Financial Stocks for Dividend Investors

Financial stocks, which used to be great dividend investments, have had their share of troubles over the past two years. The sector has rebounded sharply since hitting its lows in March. Since the major dividend growth stories of the past such as Bank of America (BAC) and US Bancorp (USB) have cut dividends, most dividend growth investors seem to have a very low allocation to the sector. As a result dividend investors could suffer inferior risk adjusted returns in the future since they won't own any financial stocks.

There are several alternatives for investors who are underweight the financial sector right now. One of them involves purchasing shares in some of US insurance companies such as Aflac (AFL) or Chubb (CB), which offer decent yields and have a long history of dependable dividend growth.

Another alternative is buying shares in the five major Canadian banks, which seem to have escaped the financial meltdown. While none of them have increased their dividends in over one year, they have not cut them either. In addition to that major Canadian banks spot very decent yields as well. It is important to check individual payout ratios in order to gauge the sustainability of the dividend payments. The major Canadian banks include
Toronto-Dominion Bank (TD) , Bank of Montreal (BMO), Royal Bank of Canada (RY), Canadian Imperial Bank of Commerce (CIBC) and Bank of Nova Scotia (BNS).

Buying Preferred stocks could also be a decent bet on the long recovery of US financial institutions. Preferred shares have a higher ranking than ordinary shares in the event of a bankruptcy, but a lower priority relative to bonds. Preferred stocks do not have voting rights but have a fixed dividend payment, just like a bond. Preferred stockholders are also first in line to receive dividend payments, which are typically fixed. They don’t typically get to share in the prosperity of the enterprise however as preferred stock dividends do not increase. In tough economic conditions however, preferred stock dividends are much less likely to be cut or suspended; as long as the company continues operating as a going concern preferred stock dividends continue getting paid. In addition to that if you buy a cumulative preferred stock, the company is obligated to pay distributions to you even if it skips a few payments. That is of course as long as the company is not bankrupt. These two ETFs PFF and PGF are good vehicles to gain exposure to preferred stocks. Most of the issues they hold are in the financial sector.

Some investors also believe that the major US financial institutions would one day return to their former glory. This could mean that companies like Bank of America (BAC), Citigroup (C) and US Bancorp (USB) could yield very decent returns if they were to increase distributions to their 2007 levels. This option of getting exposure to financials is the riskiest of all, since most of the TARPed financial institutions are already paying billions in dividends to the Treasury every year. In addition to that the Treasury and other strategic investors might elect to convert their preferred stock into common, which would dilute existing shareholders. Last but not least it is very difficult to forecast how the US banking industry would look like a few years from now. Just because a bank survives the meltdown, does not mean it would be a solid long-term investment.

The strong gains off the March lows have definitely pushed financial stocks in overbought territory. Thus, if you believe that owning US banks provides you with the best exposure to the US financial sector, you might consider waiting to buy them on pullbacks.

These options could either be used on a standalone basis or in a combination. As a dividend growth investor I currently own mostly insurers and have a position in one of the Canadian banks. I might add to my Canadian exposure, which also provides international diversification for my portfolio.

Disclosure: Long AFL, CB and TD

Comments

[Juliet:]

Also Banco Santander (STD) may be worth a look. Said to be the strongest Euro bank. Also has presence in Latin America, esp. Brazil--and nice yield.

Aug 26 10:10 AM

[greedcanbgood:]

I wouldn't be so quick to count out BAC and especially USB. USB clearly has weathered this well. While I don't see a return to the dividends of yore in the very near future, I can see it come back far faster than others.

Aug 26 10:22 AM

[mbkelly75:]

USB is a good bank - I would buy them before BAC any day of the week. I have been looking at STD because of it's connection to Brazil and it does look good to me also. The Canadian Banks have side-stepped pretty much all of our problems as they did NOT do the sub-prime mortgage thing as our Banks did and paying their dividends in Loonies instead of Dollars could be a real bonus later on down the road. Silly as it might sound - the mortgage REITs might be a great place to put some cash also. NLY is best-of-breed in that area and raised their dividend this last time. I have done well with them for several years now. They are near their 52 week high right now and still paying a 13.7% dividend and WAY ahead of all 3 Moving Averages ( 21 day, 50 day, and 200 day).

Aug 26 12:55 PM

[Invest4Life:]

This author follows my train of thought that I had this year. I bought AFL at $25 and TD at $44. Why? Both best of breed. AFL has great, honest management and is geologically diverse with operations in both Japan and the US.

TD is a good play because it has a great balance sheet, didn't play in the subprime mess but also has growth potential as it looks for opportunity to expand into the US market. Both good calls.

Aug 27 09:08 AM

[gmwright:]

Not buying RY at $25 in March is one of my great regrets. This is my favourite stock with steady growth, solid dividend and great balance sheet. Sure there were "sexier" stocks to buy fro capital gains, but if I had loaded up with RY at $25, I would not only have doubled my money, but pulling in 7+% dividend payments on my initial investment.

This is a stock you shouldn't look to time, just buy it, forget about it and let that baby grow for a couple of decades.

Aug 27 11:03 AM

[Stan Sutfin:]

Canadian banks sound like a good alternative. I believe they would deduct canadian tax from dividend payment and then you would get credit for that foreign tax paid in filing your 1040. If that is the case, it is important to not hold these shares in an IRA. Does this sound right?

Aug 27 06:53 PM

[Stargazer:]

Hello Mr. Sutfin,

You are correct in that Canada would have a withholding tax on dividends paid to an American -even if the stock in question is held with an traditional IRA or Roth IRA. Further, you are also correct that an American would lose the benefit of filling for a tax credit with this withholding if held in said IRA / Roth IRA.

I have a Roth IRA. It contains just domestic mid and large cap dividend paying stocks. At this point it is generating just $1000 a year in dividends. Not much, but it is all tax free. I have it setup so that all of the dividends are automatically re-invested into whatever stock issued a particular dividend. Works great. Some of the stocks that I maintain a position in are: BKH, CLX, JNJ, KO, O, and SO. Speaking of O, it is a wonderful stock to hold in an IRA since it offers monthly dividends. There are many articles about it here on S.A. One in particular, written by David Van Knapp, is well worth the read.

Back to foreign taxes. I have a regular trading account that holds all of my foreign investments. Last year I was able to apply all of the foreign taxes withheld as a credit to my 1040. I only had two two countries involved in this: Canada and Australia. This year I've expanded to include: Brazil, France, Hungary, and India. From what research I have done, all of these countries have an agreement with the United States to allow an investor to claim that countries taxes withheld as a credit. (Please, someone, correct
me if I am in error on this.)

Bottom line is I would not hold any foreign stocks in an IRA that paid dividends and had a withholding taxes applied to them.

On Aug 27 06:53 PM Stan Sutfin wrote:

> Canadian banks sound like a good alternative. I believe they would
> deduct canadian tax from dividend payment and then you would get
> credit for that foreign tax paid in filing your 1040. If that is
> the case, it is important to not hold these shares in an IRA. Does
> this sound right?

Aug 29 09:33 AM