Why the Best Dividend Stocks Are Your Most Reliable Investment

Financial numbers flow on the digital ticker tape at the TMX Group in Toronto's financial district. The Canadian Press/Darren Calabrese

Dividends rarely get the respect they deserve, especially from beginning investors.

That’s because a dividend-paying stock’s yearly 2–3 percent or 5 percent yield barely seems worth mentioning alongside yearly capital gains of 10, 20, or 30 percent or more.

But dividends are far more reliable than capital gains. A stock that pays a dividend of $1 this year will probably do the same next year. It may even raise it to $1.05. So with today’s low interest rates, investors are paying more attention to dividend yields.

A stock’s dividend yield is calculated as a company’s total annual dividends paid per share divided by the current stock price. The best dividend stocks respond by doing their best to maintain, or even increase, their payouts.

A couple of decades ago, you could assume that dividends would contribute up to a third of your long-term investment returns, even without the tax-cutting effects of the dividend tax credit in Canada.

In the early years of the past decade, dividend yields were generally too low to provide a third of investment returns. But since yields have moved up and interest rates remain low, it’s realistic to assume they will again contribute as much as a third of your total return.

You should also keep these two key points in mind:

1. Dividends can grow

Stock prices rise and fall. That means capital losses often follow capital gains, at least temporarily. Interest on a bond or guaranteed income certificate holds steady, at best.

But the best dividend stocks like to ratchet their dividends upward—hold them steady in a bad year, and raise them in a good one. That gives you a hedge against inflation.

2. Dividends are a sign of investment quality

Some good companies reinvest profit instead of paying dividends. But fraudulent and failing companies hardly ever pay dividends. So 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 recessions 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.

How We Select the Best Dividend Stocks

While we recommend that you spread your investments out across the five main economic sectors, the proportion you devote to each sector depends on your temperament and financial goals.

If you’re an income investor, you may wish to place more emphasis on utilities and Canadian banks. That’s because these firms generally pay high, secure dividends.

For example, you could pick from the companies in our Canadian Wealth Advisor newsletter’s Safety-Conscious Stock Portfolio.

The 18 stocks in the Safety-Conscious Portfolio are those we consider the best dividend stocks for investors who seek gains with the least risk. Nine of them come from the utilities and Canadian finance sectors. However, you'll still want to make sure your portfolio is well diversified within each sector.

Courtesy Fundata Canada Inc. © 2014. Patrick McKeough is a professional investment analyst and portfolio manager. He is the host of TSINetwork.com, where this article first appeared. Investments mentioned are not guaranteed and carry risk of loss.