A $10,000 investment yielding 6% produces $600 during the first year. Another investment yielding 3.3% produces only $330. Case closed, right?
Only if the dividend never changes.
Suppose the 3.3% payer increases its dividend by 10% annually. Its yearly income would exceed $600 by year eight and reach approximately $778 by year 10. After 15 years, the original investment would be producing roughly $1,250 annually. And that’s before any returns.
That’s the part of dividend investing a starting yield can’t show. A smaller payment that keeps growing may eventually generate considerably more income than a larger payment standing still. A high yield followed by a dividend cut can perform worse still.
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What makes a yield
A stock’s yield rises for two reasons. The company increases its dividend, or the share price falls. The first is generally welcome. The second requires investigation.
If a $50 stock pays a $3 annual dividend, it yields 6%. Should the share price fall to $30, the same payment suddenly yields 10%. Investors haven’t received a raise. The market is questioning whether the company can afford the payment.
Before buying, I’d check earnings or distributable cash flow, leverage, and the portion of profits required by the dividend. I’d also look for an actual history of increases. A board can reduce even a long-standing dividend when the financial position changes.
That’s why I’d rather own a moderate yield supported by rising profits than chase the highest number among Canadian dividend stocks.
MFC
Manulife Financial (TSX: MFC) currently pays a quarterly dividend of $0.49 per share, or $1.94 annually. At a recent share price of $59.46, that produces a yield of approximately 3.3%. That won’t win a highest-yield contest, but it may provide a better chance of receiving more income later.
Manulife stock increased its dividend by 10.2% in February. The insurer has now roughly doubled its quarterly payment from $0.24 at the beginning of 2018. Dividend growth hasn’t followed a perfectly straight line, but the direction has been difficult to miss.
A $10,000 investment at the recent price would purchase 168 whole shares, leaving $11.72 uninvested. The position would initially generate $325.92 annually.
| COMPANY | RECENT PRICE | NUMBER OF SHARES | ANNUAL DIVIDEND | ANNUAL TOTAL PAYOUT | FREQUENCY | TOTAL INVESTMENT |
|---|---|---|---|---|---|---|
| MFC | $59.46 | 168 | $1.94 | $325.92 | Quarterly | $9,988.28 |
Future increases aren’t guaranteed. However, Manulife stock’s latest results provide evidence that the dividend isn’t outrunning the business.
Into earnings
Second-quarter core earnings rose 12% year over year to $1.9 billion. Core earnings per share (EPS) increased 16% to $1.09, helped partly by share repurchases. That per-share growth is important. A company can afford larger dividends more easily when the earnings supporting each share are also increasing.
Manulife’s Life Insurance Capital Adequacy Test ratio stood at 139% at the end of June. This measures the capital available to absorb insurance risks, with a stronger cushion helping protect policyholders and shareholders when claims or markets become less cooperative.
Growth is also coming from new business. Annualized premium-equivalent sales increased 21%, while new business value rose 10%. Manulife’s Asian operations remain particularly important because rising wealth and relatively low insurance penetration create a longer runway than mature North American markets.
Not cheap
Unlike some of those falling shares with high yields, Manulife stock recently traded around 16 times trailing earnings. That isn’t extreme, although the shares remain above a $48 analyst fair-value estimate contained in the latest research available to me. Fair value is an opinion, but the premium suggests investors are already paying for improving earnings.
Insurance companies also carry risks that a simple payout ratio may miss. Manulife has been transferring portions of its older long-term-care exposure to reinsurers, but legacy risks haven’t disappeared completely. I’d therefore build the position gradually, particularly for investors holding the shares inside a TFSA, where dividends and capital gains can compound tax-free.
Foolish bottom line
A 6% yield can provide more income today, certainly. It can’t compensate for deteriorating cash flow, excessive debt, or a dividend the company eventually reduces.
Manulife stock’s approximately 3.3% yield starts smaller, but the latest 10.2% increase is supported by higher core earnings per share and a strong capital position. I’d accept less income initially for a payout with room to grow.
