Tuesday, 29 May 2012

Income Tax on Dividends: How to Cope with the Myths and the Realities

Income tax can be confusing. This week we'll try to shed some light on how taxes on dividends work.

A Walk-through of the Mechanics of Dividend Taxes

If you received dividends last year, you may have wondered while filling out your tax return why the dividends for tax purposes were considerably bumped up. Does this "grossing up" process result in higher tax on dividends?

The following table shows how the dividend tax process works for an Ontario taxpayer in the lowest bracket of taxable income (about $39,000) using 2012 rates (taken from TaxTips.ca). It show three types of dividends: eligible dividends from Canadian corporations, which is the typical type from publicly-listed companies on the TSX contained in many mutual funds and ETFs; non-eligible dividends, which come mainly from Canadian small businesses; and foreign dividends, which come from US and international companies both held individually or through mutual funds and ETFs. Naturally, the table applies, and taxes apply, only when the investor holds the shares or funds in a taxable account. It does not apply for holdings in a registered account like a TFSA, RRSP, RESP, RRIF, LRIF or LIRA while the holdings are inside. The slippery ins and outs of dividends in a registered account are discussed further on.

Myth: The dividend gross-up results in higher tax for the investor.
Reality: The tax credit that automatically goes along with the grossed-up dividend offsets the gross-up effect. The system is designed to prevent double taxation of the profits from the corporation. The gross-up reflects the amount of pre-tax profit that the corporation is presumed to have earned while the credit reflects the tax that the corporation is presumed to have paid.

In our example, the investor with eligible dividends will not pay any tax at all (since the corporation already paid). In fact, there is a small left-over credit of $1.89. Though we show the net tax as zero since it is non-refundable as cash to the investor (much like those familiar store discount coupons with no cash value though they give the right to a discount), the credit can in fact be used to reduce taxes due on any other income of the investor. Investors shouldn't get too excited as the "negative tax" on dividends only occurs in the lowest tax bracket, generally up to about $40,000 taxable income, and the percent benefit is relatively low, a few percent at best.

Reality: Non-eligible dividends do not get grossed-up as much but they also receive a lower tax credit with the net effect that investors pay more tax than on eligible dividends.

Reality: Foreign dividends do not go through the gross-up/credit process and are treated as ordinary income, which is taxed at a higher rate than dividends across all income levels in every province (see TaxTips tables).

Reality: The dividend gross-up can result in the reduction of income-tested benefits for retirees like OAS and GIS. The gross-up produces higher income and that starts eating away at OAS above individual net income of about $69,500 (2012 figure) and GIS above total income for a couple of about $21,600.

Registered vs Taxable Accounts
Registered accounts like a TFSA, RRSP, RESP, RRIF, LRIF or LIRA cause some of the trickiest and most confusing tax effects!

Myth: There is no tax levied against dividends on investments while held in registered accounts.
Reality: Though there is no Canadian tax, foreign governments can and do levy witholding taxes depending on combinations of type of account and fund structure. In a taxable account, sometimes the tax may be claimable and may thereby offset Canadian tax owing. In registered accounts like RRSPs but not in TFSAs or RESPs, sometimes it may be avoided. In all types of accounts, sometimes it is gone and lost forever, causing a net reduction to returns. See these previous posts for details - Pros and Cons of Cross-Border Shopping in the USA for ETFs and Free Tool to Compare Cross-Border ETFs.

Myth: It is not a good idea to put dividend paying securities inside an RRSP because the dividend tax credit is not available while the dividend income will eventually be taxed upon withdrawal.
Reality: The tax credit is irrelevant and there is actually no tax payable on dividends, or for that matter on any other income capital gains or interest, generated by the RRSP contribution funds. RetailInvestor.org's Nitty Gritty of the RRSP Model brilliantly decomposes the true economic reality from the illusion - see especially the section on What does the tax on withdrawal do?

Myth: When investments must be split between registered and unregistered accounts, since the tax rate on dividends is lowest, it is best to hold dividend securities in a taxable account while interest securities should go in a registered account.
Reality: RetailInvestor.org again debunks this myth on the same webpage in the section Maximize the tax-free income by showing that it is not only the tax rate that matters. What really matters is the overall amount of tax liability from multiplying the tax rate times the investment's return. The best account to hold each type of investment also depends on your province. As the example table below shows, in Ontario and Nova Scotia, an investor buying Bank of Montreal stock that currently pays a 5.08% dividend with an expected capital gain of 2% would be better in a RRSP than a Government of Canada 10-year bond with a 2.75% coupon. In Alberta it's better the other way round with the bond best placed in the RRSP per the traditional advice. The bond, if purchased today, will be bought at a premium - CanadianFixedIncome.ca shows the bond's price (as of writing date) to be 108.20 per 100 face maturity value. If the bond is held to maturity, there will be a capital loss of 8.20 that can offset capital gains in a taxable account, thus accentuating the current tax advantage for the taxable account.

