Nobody rides for free in Les Stelmach's portfolio. The price of admission for any company in the fund he helps to manage is a generous dividend – or at least the potential for a generous dividend.
As co-manager of the Bissett Canadian Dividend Fund, his job is to not only find the biggest yields, but also to spot the companies with the ability to grow their dividends before other investors drive up the stock price.
"We try to forecast future cash flows, discount it to the present and derive a value for that business that is independent to the market price" he says.
The fund returned 10 per cent last year with the help of a who's who of established Canadian companies such as the big five banks, which currently pay annual yields between 3.5 per cent and 5 per cent. The banks have become favourites for dividend investors because of their ability to consistently raise payouts.
"Sometimes it can be better to make more frequent, smaller increases in dividends than a few step changes because the market always asks, 'What have you done for me recently?' " Mr. Stelmach says.
The fund focuses on mature companies where growth comes in streams – and nothing carries a cash stream like pipelines. TransCanada Pipelines Ltd. and Enbridge Inc. pay out dividends of 3.6 per cent and 2.9 per cent respectively but Mr. Stelmach says he holds them for their ability to slash costs once a pipeline is operational.
"When you own a pipeline the biggest investment you're going to put into it is likely when you build it," he says. "You put in a big up-front investment and watch your cash flows grow over time."
For future dividend flows he looks toward interest-rate-sensitive life insurance companies Manulife Financial Corp. (3.75 per cent), Sun Life Financial Inc. (5.14 per cent) and Power Financial Corp. (5 per cent), which have dropped in price as interest rates are at historic lows. He expects those stocks to gain when interest rates eventually rise. "When that happens they will have a lot more capital to distribute to shareholders."
Mr. Stelmach represents a growing demand from institutional and retail investors alike for yield in an age of rock- bottom interest rates – and companies are responding, according to S&P Dow Jones Indices senior index analyst Howard Silverblatt.
"Companies feel the pressure of investors wanting a return, especially when they have record amounts of cash," Mr. Silverblatt says.
That response came in the form of a 17-per-cent payout boost from companies in the S&P 500 last year, setting an historic record. Much of that can be attributed to companies moving their January of 2013, payouts to December of 2012, to avoid a dividend tax hike in the United States, but Mr. Silverblatt still expects payouts to increase by 4 per cent this year.
"Companies are paying out more than they ever have before – 2012 was a record. We are easily going to make a 2013 record," he says, adding that 60 per cent of the companies listed in the S&P 500 are expected to boost dividends this year.
The biggest payers, he says, tend to have the biggest cash flows – companies such as Apple Inc., Exxon Mobil Corp. and AT&T Inc. Cash-flow levels are normally highest in sectors such as pipelines and utilities. Last year the telecom sector paid out an average 4.85 per cent compared with 2.27 per cent by the broader S&P 500.
But the fastest dividend growers are technology stocks such as Apple and Microsoft Corp. thanks to big revenues and relatively low costs. While the average dividend payout from the technology sector was just 1.75 per cent last year, Mr. Silverblatt says it has become the largest dividend payer in terms of dollars, making up nearly 15 per cent of all dividends paid on the S&P 500.
And, he says, the amount the S&P 500 is paying out in dividends is just a fraction of what those firms can afford to pay out. Right now 36 per cent of earnings are passed on to shareholders compared with an average of 52 per cent since 1936. He says economic uncertainty is causing many companies to hold back, fearing they may have to lower or cancel dividends in the future. "Once you pay a dividend, you've got to keep paying it."
Retail investors who normally rely on bond yields for income – especially those in retirement – are increasingly turning to dividend stocks, according to Macquarie Private Wealth financial adviser Stan Wong. To help meet return expectations he recommends a mix of dividend stocks.
"Here's an opportunity to get dividend yields that are higher than bonds and the ability to have increasing yields," he says. "You have a potential for not only capital appreciation but also a rising yield in your portfolio."
His challenge for clients is to create a steady dividend income stream similar to a bond ladder, where bond maturities are staggered evenly to provide regular payouts. "Unlike bonds it's difficult to figure out consistent monthly income because REITs pay monthly and stocks like BCE pay quarterly. There's going to be some lump sums where some months will be a little bit higher than others," he says.
While dividend stocks have the potential to add capital gains to income, they also have the potential to fall in value – increasing risk in the event of another market meltdown like 2008 when dividend stocks lost 30 to 40 per cent of their value.
"You have to balance that out," Mr. Wong says. "You have to be careful that you don't just pile into dividend stocks just because the yields are higher."