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Lounging on the beach in the summer sun can inspire dreams of a dividend-enabled retirement. The idea of being able to support oneself with dividend income, while not having to dip into capital, can be quite appealing.

While dividend stocks pay the way for many retirees, they aren’t without risk. But those with the right dividend policies are better positioned to survive downturns.

The dreamers can enjoy the relatively generous yields the Canadian market has to offer. I recently looked at 403 Canadian stocks with market capitalizations of more than $250-million on the TSX, including real estate investment trusts. A full 67 per cent of them pay dividends while the remaining 33 per cent do not, based on data from S&P Capital IQ.

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The average dividend yield of the stocks that pay dividends is 4 per cent, which is attractive in the current environment. The average yield for all 403 stocks drops to 2.7 per cent when the non-dividend payers are included.

You can examine the market’s yield distribution in the accompanying bar chart. It shows the number of stocks that fall into each yield category. For instance, 41 companies have dividend yields between 4 per cent and 5 per cent.

Stocks that pay unusually large yields can be tricky to deal with. They may have recently announced a dividend cut or investors might expect them to reduce their dividend soon. Alternately, they might have paid a special one-time dividend that may not be repeated.

Stelco Holdings Inc. (STLC) provides an example of the latter. The steel maker based in Hamilton has a yield north of 10 per cent including a recent special dividend of $1.23 a share. But Stelco’s regular quarterly dividend is 10 cents a share, which would result in a yield of 2.7 per cent. While investors might hope the firm will continue to pay big special dividends, they should think of them as bonus payments rather than regular income. Bargain hunters will note that Stelco trades at just five times earnings.

More distressing situations happen when firms run into trouble. As share prices fall, yields climb. If the difficulties become acute, a company might be wise to quickly reduce its dividend in an effort to save itself.

I run into this sort of unfortunate situation from time to time and High Liner Foods Inc. (HLF) provides a recent example. The packaged food company from Lunenburg, N.S., ran into trouble digesting acquisitions and moved into restructuring mode. To help conserve cash, its quarterly dividend was cut from 14.5 cents a share to 5 cents, which dropped the stock’s yield from 6.8 per cent to 2.3 per cent (based on recent prices). I own shares of High Liner, which trades at 10 times earnings. I hope it manages to regain its footing.

A dividend reduction – or elimination – is not the sort of thing dividend investors want to see. But I’d rather companies cut early and survive than pay too long and fold. It is one reason why firms should move away from fixed dividend policies and adopt variable ones. That way they’ll automatically avoid the pressure of paying dividends when times are tough.

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Norbord Inc. (OSB) offers an example of a variable dividend policy. The Toronto-based firm is in the cyclical business of producing oriented strand board, a building product. It resets its dividend each year depending on business conditions and sometimes pays special dividends.

The firm recently reduced its regular quarterly dividend from 60 cents a share to 40 cents to reflect a soft near-term outlook. The move pushed its yield down to 5 per cent from 7.5 per cent. But the reduction didn’t cause investors to panic because the change was widely expected. Investors also have fond memories of the $4.50 a share special dividend the firm paid last September. Norbord trades at eight times earnings.

Buying a basket of dividend payers worked quite well in the past. Most dividend investors start with a few of the big banks, utilities and other blue-chip stocks. Adding the three low-P/E dividend stocks mentioned above might help boost diversification by industry. With a little luck, diversified dividend portfolios will continue to turn retirement dreams into realities for many summers to come.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.

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