Building for tomorrow

If you're looking for a portfolio that is easy to assemble, requires minimal trading, and can spin off increasing amounts of cash every year, blue-chip dividend stocks are the way to go

By John Heinzl
Globe Investor Magazine,
November 18, 2008
Illustration by Andrio Abero

If you read finance books or listen to investment analysts, you probably think building a stock portfolio is as complicated as flying the space shuttle. F or example, you've got to track 50-day moving averages, pay attention to earnings surprises and navigate bouts of extreme volatility like we've seen this fall.

With that sort of complexity, it's no wonder small investors throw up their hands and buy mutual funds or turn their finances over to an adviser, both of which charge fees that eat into returns. But what if there was a simple way to build a portfolio that requires little maintenance, has no ongoing fees, generates capital gains over the long term and-when times are good-throws off a stream of income that grows every year?

With a few hours of work, anyone can build such a portfolio. The secret? Buy blue-chip stocks that regularly raise their dividends. That's it. We're talking banks, insurers, pipelines, gas and electric utilities, real estate investment trusts, cable providers, consumer staples companies. I n other words, all the boring businesses that sell products and services people need, and will keep needing for decades to come.

Charles Kennedy, partner and portfolio manager with investment firm MacDougall MacDougall & MacTier in Toronto, got hooked on dividend growth investing more than a decade ago, after realizing that trying to pick the hottest stocks from one year to the next was a mug's game. Now, instead of going for the quick score, "I look for companies that have extraordinary records of increasing their dividends," says Kennedy.

Why buy stocks with rising dividends? Because, when a company raises its dividend, it's a sign management is confident about the future. When that same company raises its dividend year after year, you can be fairly certain you're dealing with a mature business that knows how to make money in good times and bad. A nd thanks to O ttawa's generous dividend tax credit, more of the cash will stay in your pocket than if you were investing in bonds or GIC s, which pay a flat amount of interest that's fully taxed.

Companies that hike their dividends have another big advantage: They tend to beat the market. A ccording to a 2006 study by RBC D ominion Securities, dividend growth stocks returned an average of 17.2% over the preceding 10 years, compared with 8.6% for the S&P/TSX composite index and just 1.3% for non-dividend-paying stocks.

What's more, during bouts of market turmoil, dividend stocks provide shelter from the storm. Dividend growth guru Tom C onnolly, who publishes The Connolly Report from Kingston, O ntario, says his portfolio suffered double-digit losses last year. A nd yet, even as his stocks were falling, the income from his portfolio rose by 12.2%. His stocks are down again this year, but the income is up. "Patience is the big thing," C onnolly says, "because it takes years to build up your yield."

When assembling a portfolio of dividend growth stocks, keep a few principles in mind. F irst, don't just buy the stocks with the highest yields. A high yield is nice, but if the dividend is growing slowly or not at all, you may be better off finding a company with a slightly lower yield whose dividend is increasing at a faster clip. R emember, dividend growth investing is not about making a fast buck; it's about letting the magic of dividend growth work for you. I f you reinvest your dividends in more shares to take advantage of compounding, your income stream will grow even faster.

Second, don't forget about diversification. C anadian banks have some of the best dividend growth records around, but as the credit crunch demonstrated, putting too much of your portfolio into one sector is asking for trouble. So be sure to spread your money across different stocks and industries. There's no need to go overboard, however: Studies have shown that by owning just 12 to 18 high-quality companies, you'll have eliminated about 90% of the risk associated with improper diversification.

With that in mind, we've compiled a list of some of the most promising dividend growth stocks from a variety of sectors. To make the cut, the company's dividend had to have grown by at least 10% annually over the past five years (we've lowered the bar in the case of REITs). I n addition, the dividend must be expected to grow by at least 5% annually over the next three years, according to estimates compiled by Bloomberg. I t will be important to track your dividend growth stocks through the current economic downturn. I f your dividends keep rising, then you've found some winners.

We've also taken into account subjective factors such as the quality of management and the company's earnings growth prospects, market dominance and brand strength. Just because a company doesn't appear here doesn't mean you should cross it off your list; at the same time, inclusion on the list doesn't necessarily warrant a "buy," because circumstances may have changed between the time of writing and publication.

The market has been extremely volatile, but the good news is that many solid dividend stocks are a lot cheaper than they were a few months ago. F or long-term investors, that's a plus.

As always, do your own due diligence before investing in any security.