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Beginners Guide to Portfolio Planning for Income pt. III

By ADMIN - October 5 2022

Commentary and Opinion By Henry G. J. G. Godzik

Henry taught in the TDSB Learn4Life Dividend investing for Income and Building Wealth the Dividend Way programs. You can find part 1 of this article in the Spring issue 2022 and part 2 in the Summer issue.

Robo-advisors

Robo-advisors which are online investment platforms, are also available to investors through various brokerage firms offering a variety of diversified ETF portfolios designed according to the investors appetite for risk. Robo-advisors rely on the use of computer algorithms when allocating and constructing the portfolio assets and remove the emotional component from the equation. There are some robo-advisors that offer investment options including rebalancing and tax – loss selling strategies. Some accounts are completely automated and are accessible via mobile phones and web applications while others offer some limited human interaction. Compared to financial advisors, robo-advisors are a lower cost alternative and many of them only require a minimal capital investment. A disadvantage of robo-advisors is the lack of investment expertise, human contact and subjectivity that is offered when using a financial advisor. For those investors that are comfortable with this form of investment technology, a robo-advisor account could be a welcome decision making assistant when beginning the portfolio construction phase. 

Important Dates

When deciding to purchase dividend paying stocks, , there are specific dates that dividend investors should be aware of when considering buying these securities. Keeping tabs on these dates is critical to ensure that dividends that are owed to shareholders are paid as agreed. The first date is the DECLARATION DATE which is the date that the company’s Board of Directors declares and announces the next dividend payment in a declaration statement that includes the amount of the dividend, the record date and payment date to shareholders of record. The RECORD DATE is the date that shareholders that have properly registered their share ownership on or before this date will receive the next scheduled dividend payment. Probably, the most important date is the EX -DIVIDEND DATE which is the date that all shares bought and sold no longer have the right to be paid the most recently declared dividend. Investors must own the stock before the ex – dividend date. 

A basic reference guide regarding the buying / selling of stocks as it relates to the ex – dividend date are Selling B 4 ex – dividend date; No Dividend 

Selling on ex dividend date ; Yes Dividend

Selling after ex – dividend date ; Yes Dividend

Buy B-4 ex – dividend date; Yes Dividend

Buy on ex – dividend date; No Dividend

But after ex – dividend date; No Dividend. 

Finally, there is the PAYMENT DATE which is the date that the dividends are actually paid to the qualifying shareholders. Make a point to have a clear understanding of how these dates will affect your future stock buying and selling decisions. 

Investors intent on looking for other ways to diversify their portfolios need look no further than to explore the potential benefits of investing in Emerging Markets.

Emerging Markets

Emerging Markets are various economies throughout the world that are experiencing rapid economic growth, and although this aspect is encouraging, it’s important for them to continue to strive towards their full market potential. The MSCI Emerging market Index represents 27 countries which are at various stages of economic growth. Investing in emerging markets allows broader exposure to different economies and geographies that in many instances, have no commonality between them. Emerging markets offer the investor the opportunity to invest in the pace of the countries expanding growth which is driven, for example, by the growing middle class. This new group of consumers is the driving force behind the economies expansion. 

Emerging markets account for approximately 60 percent of global population and approaching almost 50 percent of global gross domestic product GDP. Research is showing that emerging market stocks are trading at the deepest discount to developed market equities in 17 years. Although they represent about 12 percent of global stock market capitalization, the emerging market populations are massively underrepresented in relation to market cap and their contribution to the global economy which based on recent data is about 36 percent. Another way that an investor can participate in foreign investment opportunities is through a Canadian or USA company with international subsidiaries and foreign outlets. These companies also hire local managers who are familiar with the customs, culture, language and trade rules and regulations of that specific region. 

However, emerging markets are not without their risks and should an investor decide to invest, to make sure to conduct a thorough analysis before doing so. Transparency risk is associated with the inability or difficulty of securing official documentation as it relates to a company’s financial records. Investors may find that attempting to conduct a thorough analysis on a company proves challenging because reliable data may be difficult to uncover. This could be partially due to lax domestic regulatory public reporting requirements.

