Stock Investing

Sector diversification is a big plus, even though there are no tax advantages.
By Andrew Hepburn | 22/05/18

It's a well-known adage that you shouldn't place all your eggs in one basket. For Canadian dividend investors, this suggests looking beyond the country's borders for yield. Fortunately, you don't need to look very far: The U.S. equity market offers many dividend possibilities.

About the Author
Andrew Hepburn is a freelance financial writer based in Toronto. He writes about investments, market trends and personal finance. He has written for Maclean's, the Globe and Mail, RateHub.ca and Canadian MoneySaver.

There are a few arguments for Canadian investors to own some U.S. dividend-paying stocks. For one, such a strategy provides geographic diversification. Should the U.S. economy outperform Canada's, for instance, U.S. equities may help offset weakness north of the border.

Another strong rationale for owning U.S. dividend stocks is Canada's highly concentrated equity market. Doug Porter, chief economist of BMO Financial Group, notes that Canada is over-represented in materials and energy, and in financial services to some extent, and reasonably represented in telecommunications.

"But in just about everything else Canada is very light," Porter said in an interview with Morningstar. "That alone is a very strong argument to diversify, at least into the U.S. And the U.S. of course offers many compelling alternatives outside of those three or four sectors. Many of those are dividend-paying, well-known names, and in some cases not so well known."

When Canadian investors purchase U.S. stocks, it's important to realize that they are usually gaining exposure to the U.S. dollar, unless the currency exposure is hedged. Equity returns for Canadians are a function both of a U.S. stock's price as well as changes in the exchange rate. This introduces a different element of diversification and risk into the equation. Should the U.S. dollar appreciate after an investor has made a purchase, investors will benefit. On the flip side, any decline in the greenback will erode returns.

"The merits of currency diversification are somewhat debatable, says BMO's Porter. "If someone expects to have most of their retirement expenses or their expenses in later years in Canadian dollars, the case for currency diversification is a little bit weak. It's not obvious that you're going to have any benefit from diversifying outside of the Canadian dollar."

Trevor Hunt, a portfolio manager at Leith Wheeler Investment Counsel Ltd. in Vancouver, believes that owning some U.S. equities is beneficial in part because the U.S. dollar tends to act as a safe haven. This can help Canadian investors during risk-averse periods in equity markets, especially because Canada has a cyclical, resource-heavy economy. That said, Hunt maintains that the key is to not have too much exposure, given the exchange-rate risk.

A taxing issue

Canadian investors receive favourable tax treatment when they own shares of domestic issuers. That's because these companies are able to pay what are known as "eligible dividends." Frank Di Pietro, assistant vice-president of tax and estate planning at Mackenzie Investments, explains that most investors receive preferential tax treatment because they are entitled to a dividend tax credit.

Essentially, the thinking behind the credit is that companies have already paid corporate tax on the money distributed to shareholders. "It's sort of an integrational mechanism to ensure there isn't a double tax issue," Di Pietro says.

But Canadian investors receive no preferential tax treatment on dividends paid by U.S. or other foreign companies, "It's effectively like earning regular employment income or interest income," notes Di Pietro.

Indeed, based on calculations provided by Mackenzie, an investor in Ontario earning $100,000 would require a 3.96% U.S. dividend to achieve the same after-tax result as a 3% yield from an eligible dividend in Canada.

Valuations and yields

For Canadian investors interested in U.S. dividend stocks, it's a good idea to know how the U.S. equity market stacks up in terms of both valuation and yield. Leith Wheeler's Hunt says the U.S. market "has never been more expensive."

He notes that the CAPE ratio (cyclically adjusted price-earnings), which averages earnings over a 10-year period, currently stands at 33 versus a historical average of 16.7. On a relative basis, this makes U.S. equities more expensive than other developed markets. Looking at relative dividend yields for broad markets, data from Leith Wheeler shows that the S&P 500 pays 1.9% compared to 3.1% for the S&P/TSX Composite Index.

Hunt points out that despite the rich valuation for the broad U.S. market, some specific stocks, sectors and industries aren't as expensive as others. In Leith Wheeler's view, lofty technology stocks, such as  Amazon.com Inc. (AMZN), are partly responsible for the U.S. market being so expensive on a headline basis.

In other sectors, Hunt's firm still sees value to be had. "We are finding more attractive opportunities in companies such as  CVS Health Corp. (CVS), which has a dividend yield of 2.9%, a 31.4% payout ratio and 11 times price-earnings multiple," Hunt says. Leith Wheeler U.S. Dividend has an overweight position in U.S. financial and industrial stocks, and underweight in information technology and consumer discretionary companies.

How to get U.S. dividend exposure

Benjamin Felix, associate portfolio manager and a certified financial planner (CFP) professional at PWL Capital in Ottawa, believes owning the broad market is a sufficient way to gain exposure to U.S. dividend stocks.

"For most investors, exposure to the U.S. market through low-cost total market ETFs or index mutual funds provides sufficient exposure to U.S. dividend-paying stocks," he says. "I would not suggest a dividend-focused ETF because they inherently lack diversification and there is no sensible reason to focus on dividends."

Dividend-paying stocks don't deserve a special place in a portfolio, says Felix, citing other important factors, such as company size and profitability, that ultimately determine investor returns.

Felix also cautions against investors buying individual dividend-paying stocks due to company-specific risks. And he doesn't think actively managed funds are a great choice, either, since very few of them outperform the S&P 500.

The bottom line

Canadian investors in search of dividend diversification can look to the U.S. Unlike in Canada, the U.S. market is not nearly as concentrated in a few major sectors. The devil, as they say, is in the details. For people with significant expenses in Canadian dollars, owning too many unhedged U.S.-dollar assets poses unacceptable currency risk.

As for how to best get exposure to the U.S. market, much turns on how an investor views the current valuation of U.S. equity indices. Index funds provide the broadest exposure to the market, which may be appropriate for people who aren't troubled by the market's apparent richness. And for those who worry that expensive technology stocks could cause trouble for the market, it may be wiser to seek out managed funds that shy away from today's high-flyers.

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