With commodity price forecasts down and investor euphoria over resource plays fading, many are now shifting their focus to a more long-term investment model: dividend stocks.
While a large number of investors follow the model of “buy low, ride the price up and sell,” more and more individuals are beginning to shift toward longer-term strategies.
The market is going through one of the most volatile periods in recent history. As a result, investing in the junior energy space has become high-risk to say the least, and a number of portfolios have suffered monumental hits. With commodity price forecasts down and investor euphoria over resource plays fading, many are now focusing on a longer-term investment model: dividend stocks.
A dividend is a fraction of a company’s earnings that is returned to shareholders, usually in the form of cash. The return on investment for dividends is an added incentive to own stock in stable companies, even if they are not necessarily experiencing high levels of growth.
There are two types of stock dividends: preferred dividends, which are determined by a fixed rate, and common dividends, which are determined by a variable rate based on the company’s latest profits.
What is the appeal of dividends?
It is unsurprising that after two years of monumental price shifts, investors are seeking safer alternatives. As a result, larger companies that offer consistent returns on low-risk investments — and stand apart from the high-risk environment of today’s junior markets — are becoming increasingly appealing.
Their appeal is largely based on the peace of mind that they offer. Those invested in such companies can be secure in the knowledge that the value of their initial investment is unlikely to drop significantly, and that they will likely profit from dividend payments. Investing in larger companies can also allow investors to enjoy growing dividends that provide even more long-term value.
Business models shifting
It is not only investors who are seeing the appeal of dividend-focused models. An increasing number of oil and gas exploration and production (E&P) companies are shifting their business strategies, with the majority moving from the growth-through-drilling approach toward the income-and-dividend model.
In November, intermediate player Whitecap Resources (TSX:WCP) announced a change in corporate strategy, stating that it will focus on “paying sustainable dividends,” while a month later Pace Oil & Gas (TSX:PCE), AvenEx Energy (TSX:AVF) and Charger Energy (TSXV:CHX) confirmed plans to merge into a dividend-focused company.
With the momentum behind resource plays waning, it is clear that some companies see increased payouts to shareholders as key to protecting their valuations.
What to look for
Investors should be mindful of certain criteria when beginning to invest in dividend-yielding stocks. For example, investors are best off only considering companies that boast a proven record of steadily increasing dividends over a long period of time, according to a division of The New York Times.
It is also important to ensure that a prospective investment has a dividend-payout ratio of 50 percent or less, with the remaining funds being invested back into the business for future growth.
Investors should also look for companies that have generated positive earnings for at least the past three years. While that might be somewhat unrealistic considering the current junior oil and gas landscape, investors must remember that the dividend model is based on protecting investments, not reaping high profits through risky stock picks.
Finally, investors should look for companies that yield a dividend of between 3 and 6 percent and have little or no corporate debt.
However, while these tips may be helpful in picking out the winners from the losers, it is ultimately up to investors to do their own due diligence.
Pat McKeough, a professional investment analyst, highlighted in a recent article that it is essential to avoid judging — or investing — in a company based solely on the fact that it pays a dividend, adding that investors should be wary of focusing entirely on high-dividend yields as they can sometimes be a sign of danger.
Is the dividend golden era over?
There is much debate as to whether the dividend-focused investment model is a safe bet moving forward. Some critics argue that the days of decent returns through dividends are over.
In a recent interview with The Globe and Mail, Dirk Lever, managing director at AltaCorp Capital, stated that he recently looked at 11 Canadian E&P companies and concluded that while total annual dividends for the firms are 30 percent below their 2008 peak, they are still more than 40 percent higher than they were in 2005.
While that might sound enticing, especially given the market environment over the past two years, Lever also noted that the total share count for these companies increased by 140 percent from 2005 to 2012. That is a concern for those wanting to avoid share dilution.
Though regular monetary payouts are appealing, investors would do well to practice caution. Many analysts question whether oil and gas juniors will be able to mix high-risk E&P with what is ultimately a blue-chip business model.
Gung-ho investors, especially within the junior space, need to realize that if capital costs or unbudgeted expenses arise, companies (especially juniors) will likely have to cut dividends or rein in activities in the field. That means that companies sending money to investors will have less cash to work in the field, the result of which will likely be a drop in share prices and dividend payouts.
Far from simple
Many feel that building a portfolio of dividend-paying oil and gas stocks is easy in that investors simply have to purchase stocks that pay the highest yields. That is not the case.
New research from Fidelity portfolio managers indicates that relying solely on information about past payouts may provide some return on investment, but can also leave investors overexposed, a very real concern within the current market.
“Backward-looking screens and passive strategies can help, but can also leave investors exposed to risk and potentially to underperformance. I think the best way to seek stock dividends is a forward-looking strategy focused on finding future dividend growth,” said Scott Offen, co-manager of Fidelity Equity Dividend Income.
In a market where a number of much-hyped oil and gas plays are not living up to initial expectations, and where capital is proving more difficult to come by, investors need to be certain that their money is aimed at companies that are able to expand operations even as they give money back to shareholders through regular dividend payouts.
Securities Disclosure: I, Adam Currie, hold no direct investment interest in any company mentioned in this article.