If you own dividend-paying stocks, you may receive a little extra income in your portfolio each quarter. Dividend income can help to top up returns and offset the impact of market declines. This article explores the case for investing in dividend-paying equities in the Canadian market.
- Over the past 30 years, dividends have accounted for 30% of the total return derived from the Canadian equity market.
- Dividends have also helped protect investors from inflation.
- Canadian equities tend to offer higher yields than U.S. equities.
The power of dividends
In recent years, equity markets have delivered exceptionally strong performance. These higher price returns have overshadowed the modest income that dividends offer. Yet dividend income can really add up. Over the past 30 years, dividends have accounted for 30% of the total return from the Canadian equity market. Should market growth begin to slow, dividends appear set to regain their prominent role in returns for investors.
Components of return for Canadian equities
Source: RBC GAM, Morningstar. Price return reflective of the S&P/TSX Composite Price Return Index. Dividend return reflective of the S&P/TSX Composite Total Return Index less S&P/TSX Composite Price Return Index. Data as of June 30, 2022. An investment cannot be made directly into an index. The graph does not reflect transaction costs, investment management fees or taxes. If such costs and fees were reflected, returns would be lower. Past performance is not a guarantee of future results.
Along with being an integral part of market returns, dividends have also helped protect investors from inflation. The table below contrasts the growth in dividends and inflation over the past 20 years.
Dividends have grown faster than inflation over the past 20 years
|Dividends & Inflation|
|Base year (2002)||Current year (2022)||Annual Growth Rate|
*The CPI (Consumer Price Index) tracks changes in the prices of hundreds of consumer goods and services.
Source: RBC GAM, Bloomberg. S&P/TSX Dividends calculated from Dividends Per Share (12 months, gross) of S&P/TSX Composite Index on December 31, 2001 and June 30, 2022. Prices calculated from CPI Index values in December 2001 and June 2022, respectively. An investment cannot be made directly into an index. The table does not reflect transaction costs, investment management fees or taxes. If such costs and fees were reflected, returns would be lower. Past performance is not a guarantee of future results.
You can see dividends in the Canadian market have grown about 7.9% a year over the past 20 years. Meanwhile, inflation has clocked in at an annual rate of 2.2%. Compounded over time, dividends grew by 361% while inflation caused price increases of 53%. The end result: investors receiving dividends saw a substantial increase in their purchasing power.
Keep in mind, the time period above not only includes the Global Financial Crisis (2008-2009) but also the COVID pandemic. These events weighed on dividend growth and propelled inflation higher.
The benefits of Canadian dividend stocks
When investing in dividend-paying companies, Canadian investors have tended to focus on those close to home. Why? Dividends issued by eligible Canadian corporations receive favourable tax treatment. Other benefits include strong valuations and dividend yields.
When assessing the strength of the Canadian market, it’s natural to compare it to the market south of the border. But the U.S. market is almost 20 times the size of the Canadian market. How can we make a meaningful comparison?
One way is to look at a measure such as the price-to-earnings (P/E) ratio. This ratio compares a company’s current share price relative to its earnings per share. A lower P/E could mean that a stock's price is low relative to earnings potential -- and possibly a good opportunity for investors.
As we can see below, at the end of 2021 Canadian equities had a lower P/E ratio overall than their U.S. counterparts. This suggests a relatively attractive opportunity for investors in the Canadian market.
Comparing valuations of Canadian and U.S. Markets
P/E spread at historically wide levels
Source: RBC GAM, Bloomberg. Data as of April 4, 2001 to June 30, 2022. P/E spread calculated as the 12-month forward price-to-earnings ratio of the S&P/TSX Composite Index less the 12-month forward price-to-earnings ratio of the S&P 500 Index.
Perhaps more important for income-oriented investors, dividend yield is a measure of how much of a company's share price it pays out in dividends each year. It’s stated as a percentage; for example, a 2% yield. The Canadian equity market now offers a much higher dividend yield over U.S. equities. In fact, the yield advantage offered by Canadian equities is currently at one of its widest levels in over 20 years.
Canadian equity markets offer a notable advantage in dividend yields
Source: RBC GAM, Bloomberg. Data as of April 2, 2001 to June 30, 2022. Canadian Dividend Yield reflective of the S&P/TSX Composite Net Aggregate Dividend Yield. U.S. Dividend Yield reflective of the S&P 500 Index Net Aggregate Dividend Yield. An investment cannot be made directly into an index. The graph does not reflect transaction costs, investment management fees or taxes. If such costs and fees were reflected, returns would be lower. Past performance is not a guarantee of future results.
What drives this difference? There are two main reasons:
- The S&P/TSX Index is tilted more towards value companies in cyclical sectors. Energy, Financials, Industrials and Materials make up roughly two-thirds of the Canadian index.
- South of the border, the U.S. S&P 500 houses some of the world’s best growth companies. The Information Technology sector currently makes up more than 25% of the Index.
Value companies tend to distribute cash to shareholders in the form of dividends. Growth-oriented companies tend to preserve their cash flow for opportunities to expand their operations. As these companies mature, they may deliver a higher rate of dividend growth. However, the general rule still holds true: the concentration of value companies in the Canadian index means Canadian equities as a whole tend to offer a higher yield than U.S. equities.
The composition of the Canadian dividend market
In light of this positive backdrop, we wanted to address a common criticism of the Canadian equity market. Namely, since energy companies make up a substantial portion of the S&P/TSX Index, volatile commodity prices may make it challenging for the market to pay out consistent dividends. However, in reality, this doesn’t seem to be the case. Approximately one-third of S&P/TSX members have a five-year track record of regular dividend increases. That figure sat at just 10% twenty years ago.¹
Furthermore, we see solid support for dividends in the key corners of the Canadian market. The following is a summary of the outlook for four key sectors in 2022:
- Real estate sector. With the benefit of hindsight, we can now say the real estate sell-off at the start of the pandemic was overdone. While some areas have recovered to pre-pandemic levels, attractive opportunities persist. Further, the sector has a positive outlook when considering the high level of free cash flow generation and low borrowing costs.
- Financial sector. The banks in Canada are generally well positioned, with good loan growth and improved credit card spending. Meanwhile margin pressure has started to alleviate. Recently, the Office of the Superintendent of Financial Institutions (OSFI) announced the end to pandemic-restrictions that prevented banks and insurers from raising dividends and buying back shares.
- Utilities sector. Many of these companies have an excellent opportunity to tap into lower carbon energy production like solar and wind. And while this will require capital outlays, the growth environment for cash flows across this sector is healthy.
- Energy sector. With higher commodity prices, many of these businesses are generating very strong cash flows. Many producers are managing their growth carefully and showing good discipline with their capital. We’re also encouraged to see many of these companies look at how they can transition their businesses towards an economy that’s less dependent on fossil fuels.
Sector contribution per $100 in TSX dividends
Source: RBC GAM, Bloomberg. Calculated as weighted contribution of each sector based on dividend per share over trailing 12 month period. As of June 30, 2022.
For investors seeking income in a lower interest rate environment, our home and native land can be a good place to start.