Dividend Investing By Sector

They say every investor should have a diversified portfolio.

They’re right, of course. But it’s not quite that simple.

First of all, I firmly believe that if you don’t like a sector, or an asset class, or even an individual company, then avoid it. It might feel like your boycott is 14 different kinds of useless, but that doesn’t mean you should abandon your principles.

For instance, I’ve chatted with numerous investors over the years who refuse to put their cash into companies that they think are unethical. Goeasy gives high-interest loans to people with poor credit, a practice some people think is abhorrent. Others might have an issue with alcohol or cigarette companies, especially if they have someone close to them who are hooked on those addictive habits. So they avoid those companies.

Your author is no fan of the entire crypto world, and if I were in charge the first thing I would do is ban it. I believe crypto has no utility, no underlying value, and tolerates way too much bad behaviour. The oldest crypto coins are ~15 years old by now, and they still have no utility other than fanatics trading them amongst themselves. Scams are everywhere, and the orchestrators of these schemes are preying on the most vulnerable members of our society.

Anyway, rant over. Needless to say I avoid that part of the market with extreme prejudice.

The point is that investing is a personal journey, and there’s no need to own something that doesn’t mesh well with your moral code. There are a million ways to get wealthy, and if you want to avoid something that you don’t like, feel free. Knock yourself out.

Today’s edition of the newsletter will take this logic to the next level. I believe dividend investors can easily strike entire sectors off our listIf we’re after dividend growth over time, some sectors will deliver while others won’t. It’s nothing against those sectors, but they just don’t check off our boxes. The best bet is to avoid them, or at least be careful when looking at companies that may offer an exception to the rule.

Let’s take a closer look at each sector in general, sorting each one by how welcoming it is for dividend investors.

The red light list

Let’s get the bad stuff out of the way first. Here are sectors I’d largely avoid if you’re looking for steadily increasing dividend income.  

Energy

Dividends come from cash flow, and an ever-increasing dividend comes from growing cash flow. Most every company will have a hiccup every now and again, but for the most part we’re looking for names that can grow earnings.

The average energy producer needs help growing earnings. Without the commodity price cooperating, it’s very hard for an oil and gas company to grow the bottom line. On the other hand, when the commodity price does cooperate, watch out. These guys can explode on the upside.

That’s not such a bad outcome for a trader, but it’s not an ideal situation for a buy-and-hold dividend investor.

Related: How I Buy Oil Stocks

When the commodity price doesn’t cooperate — like in the mid 2010s — dividends get cut. A very affordable dividend at $100 oil is toast at $50 oil. And since energy companies have no control over pricing, they’re stuck.

Put it all together, and it isn’t a great recipe for dividends.

Exceptions: Oil producers that have downstream assets (those deliver much more dependable cash flow) and oil sands producers. So Imperial Oil, Suncor, and Canadian Natural Resources. Still, as Suncor’s dividend cut in 2020 illustrates, even the exception in this case may not be such a great dividend investment.

Materials

Much like the energy sector, the materials sector suffers from a lack of pricing power. Nobody really cares if their gold comes from North America, Africa, or outer space.

There’s also a somewhat anti-dividend mentality in the materials space. Most execs remember a time when the sector was deeply out of favour and they struggled to get the next mine funded. So they hoard their cash, always looking towards the next project.

That might be good for mining company managers, but it’s not great for investors. If they want to collect some cash flow from the underlying mine — which investors own! — they have to sell their shares. Sometimes dividends exist, but they’re usually paltry.

Related: How I Buy Gold Stocks

Exceptions: There are a few miners out there that specialize in long-term projects and don’t always need to conserve cash for the next one. They’re happy to share their profits with shareholders. Examples include Rio Tinto or Labrador Iron Ore. However, don’t expect dividend growth. The payouts will be reduced when commodity prices weaken.

Exception the second: Precious metal streamers like Franco Nevada and Wheaton Precious Metals are solid dividend growers, plus they minimize your exposure to the commodity.

The yellow light list

These are sectors that can deliver solid dividends/dividend growth, but companies that do so are the exception, not the rule. They can be excellent hunting grounds for dividend value investors when the entire sector is bombed out.

Consumer discretionary

There are two groups of consumer discretionary stocks. One group is fertile dividend hunting ground. These are stocks that have been in business for decades and have a business model that can withstand recessions. They also tend to have growth potential, some pricing power, and relatively stable earnings.

There are a ton of examples here, so I’ll highlight one of the more unique names in the consumer discretionary sector. Service Corp is North America’s largest death care company, and it’s a name I’ve had my eye on for a long time. Sometimes, like in 2021, more people die than expected. Other years fewer die than expected. So there’s a bit of a cyclical nature to the stock. It has an excellent record of increasing its dividend — every year since 2006 — and is a consistent repurchaser of its own shares.

The other group should largely be ignored by dividend investors. These are companies that are either more interested in growth than dividends (like Chipotle, Lululemon, or Artizia) or companies with large swings in profits depending on the economy (like auto companies). Wildly fluctuating profits are not what dividend investors should be looking for, and should therefore be avoided.

Technology

Technology is another sector that can have massively different dividend attitudes on a company-by-company basis.

Upstart technology companies will almost never pay a dividend, and that’s okay. They’re happy to invest their cash flow towards earnings growth, which is a logical choice. I’m happy to avoid these and wait until they become more mature.

