All posts by Pat McKeough

Dividend ETFs: Finding Stability and Growth in Income Investments

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Discover the Keys to Identifying Dividend ETFs that offer Consistency, Quality, and Long-Term Growth

Image from Pexels/Anna Nekrashevich

Higher interest rates mean dividend-paying stocks must increasingly compete with fixed-income investments for investor interest. However, sustainable dividends still offer an
attractive and growing income stream for investors.

Companies that pay regular and growing dividends have performed very well over the long run when compared to the broad market indices. For example, a simple strategy such as selecting stocks with an extended history of uninterrupted dividend growth, such as represented by the S&P 500 Dividend Aristocrats, has added 11.5% per year over the past 30 years. This compares to the 10.0% annual gain for the S&P 500 Index. And not only did the dividend payers beat the overall market, but they were also less volatile.

The superior long-term performance of the dividend growth companies can be attributed to a combination of several factors: Companies with long histories of regular and growing dividend payments generally have sound competitive business models and growing profits; these are also companies with experienced managements that make disciplined capital allocation decisions, strive for lower debt levels, and operate firms more profitable than their peers.

Notably, though, the Dividend Aristocrats’ performance lagged over the past 5 years against the S&P 500 index.

Most of this underperformance came over the last year and a half, as higher interest rates made fixed-income investments, such as GICs, more attractive for income-seeking investors when compared to dividend-paying equities.

The dividend sweet spot

Income-seeking investors who decide to take on the risk of the stock markets are faced with a wide range of options including “yield enhanced” dividend-paying ETFs, moderate-yielding companies with average growth rates, and low-yielding but fast-growing companies. Then there is also the group of companies that have very high dividend yields and may seem attractive but, unfortunately, come with elevated risk.

In many cases, a high yield may be a warning sign that all is not well with a company and that future dividend payments are at risk of being cut.

As well, a dividend cut, or even an outright dividend suspension, is often accompanied by a steep decline in the share price, as income investors dump their former dividend favourites.

A 2016 study by a group of U.S.-based academics provides some statistical guidelines for sensible dividend-based investing.

In reviewing the performance of almost 4,000 U.S. companies over 50 years, they found that dividend-paying stocks beat non-dividend payers.

In particular, the middle group of dividend yielders (i.e., those with an average yield of 4.3%) surpassed both the low yielders and the high yielders in terms of total return. Equally important, this superior performance was achieved with lower risk, as measured by the standard deviation of returns.

Based on this long-term study, it makes sense to avoid the highest-yielding stocks and rather look for companies with moderate yields and sound growth prospects. This safety-first approach will result in a lower yield but likely provide a better total return (dividends plus capital) at lower risk.

How to spot dividend ETFs worth investing in

When investing in dividend-paying companies through an ETF, here are key factors to consider: Continue Reading…

U.S.-listed ADRs for Canadian Investors: The best way to buy foreign stocks

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ADRs (American Depository Receipts) are a great way for investors to invest in foreign stocks

Our view on foreign investing is that for most investors, U.S. stocks can provide all the foreign exposure they need. We also feel that virtually all Canadian investors should have 20% to 30% of their portfolios in the U.S. stocks that we recommend in our Wall Street Stock Forecaster newsletter.

If you want to add more foreign content, you could buy individual stocks. But for most investors, directly investing in foreign stocks can add an extra layer of risk and expense. As well, timely and accurate information about overseas companies is not always available, and securities regulations vary widely between countries. It can also be hard for your broker to buy shares on foreign markets without paying a premium. Tax rules and restrictions on transferring funds between nations add further uncertainty and cost.

Understanding the Ins And Outs of ADRs

All in all, we think the best way to invest in foreign stocks is to buy high-quality firms that trade on the New York Stock Exchange as American Depositary Receipts (ADRs). An American Depositary Receipt is a U.S. traded proxy for a foreign stock and represents a specified number of shares in that foreign corporation.

