Dividend stocks remain unpopular with some investors because dividends are perceived to be a poor use of capital that would deliver better returns for shareholders if it was reinvested in the business. This, naysayers claim, leads to dividend stocks providing inferior returns to investors.
Despite these criticisms, I’m a strong advocate of dividend investing because, when executed correctly, it provides one of the easiest means of achieving investing success along with a range of other important benefits.
Firstly, dividends represent a significant portion of total market returns.
Research from ratings agency Standard & Poor’s shows that since 1956 dividends have made up almost 40% of the total returns generated by the S&P/TSX Composite Index.
This is a massive chunk of returns that is way too large for investors to miss out on.
It is easy to see just how important dividends are when examining the returns to shareholders by Toronto-Dominion Bank (TSX:TD)(NYSE:TD) over the last 10 years. For that period it delivered an impressive total return of 129%, of which 36% can be attributed to the dividends paid.
Secondly, dividends reduce investment risk.
You see, dividends are typically paid by established companies with mature businesses, reliable cash flow, and wide economic moats. These types of companies tend to be the most resistant to market gyrations and economic slumps.
Furthermore, their earnings and cash flows tend to be highly resilient to economic downturns, meaning that they continue to reward investors regardless of the state of the economy.
An outstanding example of this is regulated electric utility Fortis Inc. (TSX:FTS).
It derives a considerable portion of its earnings from regulated assets. When that’s considered in conjunction with the wide economic moat associated with electric utilities and the inelastic demand for electricity, its earnings are virtually assured. This has allowed Fortis to reward patient investors with a dividend hike every year for the last 42 years, which is an impressive record by anyone’s standards.
As a result, its annual dividend now yields a healthy 3.6%. With a payout ratio of 60%, the dividend should remain sustainable even during times of economic distress.
Finally, dividends can be a tax-effective form of income; eligible dividends receive favourable tax treatment in the hands of investors.
The majority of dividends paid by Canada’s major publicly listed companies such as Toronto-Dominion Bank and Fortis are designated as eligible dividends because they are paid out of taxed corporate profits.
As a result, at both provincial- and federal-level tax credits are offset against the dividends received in order to prevent double taxation. This means dividend payments are taxed at a lower rate than either interest or employment income, making them a very attractive form of income.
These are just some of the many benefits that investors are able to obtain when investing in dividend stocks, highlighting why they are an effective means of building long-term, tax-effective income stream and achieving investing success.
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Fool contributor Matt Smith has no position in any stocks mentioned.