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Which path to take? Some investors are pulling back on blue-chip dividend stocks; others are standing pat.

Canadians love dividend stocks, and dividend stocks love them right back. Over the past five years, the iShares ETF that holds Canada's so-called dividend aristocrats—superstar dividend stocks such as Exchange Income Corp. and BCE Inc.—has zoomed ahead by an average of 12% a year, compared with just 8% for the stock market as a whole.

Many investors have concluded that stocks with big dividends will go on thrashing the competition. But the recent burst also offers reason to worry about what comes next.

Financial theory provides no convincing reason why a stock that pays a big dividend should outperform one that pays a small one, or none at all. Two giants of modern economics, Franco Modigliani and Merton Miller, published a paper in the 1950s that showed that, in an idealized world, a company can't raise its stock market value by increasing its dividend.

Common sense suggests that the same thing holds true in the real world. If you receive a dividend of $1, the intrinsic value of the underlying shares should also decline by a buck. If it didn't—if management could conjure up payouts out of thin air without any effect on the value of the business—every company would pay triple-digit dividends.

A dividend essentially takes some of the value in your shares and deposits that amount in your bank account instead. This might be a valuable feature if you don't trust the company's top executives to deploy your money wisely. But it also raises a deeper question: Why would you hold a stock with such feeble leadership in the first place?

Dividend lovers brush aside such objections. They argue that dividend investing works in practice even if it doesn't work in theory. Well, perhaps. In Canada, it's tough to argue with the track record in recent years. But look elsewhere and some holes appear.

Aswath Damodaran, a professor of finance at New York University, found that U.S. high-dividend stocks beat their lower-yielding counterparts from 1952 to 1970, lagged behind from 1971 to 1990, and edged ahead again from 1991 to 2001. Over the entire half century, though, high-dividend stocks performed only slightly better than their low-dividend counterparts. There was also no evidence that a large dividend provided any buffer in down markets—just the opposite, in fact.

So why has dividend investing worked so superbly in Canada? Perhaps it's because the Canadian market is chock full of resource companies. Dividend in-vestors here may do better than the overall market simply because they don't venture into its dreckiest corners—yes, I'm talking about you, junior miners.

Another possibility is that Canadians have been lucky winners of a roll of the dividend dice. Financial institutions and big oil patch players are many of our most reliable dividend gushers, and they've been boosted in recent years by a hot housing market and a booming energy sector.

Those fortunate circumstances may not continue forever. It may be time for Canadian dividend lovers to become more selective in their affections, and to look at other factors.

J.P. Morgan Asset Management recommends that dividend investors resist the urge to only hunt for large yields. They should focus on cash-rich companies that pay out only a small fraction of their earnings as dividends, and that also reward investors by buying back shares. That's wise advice.

Smart Money

Investors have piled into blue-chip dividend stocks in recent years. We asked Aubrey Hearn, manager of the $1.2-billion Sentry Small/Mid Cap Income Fund, why smaller companies with regular payouts can also be enticing.—Shirley Won

What advantages do small dividend stocks offer?

These companies tend to grow faster than their larger-cap peers, and they generally expand when the economy is improving. You can also find better bargains or mispriced opportunities among them, because there aren't as many eyeballs watching the names.

What kinds of companies make your shopping list?

We focus on companies that are protected by barriers to entry for rivals, have low debt and generate high returns on invested capital. We look for companies that pay and grow their dividends, or buy back shares. They tend to be in the industrial, consumer staples, technology and financial sectors. We own energy service firms, too.

What are some favourite names now?

We like Canadian dividend payers like Information Services Corp., a land registry company, and Toromont Industries, a dealer for Caterpillar construction equipment and mining gear. We also own non-dividend-paying U.S. stocks like Crown Holdings, which makes cans for food and beverages, and Varian Medical Systems, which makes medical devices. These companies usually buy back a lot of their shares, and they could pay a dividend some day.

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Tickers mentioned in this story

Study and track financial data on any traded entity: click to open the full quote page. Data updated as of 28/03/24 3:54pm EDT.

SymbolName% changeLast
BCE-N
BCE Inc
-0.82%33.98
BCE-T
BCE Inc
-1.01%46.03
CCK-N
Crown Cork & Seal Company
+0.96%79.26
CE-N
Celanese Corp
+1.31%171.86
E-N
Eni S.P.A. ADR
+0.79%31.72
E-T
Enterprise Group Inc
-1.16%0.85
EIF-T
Exchange Income Corp
-0.46%49.51
ISV-T
Information Services Corp
+0.87%27.69
TIH-T
Toromont Ind
+0.56%130.35

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