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Canadian dividend stocks delivered out-sized returns to investors over the last 16 years. To reap their benefits it’s best to focus on stocks with generous yields while avoiding the extremes.

Even simple dividend portfolios proved to be highly profitable in recent years. For instance, if you had purchased an equal dollar amount of the dividend stocks in the S&P/TSX Composite Index and rebalanced your portfolio at the end of each year, you would have gained an average of 10.2 per cent compounded annually over the 16 years to the end of 2017.

In comparison, the market climbed at a 7.5-per-cent annual rate over the same period and trailed by an average of 2.7 percentage points a year. (All of the return figure herein include dividend reinvestment, but they do not include funds fees, taxes or other trading frictions.)

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A key advantage of dividend investing in Canada is that it tends to steer investors away from riskier areas of the market. For instance, speculative mining and energy companies rarely pay dividends. Similarly, ailing firms usually can’t afford to pay dividends.

The risks become apparent when looking at the index’s non-dividend-paying stocks, which underperfomed. They gained an average of just 2.5 per cent annually over the 16 years to the end of 2017 and trailed the index by an average of five percentage points a year.

Mind you, dividends aren’t a perfect prophylactic against disaster. Seasoned dividend investors know to be wary of stocks with extremely high yields.

To get a fine-grained look, I used the local Bloomberg machine to sort the stocks in the S&P/TSX Composite by yield into 10 portfolios (or deciles) at the end of each year with (as close a possible to) an equal number of stocks. The portfolios were tracked over time and the results shown in the accompanying chart. It highlights the annual performance advantage offered by each group against the market over the 16 years to the end of 2017.

For instance, the second-highest yielding portfolio grew at a compound annual rate of 12.2 per cent and outperformed the market by an average of 4.7 percentage points a year. Over the 16 years, an investment in it would have turned $100,000 into about $629,000 while an investment in the index would have grown the same amount to only about $319,000.

But it wasn’t all roses for dividend investors. The portfolio with the highest yielding stocks didn’t fare well at all with average annual returns of just 4.1 per cent. It trailed the market badly.

The poor results show that it pays to be cautious when it comes to stocks with extremely high yields. In such cases, something bad may have happened to the company that prompted its stock price to collapse. A giant yield usually indicates that the market doubts the sustainability of the dividend and perhaps of the company itself. As a result, cautious investors should generally steer clear of stocks with extremely high yields.

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Getting even more fine-grained, when I split the extreme high-yield portfolio (decile) in half by yield to look at the returns of both halves (not shown), it became apparent that stocks with the very highest yields are particularly problematic. The half of the extreme-yield group with the highest yields gained an average of just 0.5 per cent annually over the past 16 years while the half with slightly less extreme yields gained 8.4 per cent annually and actually beat the market. That makes it particularly important to be cautious of the 5 per cent of stocks with the highest yields. In today’s market, that means stocks with yields north of about 7 per cent.

When dealing with stocks with more moderate yields, the general – and admittedly uneven – trend is to see higher total returns from those with higher yields. Simply opting for stocks with above-average but not extreme yields would have generated average annual returns of 11.2 per cent, or 3.7 percentage points more than the market. That’s based on averaging the results of the second- through fifth-highest yield groups, which currently includes stocks with yields ranging from about 3 per cent to 6.4 per cent.

While it’s foolhardy to guarantee that the past provides a perfect guide to the future, it’s hard to imagine going too far wrong with a low-cost broadly diversified portfolio of dividend payers. With a little luck dividend stocks will continue to pay off for investors.

Using Dividend Yield to Beat the Market

From 2001 to 2017

Avg. annual outperformance vs. S&P/TSX Composite (pp)

6

5

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2

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1

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Highest

Lowest

Yield from high to low (deciles)

pp=percentage points

THE GLOBE AND MAIL, SOURCE: bloomberg

Using Dividend Yield to Beat the Market

From 2001 to 2017

Avg. annual outperformance vs. S&P/TSX Composite (pp)

6

5

4

3

2

1

0

-

1

-

2

-

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-

4

1

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Highest

Lowest

Yield from high to low (deciles)

pp=percentage points

THE GLOBE AND MAIL, SOURCE: bloomberg

Using Dividend Yield to Beat the Market

From 2001 to 2017

6

5

Average annual outperformance vs. S&P/TSX Composite (pp)

4

3

2

1

0

-

1

-

2

-

3

-

4

1

2

3

4

5

6

7

8

9

10

Highest

Lowest

Yield from high to low (deciles)

pp=percentage points

THE GLOBE AND MAIL, SOURCE: bloomberg

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

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