ADRs are bought and sold on U.S. stock markets, just like regular stocks, and are issued or sponsored in the U.S. by a bank or brokerage firm. If you own an ADR, you have the right to obtain the foreign stock it represents. However, investors usually find it more convenient to continue to hold the ADR and to sell the ADR when it no longer serves their needs. Continue Reading…

Is Now a Bad Time to buy Bonds? Yes, and Here’s Why

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We think Now is a bad time to Buy Bonds … Here’s Why

Recently a friend asked, “Pat, I see that several prominent Canadian investor advisors recently wrote articles that said it’s a bad time to buy bonds right now. Do you agree?”

He was surprised when I told him I haven’t bought any bonds for myself since the 1990s. I haven’t bought any for our Portfolio Management clients in the last couple of decades, except on client request.

In the 1990s, I used to buy “strip bonds” for myself and my clients, as RRSP investments. This was the Golden Age of bond investing. Back then, high-quality bonds yielded almost as much, pre-tax, as the historical returns on stocks. In addition, they were more stable than stocks and provided fixed income that simplified financial planning.

Bonds have tax disadvantages, of course. But you can neutralize those disadvantages by holding your bonds in RRSPs and other registered plans.

The big difference back then was that bond yields and interest rates were much higher than usual. That’s because we were still coming out of (or “cleaning up after,” you might say) the inflationary bulge of the 1970s and 1980s.

In the 1980s, government policies pushed up interest rates and took other measures to hobble inflation, and it worked. But interest rates stayed high for a long time after the government policies broke the back of inflation: kind of like finishing the antibiotic prescription after the infection goes away.

Long-time readers know my general view on the stocks-versus-bonds dilemma. When interest rates are as low as they have been in recent decades, high-quality stocks on the whole are vastly superior to bonds. However, you have to understand the differences between the two. For one thing, stocks are more volatile than bonds. But volatility and safety are two different things.

Volatility refers to sharp price fluctuations, often due to short-term uncertainty and the randomness of short-term market movements. Safety refers to the risk of permanent loss.

Bonds improve portfolio stability but cut investment returns

You might say that what you get from bonds is the opposite of what you get from the stock market.

Inflation near-automatically reduces the purchasing power of bonds. Inflation can also hurt the returns you make in the stock market, of course. However, companies you invest in can take steps to cut the costs of inflation. They can pass on cost increases to their customers. They can introduce new processes and equipment to improve productivity and cut their costs. Continue Reading…

The revival of the 60/40 rule: Good for brokers, but not for investors

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The revival of the 60/40 rule is a plus for brokers – but not for investors

Image by Pexels: RDNE Stock Project

Some experienced brokers (now more often referred to as investment advisors) are pleased at the recent rise in interest rates and inflation. After all, it could lead to a revival of the 60/40 rule, which was in common use for much of the second half of the 20th century, especially among experienced stockbrokers. Veteran brokers understood how to use it to spur clients to do more trading between stocks and bonds, and pay more brokerage commissions and fees.

The 60/40 rule is based on the proposition that a good-quality, balanced portfolio is made up of 60% good-quality stocks and 40% good-quality bonds. This idea leads to another: that investors can enhance their results by “rebalancing” their portfolios when they get away from that 60/40 goal, due to divergences between the bond and stock markets.

This is one of those clever ideas that at first glance, seems to make sense to many investors. It makes sense to brokers because it’s sure to make money for them. The payoff is rather less certain for the paying customers: the investors.

The problem is that stock and bond prices rise and fall under the influence of ever-changing sets of random factors: sometimes moving them in the same direction, other times moving them apart. These sets of random factors will vary in a random fashion as well. The stock/bond balance in a portfolio can hold steady for long periods, or swing abruptly from the “ideal” 60/40 split in a single day. This can happen even on a quiet day with few news developments to promote buying or selling.

The 60/40 rule gives the broker a rationale for proposing trades in a portfolio when changes in stock and bond prices have moved the portfolio away from the idealized 60/40 split.

