The Power of Dividends

Understanding the current environment
Why now is an excellent time to consider dividends for your portfolio.

Until the end of the 1990’s, the Dow and TSX indices were in a long-term bull market that saw consistent returns above 8%, year after year. Although today’s economy is quite strong, the illusion of easy, low-risk returns has been broken by experience. It’s now clear that we need to take sensible precautions to earn solid returns without inviting excess volatility.
Meanwhile, the landscape for earning investment income has also changed. Interest rates remain near historic lows, and the benefits of income trusts have been significantly reduced by their new tax status. That means we’re living in a challenging time for investors seeking investment income.

Dividends are particularly timely because they address several needs in today’s economic environment. They can enhance returns without adding undue risk to a
portfolio. They can provide a cushion against market volatility. And they can generate a stream of reliable, tax-advantaged income.

The Rule of 72
How important is your rate of return?

Everyone knows that a higher rate of return is preferable to a lower one. But The Rule of 72 is a great way to illustrate just how much of a difference it can make. Simply divide the number 72 by a given rate of return to find out how many years it will take to double your money.

Using a target rate of return of 8% and The Rule of 72, we can calculate that:

• It will take nine years to double your money
• In nine years, $100,000 will become $200,000
• In 18 years, $100,000 will become $400,000

If you were to lower your target return to 5%, the outcome would be dramatically different. It will take almost 14 and a half years to double your money, and after nine years, your $100,000 will only have grown to $155,133. So there’s no doubt that returns are very important.

Looking back over the history of the market, and considering the investment strategies currently available to savvy investors, 8% is not an unreasonable target return. However, you may need to tap into the power of dividends to get there.

Dividends for growth & income
How can you achieve an 8% return?

Most investments are categorized as either growth-oriented or income-oriented. But dividend-paying stocks offer both growth and income to help you achieve your target return. Bank of Montreal (BMO) is a great example. Let’s look at how BMO helped investors make money during the five-year period from the last trading day of 2001 to the last trading day of 2006.

• At the end of 2001, BMO stock traded at about $36 per share and paid a $1.12 dividend. That equals a rate of income (or “yield”) of 3.33%. Therefore, to reach a target return of 8% in 2002, BMO only had to appreciate by 4.67%.
• During the next five years, BMO consistently increased its dividends. An investor who paid $36 per share would now be receiving an annual yield of 6.28%. In other words, BMO shares only need to appreciate by 1.72% to generate a return of 8% in 2007.

This goes to show how the combination of dividends and growth can put an 8% overall return well within reach. In fact, given the current price of about $70, investors who bought BMO shares at the end of 2001 have already more than doubled their money—in just five years!

Dividends to manage risk
Dividends can provide a cushion against volatility, but you must be selective.

Dividend-paying stocks have a distinct advantage during periods of market volatility. Whereas nondividend-paying stocks need earnings growth and investor optimism to support their price, the income from dividend-paying stocks gives them intrinsic value, even in volatile markets.

All else being equal, if the price of a dividend-paying equity falls, its dividend yield rises, making it more attractive to income-seeking investors. This phenomenon tends to reduce the volatility of dividend-paying stocks.
Nonetheless, it takes careful research to benefit from the risk-management aspect of dividend-paying stocks. You need to select companies with attractive dividend records and strong underlying fundamentals. Bank of Montreal once again provides a good example:

• Rising dividends. BMO has a long history of rising dividends. Since 1992, the annual dividend has risen from $0.53 to $2.26 per share.
• Earnings growth. The price of BMO shares are underpinned by solid earnings growth. Since 2000, earnings per share have increased from $3.05 to over $5.00 per share.
• Margin of safety. BMO pays less than half of its earnings out in dividends. Therefore, even if earnings were to decrease, the company can still afford to maintain a healthy dividend.

A company that lacks these characteristics could be vulnerable. For example, a drop in operating income could result in a dividend cut and a share price collapse. Further, if interest rates rise, a company that can’t afford to raise its dividend won’t be able to maintain a competitive yield.
In summary, dividend-paying stocks can help moderate the volatility of many portfolios. The key is to select shares that are issued by conservatively managed companies with a proven history of earnings growth and rising dividends.

Dividends for tax savings
The tax treatment of dividend income offers unique opportunities.

Interest income is like employment income — every dollar is taxed at your full marginal rate. Dividend income, on the other hand, is eligible for a Dividend Tax Credit that can result in a preferential after-tax return. Here’s a look at how the three main types of investment income are taxed:

As an investor, the implications are clear. An interest payment and a dividend payment of the same amount before tax will produce two very different outcomes after tax. Based on the above table, an investor who earns $10,000 in interest will keep only $5,630, while an investor who earns $10,000 in dividends will keep $8,153. It’s not hard to see how the tax advantages of dividends can have a significant impact, especially if you rely on your investments for retirement income.

Tax-free dividends are possible too!

For an individual without any other taxable income in 2007, it is possible to receive approximately $66,460 in dividends from Canadian public companies without having to pay any income tax at all. There are four distinct tax principles that – when combined – make it possible to receive tax-free dividend
income.

They are:

• An individual in the lowest tax bracket only has to pay 15.5% federal tax on their first $37,178
  in income.
• Dividends received from a Canadian corporation must be grossed up by 45% when reported on
  your tax return.
• Individuals receiving Canadian dividend income are eligible for a dividend tax credit equal to
  18.97% of the grossed–up dividend.
• Every individual has a basic personal tax credit which eliminates federal tax on the first $8,929
  of annual income.

How much tax is due?
Let’s assume you receive Canadian dividend income totaling $66,460 and no other taxable income for the year. Here’s how the calculations work to eliminate your federal tax bill:

It is important to understand that this tax-free income is the result of both the dividend tax credit and the basic personal tax credit. Without either one of these, it would not be possible to receive $66,460 of Canadian dividends tax-free. It is also important to note that provincial taxes may still be owing as provincial levels for tax-free dividends are lower than federal levels (see table below).

Taking into account your specific investment goals and risk tolerance, it can be a wise tax decision to hold Canadian dividend-paying companies in your portfolio.

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