Then there are the mature tech companies that are acting like they’re still young and sexy. Rather than getting Botox, plastic surgery, or a convertible — like humans do when having a mid-life crisis — these companies will embrace their youth by refusing to pay out dividends. This stance is taken despite the company easily earning enough cash to fund all of its expansion plans and repurchase enough shares to offset the impact of share-based compensation.

These companies have the potential to be solid dividend growers once they decide dividends are a priority, but until then I’m happy to avoid them. Examples today are Adobe, Airbnb, and Salesforce.

Finally, we have the mature tech companies that still offer growth potential but are also paying out some of their earnings as dividends. This is a fertile hunting ground for dividend investors, and these companies are sometimes available for surprisingly good prices. Examples would include Enghouse Systems, Open Text, and Accenture.

The green light list

Dividend portfolios will naturally focus on these sectors, since they offer so much of what dividend investors are looking for. We like stable cash flow, strong operating history, solid balance sheets, and companies that just aren’t very exciting. The majority of my portfolio is invested in these sectors, and usually when I discover a new stock it’s usually in one of these sectors.

Financials

While the financial sector is somewhat volatile, it’s still a fertile hunting ground for both dividends and solid total returns. Especially in Canada where we have near monopolies that dominate the banking and life insurance sectors.

I’m also a big fan of niche financial stocks. These can deliver impressive returns while operating on the periphery. Some examples of these types of stocks include H&R Block, Propel Holdings, or Element Fleet Management.

Depending on how much income you might be looking for, certain financial stocks with small yield (but nice potential dividend growth) might be off your list. But that’s the exception, not the rule.

Consumer staples

Virtually every consumer staple stock on the planet pays a generous dividend, with many of them offering enviable dividend growth streaks, too.

It’s just the nature of the business. These companies tend to be mature with operations that have often been honed after decades of practice. Coca-Cola is approximately 150 years old. Rogers Sugar was established in 1890. Campbell’s invented condensed soup in 1897. And so on.

These companies will sometimes rise and fall with the economy, like the big food companies have done in the past few years. COVID was a great time for staples, with so many people being forced to avoid restaurants. Now growth has slowed and investors don’t love the space anymore. Still, these companies are solidly profitable, and dividend cuts are rare. It’s a good hunting ground, especially for those of us who enjoy a good value stock.

Industrials

Like consumer staples, most industrials are pretty steady businesses. The economy continues to chug along and widgets are still produced. Many industrials have some pricing power, and will pass on cost increases to customers. Many have also been at it for decades.

There are some areas which have more exposure to the whims of the economy — I’m looking at you, transportation — but for the most part these are fairly steady businesses. That makes them ideal for dividend investors.

Examples with excellent dividend growth histories include CN or CP Rail, Huntington Ingalls, or Toromont.

Healthcare

While there are examples of sexy healthcare startups that are looking to land the next big drug or treatment option, it’s easy for dividend investors to avoid them. They don’t pay dividends, have no earnings, and are often purchased by larger players (for a reasonable multiple) once they hit.

Meanwhile, mature healthcare companies have long been excellent choices for dividend investors. They tend to offer decent yields, yet they keep enough cash flow to fund the next generation of treatments. Plus, these stocks are often on sale when the short-term looks bleak. This can be a great buying opportunity.

Many healthcare names are cheap today, and I think it’s a fertile hunting ground. Some names I have my eye on include Sanofi, Pfizer, and Novo Nordisk.

Utilities

There’s a reason why so many utilities are dividend growth standouts. They offer many qualities dividend investors are looking for, including monopoly-type businesses, predictable cash flows, government protection, and managers who realize just how important dividends are to shareholders.

Utility shares are also quite boring. They tend to fall less than most other stocks when everybody is freaking out, a quality that endears them to retirees and other risk-adverse investors.

A utility doesn’t have to be a company like Fortis or Capital Power, either. It can also include TC Energy and Enbridge, companies that still make a large portion of profits transporting oil and natural gas around. That’s why I didn’t include those names in the energy section above, since they have very little exposure to underlying commodity prices.

Real estate

Real estate is a wonderful place to look for dividends. Real estate has been valued as an investment for centuries because it’s easy to understand, it spins off loads of cash flow, is highly predictable, and is relatively hands off. Dividend investors can easily get ample income from REITs, which represent real estate ownership with zero work.

Related: Why REITs are Better Than Physical Houses

REITs haven’t delivered a lot of capital appreciation — at least lately — but investors should be able to count on the value of both the land and buildings to increase slowly over time. This will inevitably translate into higher rents, which eventually trickles down to the bottom line.

The best REITs are those that hike their distribution on a regular basis. In Canada those include Granite REIT, CT REIT, and Primaris REIT, to name a few.

The bottom line

This philosophy has done me well over the years. Instead of scouring the energy market or a list of gold miners to see whether high dividends are sustainable, I largely avoid these sectors completely. That frees up my time and mental bandwidth to focus on sectors that have the qualities I’m looking for.

In short, I’m shrinking my investment universe, which is an underrated way to make this whole exercise easier.

Just because an asset class is conducive to dividends doesn’t necessarily make the entire sector a buy today, either. Canadian banks have a fantastic history of dividend growth, but I’m not about to buy bank stocks at a 52-week high. Same with utilities, life insurers, or anything else. Consumer staples, certain REITs, and healthcare stocks are cheap, and so those areas are more interesting.

Buying unloved assets in the right sectors can really supercharge your dividend income, plus it can help deliver market-beating total returns, too. That’s a really nice combination.