Investing in dividend stocks remains a popular strategy on Bay Street. Basically, investors can create a steady stream of recurring income and benefit from long-term capital gains by holding dividend stocks.
But investing in dividend stocks can be quite tricky, especially amid a challenging macro environment and rising interest rates. As dividend payouts are not guaranteed, several companies may look to cut or entirely suspend these payments if their financials remain under pressure.
For instance, several TSX energy companies revoked or reduced dividend payments when oil prices crashed at the onset of COVID-19. Similarly, a rising interest rate environment has forced TSX companies such as Algonquin Power & Utilities (TSX: AQN) as well as Northwest Healthcare (TSX:NWH.UN) to reduce dividend payouts by more than 50% in recent months.
Both AQN and Northwest Healthcare are part of recession-resistant sectors, which suggests their cash flows are stable. For example, AQN generates a majority of its cash flows from its utility business, and Northwest Healthcare owns and operates a portfolio of healthcare properties.
But both these sectors are extremely capital intensive. While interest rates were quite low in the past decade, quantitative tightening strategies have meant the cost of debt has increased multiple-fold in the last 20 months, narrowing the profit margins of both AQN and NWH significantly.
As their payout ratios surged over 100%, a dividend cut was inevitable, resulting in lower share prices, too. Right now, shares of AQN have fallen by 59% below all-time highs, while NWH stock is down 63%.
So, how do you invest in dividend companies that can sustain their payouts across market cycles?
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Investors should avoid chasing high yields
A high dividend yield might seem attractive. However, as dividend yields and share prices are inversely related, a high yield most likely means the stock is out of favour and might be fundamentally weak.
You need to analyze the company’s financials further to see if it can sustain its dividend payout. Ideally, the company should have a low payout ratio, providing it with enough room to reinvest in growth projects, make regular interest payments, lower balance sheet debt, and increase dividends over time.
You should also invest in companies part of expanding addressable markets, which should result in widening cash flows and dividends.
Invest in Royal Bank of Canada stock
One TSX dividend stock that ticks most boxes is Royal Bank of Canada (TSX: RY), which currently offers you a dividend yield of 4.7%. While the banking sector is highly cyclical, RBC has maintained its dividends across market cycles, showcasing the resiliency of its business model.
RBC has a conservative approach to lending, allowing it to maintain robust liquidity positions when market conditions deteriorate. Since the start of 2000, RBC has survived multiple downturns, including the dot-com bubble, the financial crash, the COVID-19 pandemic, and the current period of higher rates and inflation.
In the last 23 years, RBC has increased its dividends by 10% annually, which is exceptional for a banking company. With a payout ratio of less than 50% and a forward price-to-earnings multiple of 10 times, RY stock trades at a discount of 18% to consensus price target estimates.