Evidently, there is no one size fits all best strategy for all investments, market conditions and provinces. To figure it out for your own situation, do the same comparison we have done with your marginal tax rates for dividends and for interest in your province.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 24 May 2012

Purple Chips - Yet Another Angle to Finding Good Stocks

We've spent the last several posts looking for solid equity stocks amongst those with low volatility compared to the overall market. Now along comes another approach called Purple Chips to give us another perspective. Interestingly there is a considerable overlap of the conclusions.

Purple Chips is the name created by investment advisor John Schwinghamer to describe the cream of the crop of blue chip stocks. His criteria for inclusion is quite stringent: a minimum of seven years of smooth, predictable, positive and rising earnings per share. To ensure stability - he likens to the difference between an ocean liner and a small boat - he further restricts stocks to large companies, those with a market cap of shares outstanding of at least $1 billion. Schwinghamer explains his method in detail in his recently published book with the title, what else could it be, Purple Chips.

In addition to identifying the solid performers, he has developed a simple method for determining whether the stock price at any given time is cheap or expensive. Based on the relationship between Earnings per Share (EPS) and stock price, the method adjusts for changing market conditions from bull markets, when the market is willing to pay more for each dollar of earnings, to bear markets, such as nowadays, when the market sees risk everywhere and isn't willing to pay much for earnings. Conveniently for those investors who just want to see the results, he has created the purplechips.com website where the US and Canadian Purple Chip stocks are listed along with the current under- (stocks to buy) or over-valued (stocks to sell) price assessments. The website lists 41 Canadian and 233 US Purple Chips. Let's see how his Canadian list compares with the low volatility stocks we've recently examined.

Lots of overlap between Purple Chips and Low Volatility Stocks
More than half - 26 of 49 - the stocks in one or the other of the two low volatility Canadian equity ETFs (PowerShares S&P/TSX Composite Low Volatility Index ETF (TSX: TLV) and BMO Low Volatility Canadian Equity ETF (TSX: ZLB) we posted about here show up in Schwinghamer's Purple Chips list too. It's gratifying and reassuring to find that stocks with a relatively stable market price should also be steadily profitable.The table below shows which holdings of TLV and ZLB overlap with the Purple Chips, along with the indicator as to whether each stock is currently over- or under-priced (cells bordered by either red for over-valued or green for under-valued).

Less convergence on which ones are Under-Valued Buy Stocks
Of our Top 10 Picks in last week's post, only two stocks are rated a Buy, and a weak Buy at that, on the Purple Chips website - Metro Inc (TSX: MRU) and Rogers Communications (TSX: RCI.B). Two of our Top 10 are rated the opposite as slightly over-valued by Purple Chips - Shoppers Drug Mart (TSX: SC) and Astral Media (TSX: ACM.A). The rest are in the middle, more or less fairly valued.

The disagreement on value is a good reminder that all our assessment methods are based on past data. The future may not be like the past so our seemingly sure stock picks may not work out as well as we hope. Schwinghamer warns us too that his method works on average over a large number of stocks and with a rigorous buy-sell discipline maintained over years through all sorts of market conditions. With each individual stock the investor has a good chance of making money but not a certainty.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 11 May 2012

Top 10 Picks Amongst Low Volatility Stocks

Last week we ended our review of low volatility stocks with the comment that further drilling into their fundamentals would give more confidence about their investment merit. That's what we will do this week.

What we hope to find is stability and safety based on:
  • earnings consistency, or even better, earnings growth with high return on the investor's equity
  • dividend growth or at least maintaining pace with about 3% annual inflation and certainly avoiding dividend cuts
  • manageable debt levels within or below norms for an industry sector
  • reasonable stock valuation levels of the current market price relative to the overall market TSX (which now has an average Price per share to Earnings per share ratio of about 14.9 per this TMX Money page), and compared to the industry sector average
The Ten Best Stocks
Our detailed comparison table below shows the figures we used to arrive at our choices. Blog readers may wish to expand on our choices or make their own alternate selections. In our table green cells contain good numbers while the red cells contain the bad and the white cell numbers are acceptable.

We've made some effort to spread our choices out amongst different sectors though there are no top picks in three sectors: utilities and pipelines, because those stocks appear not to be good bargains with P/Es over the TSX average and; financial services, because most have had declining earnings.

