Dividends are great if they don’t strain the business

Corporate dividends should not be paid at the expense of strategic opportunities or necessary reinvestment, says James Black, vice-president, Canadian Equities, and director of equities research at Beutel Goodman Investment Counsel.

Black said many investors are understandably looking for dividend income, but they should be wary of demanding it when it is not in the company’s long-term interest. When great businesses generate excess cash, dividends are welcome when they’re based on a reasonable payout ratio, and share buybacks are great when the stocks are attractively valued.

“We don’t want companies stretching their balance sheet or stretching their financial flexibility to return cash to us,” he said. “We want the dividend level to be sustainable, providing them with flexibility over time.”

Black said there are circumstances when a company should hold onto its free cash in order to accommodate a period of heavier investment or to consider acquisition opportunities.

“We would absolutely not want a company to raise its dividend if that prevented it from being able to pursue either organic investment or creative acquisition growth,” he said.

He has seen multiple cases where companies paid too much in dividends and, in so doing, failed to invest adequately in their own businesses or stretched their finances in an unsustainable way.

“We try to avoid investing in companies that take that approach,” he said.

He pointed out that dividend stocks are a perennial investor favourite, particularly among retail investors, retirees and charitable foundations where generating income is an important consideration. The dividend speaks to the company’s healthy level of capitalization and good cash flow.

“The very fact that a company can pay dividends should foster investor confidence,” he said. “Dividends are the gravy that results after a business has been really well run. They are the evidence that this business is truly a good one and a resilient one.”

And, according to Black, these well-run companies are usually well protected against market pressures like inflation and high interest rates. Furthermore, he suggested that some dividend-paying businesses, like banks, benefit when interest rates increase because that’s when their margins tend to expand, creating greater levels of profitability.

Black added that the appetite for dividend stocks has been solid for quite some time, and will likely remain popular in lower interest rate environments.

“Our view would always be that there’s likely going to be an appetite for stocks that can pay ongoing dividends, particularly those that can grow through time,” he said. “Sustainable and growing dividends are indicators of a great business. And when valuations are attractive in stocks like that, we want to be buyers of them.”

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.