At a high level, when it comes to stock investing, there are two ways to make money. One, you can get price appreciation — buy a stock and then sell it in the future at a higher price. Price gains are taxed at 50% of your marginal tax rate, if materialized in your non-registered account. This is favourable income versus ordinary income. Two, you can earn dividend income from stocks that pay out dividends. Eligible Canadian dividends are also taxed at a lower rate versus ordinary income.
Earn dividend income as the foundation of your returns
From dividend stocks, you can get a return from company earnings no matter what the stock price does. From dividend income, you can improve your total returns and return stability. When a company persistently pays out dividends, the management has less capital to work with and so should be more careful with the spending of the capital that’s available.
Notably, only dividends that are declared must be paid out. In other words, companies have all the right in the world to cut any future dividends that haven’t been declared and, in the worst-case scenario, eliminate the dividend altogether. This is why investors should focus on the business quality when investing in stocks.
Focus on business quality
Warren Buffett’s number one rule of stock investing is “never lose money.” Our capital is limited, after all. How do you go about protecting your money? One way is to ensure you’re buying wonderful businesses that drive the long-term stock price performance.
By focusing on business quality, you’re probably not striving for the highest returns. However, you should improve your long-term return stability. That is, these businesses should have more predictable earnings and a lower-volatility stock price.
You want businesses that don’t have over leveraged balance sheets. One quick check is to compare the credit rating of a stock with those of its peers. For example, Royal Bank of Canada’s (TSX:RY) S&P credit rating is AA-, which is the highest among the big Canadian bank stocks. RBC offers a “low” yield of 4.1% versus its peers that yield up to 6.3%. The “low” dividend yield is a indication of its quality.
Strive to buy stocks on sale
You don’t want to overpay for stocks, because it could take years for their earnings to catch up, which means, at best, the stock price could go sideways for some time. Unfortunately, quality businesses that pay dividends tend to have shares that trade at a premium valuation.
For example, at $128.55 per share at writing, RBC stock trades at about 11.3 times earnings. This is a premium valuation to the rest of the Big Six Canadian bank stocks, which trade at price-to-earning ratios of between eight and 9.7.
Royal Bank trades at a discount of about 10%, according to the analyst consensus 12-month price target.
Investor takeaway
To summarize, if you strive to improve the quality of your returns — that is, improve your returns stability and likely long-term total returns, you can populate your diversified portfolio with quality businesses that pay out persistent dividends. And aim to buy the shares at any discount you can find.
For reference, RBC stock’s 10-year returns are about 12.9% annually, which essentially turned a $10,000 investment into approximately $34,212 in the decade. This is a very solid return for a quality company.