  • Metro Inc (TSX symbol: MRU) - The grocery retailer has presented a steady diet of fine results to investors and there seem to be no signs of that ending.
  • Shoppers Drug Mart (TSX: SC) - The drug retailer's growth may be slowing (per the latest quarterly report) but slow and steady progress is a lot better than other stock performances these days.
  • RioCan Real Estate Investment (TSX: REI.UN) - The largest of the REITs, it runs shopping centers. You know where your money is invested and you can feel good about going shopping at a facility you partly own.
  • First Capital Realty (TSX: FCR) - This is another shopping center developer and operator that has been consistently delivering solid results.
  • Bank of Nova Scotia (TSX: BNS) - The Canadian banks all make money but this one has slightly better numbers.
  • National Bank of Canada (TSX: NA) - Maybe it is less noticed by investors in the shadow of its bigger rivals but National has the best numbers of the lot.
  • CGI Group (TSX: GIB.A) - The information technology and business process service provider has not yet ever paid dividends but it has provided consistent, strong and growing profits as this TMX Money page shows.
  • Rogers Communications (TSX: RCI.B) - The cable and wireless service company also has done consistently and brilliantly well for investors. One analyst is predicting a slowdown in profit growth according to this GlobeInvestor article.
  • Astral Media (TSX: ACM.A) - Astral provides pay and pay-per-view tv and radio broadcasting. Financial results are very solid.
  • Canadian National Railway (TSX: CNR) - There is a lot of machination going on at CP and perhaps a revival of the company in the offing but investors can simply buy shares in the railway that is already well run. For all its well known success, CN still seems a fairly priced stock at the moment.
Even with all this data gathering, we cannot be 100% sure that all these stocks will continue to perform well. As ever, the future may not be like the past. However doing such investigation improves the odds in our favour.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 4 May 2012

Low Volatility Safe(r) Canadian ETFs and Stocks

Recently we posted about a relatively new flavour of ETF - Low Volatility ETFs - that offer a credible promise of generating both safety and decent returns. In the short time since the post, another Canadian entrant from Invesco, the PowerShares S&P/TSX Composite Low Volatility Index ETF (TSX: TLV), was launched in late April, in competition with the BMO Low Volatility Canadian Equity ETF (TSX: ZLB). 

For investors interested in buying individual stocks, these ETFs' holdings might provide some good buying leads. We can look inside the ETFs to see what stocks are there (by clicking on the Holdings tab in the above provider websites to get an up to date list).

The safety and return promise sure looks good in the short time since the October 2011 launch of ZLB, as we see at a glance in the Google Finance chart below of ZLB's performance compared to the TSX.
In addition, we'll double check against these other lists of promising stocks to see what overlaps and repeats there might be:
The more often a stock shows up, the better. Finally, we'll check some common financial ratios to see whether each stock's price looks attractive at current prices.

46 Stocks show up in multiple lists
Whether stability is measured by beta, as ZLB does, or by simple volatility of each stock's market price, as TLV does, the results overlap extensively. More than half the stocks appear in both ETFs, as shown by the green highlighted cells in the detailed table below. When we add other stocks from the promising stocks lists, many stocks show up multiple times. Red text shows TLV stocks that are repeated, while blue text shows ZLB repeats. That's a very encouraging result - coming at these stocks from different angles at different times produces a consistent thumbs up.

As an aside, we also checked against previous posts on companies with overpaid top 100 CEOs, where no overlaps appeared as we would hope and expect; food companies, where one (Saputo) of our four highly rated companies appeared; beer/wine/spirits companies, where none of the six Canadian companies overlapped as we again would hope and expect since we liked none of them, dividend initiators, where none of the three Canadian companies showed up again.

Which stocks exhibit attractive price and other financial ratios?
We then entered all the stock symbols for the 46 companies into GlobeInvestor's My Watchlist, a very handy free tool that will display lots of useful financial numbers in customizable or pre-set display formats. The image capture below shows the candidate stocks arranged in ascending order of the most popular value test, the Price-to-Earnings per share ratio. Many of the stocks look reasonably priced, with P/E well below the TSX 60 Index large cap average of 14.7 (from this TMX page). Many also sport low Price-to-Book ratios, another measure of value.

The evaluation above is not complete, as we would want to look at the level and consistency of profitability, the amount and sustainability of debt and above all, we would want to ask whether there are factors such as new competition threatening the future stability and success of the company. But our digging into the list of low volatility companies shows us some worthwhile possibilities to consider. Or, the investor can simply buy one of the two ETFs on offer to cover all bets and get instant diversification.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Disclosure: This blogger owns shares in several of the companies discussed in the above post.