be dividend-paying stock for cash flow,” Mr. Willis said.

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