This leads to another of the many conflicts of interest that exist in the investment business. However, unlike the hidden bond commissions I mentioned above, some brokers made a living out of the 60/40 rule. In my days as a broker, some old-timers in the office told me they could use the rule to add 2% to 4% of a client’s total portfolio to their gross annual commissions.

Any trade in your portfolio will cost you money in the form of fees and/or commissions, regardless of whether you make or lose money. But every trade you do in your portfolio will make money for the brokerage firm and/or salesperson, of course. That’s how they get paid.

Useless as a market indicator, great as a marketing device

We’ve often pointed out that market indicators sound a lot better than they perform. The 60/40 rule falls a step or two below an indicator. Rather than telling investors how they can make money in their investments, as market indicators supposedly do, this rule tells brokers and financial advisors how they can encourage their clients to do more buying and selling in the market, and thus increase broker incomes.

After all, the rule is based on a belief about the supposed advantage of a particular ratio of stocks to bonds in a portfolio. It’s not as if the rule comes with instructions on when to buy or sell, as you can derive from many market indicators. Instead, it gives brokers a rationale for advising their clients to buy bonds and sell stocks (or vice versa) more often. Continue Reading…

Why Debt-to-Market-Cap matters more than Debt-to-Equity

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Understanding the Importance of the Debt-to-Market-Cap Ratio in Stock Analysis

Image courtesy TSINetwork.ca

When evaluating stocks, it’s crucial to assess their resilience during economic downturns and their potential for future prosperity. While the commonly used debt/equity ratio offers insights into a company’s financial leverage, it fails to capture certain nuances. In this article, we explore the significance of the debt-to-market-cap ratio in stock analysis and why it surpasses the debt/equity ratio.

By understanding the intricacies of this approach, investors can make more informed decisions and increase their chances of identifying companies poised for long-term success.

I was recently asked why I use debt-to-market-cap in my analyses, which is different from the debt/equity ratio seen in most other reports. My answer is two-fold. In analyzing a stock, you need to form an idea of how much it would get hurt in a recession. To put it another way, how likely it is to survive a business slump and go on to prosper when good times return? To do that, you need to look at a number of factors. These include the interest rate on its debt, how sensitive it is to the economic cycle, its pluses and minuses in relation to competitors, its vulnerability to adverse legal and regulatory decisions, its credit history and current credit rating … and so on.

Analyzing Debt-to-Equity Ratio

Many successful investors start by looking at the debt/equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity. You assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital. If so, the excess goes to shareholders’ equity, raising the total return to shareholders.

But leverage works both ways. If the total return falls short of the interest costs, the difference comes out of shareholders’ equity. When a company loses money, it still has to pay the interest and one day settle the debt. Generally, it does so by dipping into shareholders’ equity. In extreme cases, losses wipe out shareholders’ equity, and the stock becomes worthless. Then bondholders and lenders take over the assets to try to get back their investment. A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump.

However, this ratio can mislead because it compares a hard number with a soft one. Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are softer or ‘‘fuzzier.’’ They mostly reflect asset values as they appear on the balance sheet (minus debt, of course). But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have shrunk in value since the company acquired them (that is, lost more value than the company’s accounting shows). In that case, the company may need to correct its balance sheet figures by cutting them or “taking a writedown.”

Or the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate, patents and other assets (which we refer to as “hidden assets”).Much of a company’s real value may rest in its “goodwill” — its brands, or the reputation and relationship it has built with customers over the years. This value would only appear on the balance sheet if it was bought rather than built up by the company’s operations.

Analyzing Debt-to-Market-Cap

Efficient market theory also leads us to favour debt-to-market-cap over debt-to-equity. This theory says that it’s impossible to beat the market, because the market is efficient and eventually reflects all information, good or bad. This idea had a lot to do with the creation of index funds. Market cap — the value of all shares the company has outstanding — benefits from the “wisdom of crowds.” Continue Reading…