When an investment strategy — new or not — becomes a fad, watch out. Because that’s the point at which the concept falls flat in execution. This experience has just been re-lived by dividend indexing of stocks, in contrast to weighting by market capitalization.

Four years ago, dividend indexing was the hot new idea in the market. In the September 2006 issue of Investment Executive, this column featured a list of stocks that presented an example of what a dividend-indexed portfolio might look like. The list included 30 common stocks with the highest total indicated annual dividend payments.

Since then, the average price change for the group has been a drop of 12%. In contrast, the S&P/TSX composite index has risen by almost 5%, while the TSX 60 index has risen by 1%.

So, is that the end of the story? Not at all. Now, another market phenomenon comes into play: when a hot idea becomes discredited and ignored — when did you last talk about dividend indexing? — it often starts to work.

Current trends favour indexing by dividends. Indicated dividends on the S&P/TSX composite index continue to rise, and dividend yields are also rising. When that happens, it often corresponds with a period of rising stock prices. Dividend increases have been frequent this year. In the first six months of 2010, the Toronto Stock Exchange reported dividend increases by 58 companies. The average increase is 12.7%.

Indicated annual dividend on the S&P/TSX composite index is now $326 — up by 3% in the six months ended June 30, and up by 3.6% from a low in September 2009. Mind you, dividend payments are still far below their record high of $406 seen two years ago.

Recent yield on the composite index is 2.9% — a 7% rise in the six months ended June 30. Eight years ago, the yield was below 2%; at the low of the 2008-09 crash, it was above 4%.

More important, in a market so confused it does not seem to know which way to turn, owning dividend-paying stocks in a portfolio is as strong a defensive strategy as you can find — short of going to all cash. The accompanying table lists the current leaders in the dividend department. It contains many of the old names from four years ago, but a slew of newcomers as well.

The premise of dividend-weighted stock indexing is as follows: companies that pay the largest amount of dividends offer lower risk than companies with smaller payouts. This echoes one simple gauge of investment quality: large companies rank higher than small companies.

Yields alone are less favoured in indexing strategies because unusually high yields indicate higher risk. Targeting stocks with above-average but not super-high yields does have appeal. Rating stocks by the number of dividend increases, by dividend growth rates and by continuity of dividend payments have their proponents, too.

The prime reason for the big price drop among those companies in the 2006 list of top dividend-paying stocks was the financial services sector, which was savaged by the worldwide debt crisis. The top of the current list of the largest dividend payers is more diversified, thanks to an infusion of energy, utility and media companies that have boosted their payouts in the past few years.

Of the 56 companies that pay $100 million or more a year in dividends (based on present indicated rates), 35 yield more than the S&P/TSX composite index’s current 2.9%. Some of these yields are very high in comparison and, therefore, have higher risk. That risk is a dividend cut or omission.

Stocks in the top 56 with unusually high yields include propane distributor Superior Plus Corp., at 12.7%; First Capital Realty, at 9.4%; and Crescent Point Energy Corp., at 7.4%.

The focus should be initially on companies yielding between 3% and 5% — they are attractive because they are higher than bond or money-market yields (and also offer the advantage of the dividend tax credit) but not high enough to indicate serious risk. This puts financial stocks front and centre again — plus utilities, real estate, energy and industrials.

IE