Stocks market gains could be limited this year, so advisors should look to dividend-paying stocks to enhance the returns of client portfolios, according to Juliette John, lead manager of the Bissett Canadian Dividend Fund, which is sponsored by Franklin Templeton Investments Corp.

Speaking at Franklin Templeton’s annual Investment Outlook and Opportunities Forum in Toronto on Thursday, John said dividend-paying stocks could substantially improve a portfolio’s total returns in the long run.

“We actually believe that dividends offer long-term benefits,” she said. “Reinvested dividends have been a significant contributor to total returns over time.”

John pointed to data showing that over time, stocks of companies that pay dividends tend to outperform those that don’t. Dividend-paying companies also tend to have more stable conservative business models, she said, with more discipline in how they allocate capital and more focus on the long-term potential of the projects in which they invest.

“In turn, this improves the quality of those investments, which services more shareholder value,” John said. This type of stability is likely to be particularly appealing to investors in the current environment, she said, as the market downturn of 2008 and 2009 remains fresh in their minds.

Also contributing to the appeal of dividends is the fact that capital gains in the stock market may be disappointing this year, according to John. She said one indicator of stock market gains has historically been the Institute for Supply Management’s manufacturing index. A low index indicates a period of low economic activity, and is typically followed by a year of robust stock market returns. The ISM index is currently higher than average, hinting at weak market performance in the year ahead.

“It’s still quite high, and doesn’t necessarily support the same extent of the gains as when ISM readings are lower,” John said.

“An [investment] approach that embraces dividends really will be one that enhances returns, to allow investors to rely less on capital gains.”

Canadian dividend-paying stocks that John favours in particular include clothing retailer Reitmans (Canada) Ltd. (TSX:RET.A), which she said has a strong balance sheet and strong profitability; and Thomson Reuters Corp. (TSX:TRI) — a stock which she believes shows strong potential for growth and cost synergies as it completes the integration of Thomson and Reuters, which merged in 2008. As of June 30, the dividend yield for Reitmans was 4.3%, and for Thomson Reuters, was 3.2%.

In terms of market sectors, John urged advisors to steer clients away from cyclical stocks and towards defensive sectors such as telecommunications and utilities. Although commodities, industrials, and other cyclical sectors have outperformed since the market bottom of March 2009, John expects defensive sector equities to perform well in the months ahead.

“As we move through the rest of the year, we do expect some of these more defensive groups to gain momentum,” she said. “Investors who remain untrusting of the recovery may look to the defensive characteristics and dividend support provided by some of these sectors.”

John added that if economic activity weakens, securities with more earnings stability are likely to gain appeal, while more cyclical stocks could decline.

IE