The Globe and Mail, Report on Business
Published September 4, 2010

One of the joys of my day job is talking with smart, turned-on people from all aspects and levels of the investment business. My good fortune comes from having a long and diverse career (as Woody Allen put it, 90 per cent of life is just showing up), running a company that’s still too small to threaten anyone and, on most days, just being a nice guy.

Over the past few weeks, I’ve been camped out in Toronto meetings with a broad range of analysts, portfolio managers and executives. At some point in each conversation, I’ve asked the question: “What is the elephant in the room? What do you see out there that’s being overlooked or underappreciated?”

There have been an array of answers, but the consensus hit on two themes, neither of which could be described as under the radar. First, why would anyone buy a 10-year government bond yielding less than 3 per cent? And the second, which is related to the first, is that a portfolio of dividend-paying stocks is now a better way to generate a stream of income and higher return.

Few of my confreres are calling government bonds the next bubble, as Warren Buffett and Jeremy Siegel are, but they’re all struggling to make the math work and are dumbfounded by the massive flows going into bond mutual funds, particularly in the U.S. It would appear that individual investors are chasing past returns that are not achievable given the current level of interest rates.

Bond yields are low because of the economic outlook (can you say double dip?) and the possibility of deflation. In a deflationary environment, even low-yielding bonds look attractive. But in the more likely scenario where there is some inflation, 2.5- to 3-per-cent yields provide little cushion.

Of course, these investment professionals do still own government bonds in their clients’ portfolios for liquidity and diversification reasons, but it’s a matter of degree. Their point is that buying bonds or GICs in isolation, which was the safe strategy of the past, will lead to disappointment.

The other half of the consensus is that dividend-paying stocks are the way to go. By being an owner instead of a lender, the income stream is higher (none of us have gone through a period when dividend yields were above bond yields), more tax-efficient, and likely to grow over time as corporations increase their dividends.

Of course it’s easy for these (mostly wealthy) professional risk-takers to have this view, but what does it mean for investors who are living off of their portfolios. Certainly being an owner comes with its risks – dividends are paid only after all other obligations have been met and lenders (including bondholders) have been paid in full. If a company hits a rough patch, the first thing to go is the dividend. Manulife Financial Corp. was a core holding in most income-oriented portfolios and it cut its dividend in 2009, as did Manitoba Telecom Services Inc. recently (not to mention the many income and royalty trusts that reduced their distributions).

Being an owner also means the portfolio’s market value will bounce around with changes in interest rates, news on the companies’ business prospects and the stock market in general. Nobody expects another 2008, but a dip of 20 per cent or more is possible at any time, even for a conservative stock portfolio. Indeed, it’s assured of happening some time in the next 10 years.

It’s important to be prepared for this because the dividend strategy only works if you stick with it. If you bail out when prices are down or dividends are being cut, you will end up worse off than owning a low-yielding bond.

Even though I hate running with the herd on anything, I have to agree with my informal consensus. The reward/risk for bonds doesn’t look great, while the case for high-quality stocks is quite compelling.

Having said that, I go into this strategy with my rose-coloured glasses buried deep in the drawer. That’s because valuations are attractive for a reason. Corporate profit margins are already levitating at record levels, economic growth is expected to be slower and the business environment will be more competitive than ever. In other words, dividend growth will be harder to come by and there will be more Manulifes and MTSs ahead.

I want to diversify across industries and types of stocks as much as I can. While the financial sector dominates the dividend stock universe, there are other companies that pay reasonable dividends and have a record of increasing them – we own Rogers Communications Inc., Corus Entertainment Inc., and Enbridge Inc., to name a few. And for registered accounts, there are many high-quality foreign stocks yielding well in excess of 3 per cent.

As always, I want to be sensitive to valuation. Buying a big, fat quarterly dividend to maximize income in the short term can lead to disappointment (i.e. cuts) or mean less growth in the future.

We are in a unique circumstance where reaching to equities for income makes sense, but make no mistake: This approach requires discipline, fortitude and careful cash management. And it should be done in the context of a diversified portfolio, one that even has a few bonds in it.