Investing tip: Stocks that pay dividends can’t fake real success

You won’t find many risky stocks that pay steady dividends, and here’s why.

We think Canadian stocks that pay dividends are some of the best investments you can own. Some good companies reinvest profits instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends.

The best Canadian dividend stocks respond to tough economic times by doing their best to maintain, or even increase, their payouts. As well, dividends are impossible to fake–either the company has the cash to pay dividends or it doesn’t.

Stocks that pay dividends are a good sign of investment quality

If you only buy stocks that pay dividends, you’ll automatically stay out of almost all the market’s worst stocks.

For a true measure of stability, focus on companies that have maintained or raised their dividends during economic and stock market downturns. These firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

Stocks that pay dividends are great for income-seeking investors

Income stocks are stocks that produce above-average income, usually in the form of dividends.

Even if you don’t need current income from your portfolio, you still may want to invest in dividend stocks. When you pick the best dividend stocks, you are, for the most part, investing in safer and more secure companies. That’s in large part because of the dividends that the best income stocks pay. Dividends, after all, are much more stable than earnings projections.

You can identify income stocks by their high dividend yields (the percentage you get when you divide a company’s current yearly payment by its share price). For example, stocks with a dividend yield higher than, say, 3% would typically be attractive to an income-seeking investor.

Maintaining or increasing dividends from stocks that pay dividends

Apart from a high dividend yield, you should look for stocks that have a long history of paying (and raising) their dividends. As mentioned above, for a true measure of stability, focus on those companies that have maintained or raised their dividends during the recent recession and stock-market downturn.

That’s because these firms leave themselves enough room to handle periods of earnings volatility. By continually rewarding investors, and retaining enough cash to finance their businesses, they provide an attractive mix of safety, income and growth.

The dividend tax credit offered to Canadians can greatly increase your investment returns on stocks that pay dividends

Canadian taxpayers who hold Canadian dividend stocks get a special bonus. Their dividends can be eligible for the dividend tax credit in Canada. This dividend tax credit—which is available on dividends paid on Canadian stocks held outside of an RRSP, RRIF or TFSA—will cut your effective tax rate.

This means that dividend income will be taxed at a lower rate than the same amount of interest income. Investors in the highest tax bracket pay tax of around 29% on dividends, compared to 50% on interest income. At the same time, investors in the highest tax bracket pay tax on capital gains at a rate of about 25%.

Bonus tip: a “dividend capture” strategy because it’s unlikely to pay off

“Dividend capture” is the trading technique of buying dividend stocks just before the dividend is paid, holding it just long enough to collect the dividend, then selling it. If you can sell it for as much as you paid for it, you have “captured” the dividend at no cost, other than the transaction costs.

To do this, you would buy shares in stocks just before the ex-dividend date, so that you would be a shareholder of record on the record date, and would receive the dividend. Because the stock falls by the amount of the dividend on the ex-dividend date, the strategy then calls for you to wait for the stock to move back to the price where you bought it before the ex-dividend date. At this point, you sell the stock for a break-even trade.

This can pay off when stock markets are rising. Of course, any strategy that leads you to buy can pay off when stock markets are rising. However, you have to pay a brokerage commission to buy the shares, and a commission to sell. The commissions can eat up much of the dividend income. They may even exceed the dividend income.

In the end, dividend-capture strategies may have appeal for securities dealers or brokers who are executing huge trades with very low transaction costs. They may also have tax benefits, particularly for corporations. But the average investor doesn’t have much chance of making a significant profit.

Some investors don’t care about a company’s dividend policy because they can always sell stock if they want cash. What’s your take?

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