Don't be distracted by high dividend yields

Remember Manitoba Telecom the next time you hear about the magic of dividends.

Last quarter, MTS shareholders received 65 cents in cash for each share they owned. Next quarter, after the company chops its payout by 35 per cent, they'll get 42.5 cents. There's no telling what MTS shares will be worth then, but they were down 8.5 per cent the day following the announcement of the dividend cut.

In an investing world that seems almost maliciously unpredictable, dividends are a true friend to investors. That's why so many financial experts are telling people to focus on dividend stocks these days.

Smart dividend investing requires some discipline, however. This is especially true in the area of yield, which is a term that describes the rate of return you get from the dividends paid by a stock. To calculate yield, divide the annualized dividend by the share price and multiply by 100.

Dividend yields move inversely to share prices, which means a high yield is a sign investors are worried about a stock and are selling their holdings. MTS had a yield of about 9 per cent before the dividend cut was announced. By comparison, the yield on the S&P/TSX 60 index of big blue-chip stocks is about 2.8 per cent.

There's a chance that stocks with high dividend yields will turn out to be spectacularly good picks. Back in early 2009, for instance, the yield on Bank of Montreal shares hit 11 per cent. Investors who bought then have seen their shares more than double, and there's an opportunity for even higher yields in the future. Where once there was rampant concern that BMO would cut its dividend, today investors are looking ahead to an eventual increase in the quarterly payout.

But they're not the rule. No matter how frustrated you get with low returns on bonds and guaranteed investment certificates, you can't let your guard down when looking at high dividend yields.

MTS is a classic lesson in the bad stuff that can happen when you choose a dividend stock unwisely. Your flow of dividend income declines, and the price of your shares is likely to fall, too.

The differing BMO and MTS stories show there's no point in making an absolute rule about when a dividend yield is too high. But that doesn't mean there aren't guidelines you can follow.

"At this time, a 6-per-cent yield is pretty much a ceiling," said Vaughn Warrington, an investment adviser with RBC Dominion Securities who has published an e-book called Dividends Rule (you can read it online at: bit.ly/9saCO4).

But there are exceptions, Mr. Warrington added in an e-mail response to some questions. Some income trusts that converted into corporations have dividend yields above 6 per cent and seem to be holding up well. An example he cited was AltaGas, which as of late this week had a yield of 6.7 per cent. (Read more on trusts that are converting into corporations paying a big dividend at: tgam.ca/klW).

Mr. Warrington said that with the yield on Government of Canada 10-years bonds hovering around 3 per cent, he shoots for stocks with dividend yields in the range of 4 to 5 per cent. These days, his portfolio of Canadian dividend stocks (including some income trusts) has a combined yield of 4.5 per cent.

Avoiding stocks with yields over a certain threshold is one way to prevent a dividend disaster. Another is to carefully research a high-yield dividend stock before buying. That's basically how dividend expert David Stanley came to avoid buying MTS.

"You have to look at the underlying business," said Mr. Stanley, a former university professor who updates his Beating the TSX dividend strategy regularly in Canadian MoneySaver magazine and has been featured in our Let's Talk Investing video series (check out the series at: tgam.ca/letstalkinvesting). "If you had done this with Manitoba Telecom, you would have seen that Telus is kind of eating its lunch."

Mr. Stanley also noted MTS's high payout ratio, which measures the percentage of earnings that are paid out as dividends. The GlobeinvestorGold website shows MTS with a payout ratio of 165 per cent.

Payout ratios are as subjective as dividend yields themselves. Mr. Warrington said a ratio under 40 per cent is nice to have, but he's not strict about that. Other experts say up to 50 per cent or so is ideal, and they can live with as much as 70 per cent or so for solid, well-established companies.

Picking reliable dividend stocks also requires a look at a company's dividend payment history, which you should be able to find in the investor relations area of its corporate website.

Mr. Warrington has some specific guidelines for a company's dividend history. "I'd like them to have at least maintained a dividend for five years with no decreases. And if they've grown the dividend in the past five years, I'm even more excited."

Here, we arrive at a schism in dividend investing. On one side, those who prefer a high dividend yield above all to maximize their income. On the other, those who will settle for lower yields as long as the dividend is regularly increased. Note that regular dividend hikes have the effect of gradually juicing the yield you get on your initial investment.

If you focus on dividend growth, you put yourself in a realm where dividend cuts are almost unheard of. Instead of buying MTS, which has had a level dividend since the latter part of 2004, you might have chosen BCE or Telus.

BCE has turned itself into a dividend grower following the collapse in late 2008 of a deal that would have taken the company private. Telus has returned to dividend growth status after cutting its quarterly payout back in 2001, and its most recent increase came in June.

Dividend cutters should be avoided by investors until they re-establish their ability to maintain and increase their quarterly payout over a period of three to five years, Mr. Warrington says in his e-book. The point is to see whether the additional financial flexibility a company has given itself by chopping the dividend helps it to become stronger financially.

That so far hasn't been the case at Manulife one of the most notorious dividend cutters of the past couple of years. The company just reported a surprise $2.4-billion quarterly loss earlier this month, almost a year after halving its dividend.

Mr. Warrington's still waiting on Manulife. "I've had a number of clients request that I add it to portfolios, and I've been adamantly rejecting them because I feel it's not going to get back to stable dividends for another couple of years."

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Dividend stocks are being mentioned a lot these days as a good place to invest at a time of great stock market uncertainty. Here's a portfolio of dividend stocks used by investment adviser Vaughn Warrington for his clients.