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Dividend investing is good strategy as payout ratios climb

Corporations are sitting on historic cash highs, and they're starting to pay it out to investors.

(Photo: Dimitri Vervitsiotis/Getty)

As good as dividends have been for investors in Canada, in quarters ahead there could be grounds for further rejoicing. The pace of dividend hikes is picking up, corporate cash balances have climbed to Olympian heights, and dividend-payout ratios have room to climb.

So far in 2012 nearly a third of dividend announcements have raised payments to investors. That’s the highest rate since 2006, according to a CIBC World Markets Inc. report by economist Peter Buchanan. The trend has been up since the second quarter of 2009, when only 5% of dividend announcements specified higher payments.

The capacity to raise dividends keeps on expanding. Cash balances on corporate balance sheets recently surpassed $500 million in Canada, an amount equal to about 30% of Gross Domestic Product (GDP). Normally, corporate cash balances are about 10% of GDP.

The pressure to share the wealth is mounting. Not only are shareholders pushing for greater distributions but so are groups seeking economic growth, jobs, and reductions in government deficits. Even business-friendly Prime Minister Harper may be getting into the act: the federal budget due in late March may impose penalties on CEOs who hoard cash.

As executives and Boards of Directors feel the heat, it wouldn’t be surprising to see them dipping more into their cash coffers to raise dividends. They could also allocate more to share buybacks, additionally boosting shareholder value. Capital expenditures will also likely be ramped up, generating cost savings and revenue growth that contribute to shareholder value over the longer term.

According to CIBC World Markets, the dividend-payout ratio for companies in the S&P/TSX Composite Index stands at 41% (based on average earnings over the last four quarters). Considering the historical median is 45%, there would seem to be room for this ratio to grow.

In fact, there is some possibility the payout ratio could rise substantially above the historical norm, if comparable (commodity-based) stock markets are any guide. Notably, the companies in Australia’s main stock market index, the S&P/ASX 200, pay out 65% of their earnings in dividends.

In Canada, the utilities, industrials, and materials sectors have the most room for dividend increases. Their payout ratios are the lowest relative to their respective historical averages. Energy, consumer-discretionary and telecom sectors have the least room.

From 2010 to 2011, corporate profits in Canada rose 15% to $208 billion, further augmenting cash reserves. As a percentage of corporate assets, cash currently stands at 7%, up substantially from 4% a decade ago (financial companies excluded).

The materials and energy sectors have been mainly responsible for the growing cash piles. CIBC World Markets says an in-house study found that companies with twice normal cash balances had a 7% chance of raising their dividend in a quarter, compared to 4% for companies with payout ratios 25% or more below their norm.