Political risk can also prove to be detrimental for investors in an emerging – market economy. Unstable, precarious leadership could lead to major economic consequences and pose a threat to expected returns for the shareholders. Poor government policies can compromise the reputation of companies to the point that prospective investors lose faith and seek opportunities elsewhere. Currency risk is another critical issue when dealing with domestic securities and emerging markets. Fiscal and monetary mismanagement can result in currency weakness, low demand for exported goods and rising interest rates resulting in the emerging markets inability to service its debt financed growth. Dealing with foreign stock can be a more daunting task since information is not always readily available. Data on dividends and earnings could become vulnerable to unforeseen changes. However, a recent report issued by Morgan Stanley analysts suggest that the time may be approaching soon to get more bullish on Emerging Market securities. 

Dividend investors can also participate in the emerging market environment by purchasing American Depositary Receipts (ADR’s), which are certificates issued by a US depositary bank representing shares of a foreign company’s stock. These ADR certificates enable investors an opportunity purchase stocks in other countries that would not otherwise be available to them. ADRs are an easier way to participate in foreign company ownership. Foreign company ADRs are listed on the N.Y. Stock Exchange and are denominated in US dollars to assist in avoiding fluctuations in currency rates. Depending on which category level the ADR is classified in (Level 1-2-3), the US depositary bank requires detailed financial disclosure, thus allowing investors easier access in order to determine a company’s financial health. Although ADRs are a good way for investors to gain exposure to foreign markets and diversify their portfolios internationally, as with any other security, ADR’s come with their own set of risks, including issues with “ double taxation” both locally and abroad. Unsponsored ADRs (Level 1) need not comply with all the rules and regulations set forth by the Securities Exchange Commission (SEC) resulting in a highly speculative ADR which pose a greater risk for potential investors. Currency conversion fees are another investor’s concern and are established to directly link the foreign security with the one trading on the domestic market. As previously stated, political risk can affect all aspects of emerging market investing and that includes ADRs as well. Political leaders may not be as responsive to foreign ownership of their company stock, creating an unpleasant investment environment unsuitable for further investor interest. With all this being said, there will still be foreign companies that will welcome the opportunity to list their stock on US exchanges enabling them greater exposure to international markets and a broader range of investors. As a result, financial analysts would be more inclined to add their perspective and cover these stocks in more detail. Tax advisors who are familiar with ADR investment and taxation should be consulted when considering adding an ADR to a registered and/or non-registered account. 

Canada has its own version of the ADR known as the Canadian Depositary Receipts (CDR) which were launched by CIBC last July 2021. These receipts trade on Toronto’s NEO exchange in Canadian dollars and allow small retail investors the opportunity to purchase US shares at a fraction of the price of shares that are listed on the N.Y. and NASDAQ exchanges. Examples include Apple, Amazon, J.P. Morgan, Walt Disney Co. to name a few. Presently, there are 23 (and counting) CDRs available to trade and their lower price has appeal to small investors allowing them to test their exposure to these companies by making small incremental purchases. At this time, they differ from the US ADRs by only issuing US CDRs. Owning a CDR has the same tax effect as if the investor held the underlying security directly and foreign withholding taxes may apply by the foreign government where the CDR company is located. CDR dividends that are scheduled to be paid will be in Canadian dollars subject to current foreign exchange rates. Another important item to consider when purchasing CDRs is the liquidity issue. CDRs issue fractional shares and unless the underlying security experiences high trading volumes, the investor might find some difficulty in selling the shares if cash is needed. Since the investor is only purchasing fractional shares, their dividend entitlement will only be a percentage of what a full share dividend would normally pay. As with ADRs, CDR holders must file a W-8BEN tax document stating that the holder of the securities and subsequent income received is not a resident of the USA and as a result of the Income Tax treaty, the investor is subject to a lower withholding tax rate of 15%. Besides ADRs and CDRs, International ETFs can also contribute to a well diversified portfolio by not being fully correlated to Canadian and USA markets, thus decreasing portfolio risk and volatility and allowing exposure to the economic growth of other countries. However, like other investments, ETF purchases depends on the investor’s tolerance for risk and close attention needs to be paid to these ETFs since each country can experience rapid changes to their economy, currency and debt issues and political uncertainties which can adversely affect the overall performance of the portfolio. 

Tax Treatment

From a taxation perspective, dividend investors purchase these dividend paying securities for the favourable tax treatment they receive when filing their annual tax return.

As dividend investors, addressing the issues related to the taxation of the portfolio and what accounts are best suited for specific securities is crucial, however; don’t base the investment decision solely on the tax implications that might arise. A properly designed portfolio will have addressed the issues of the tax impact of income producing securities and growth stock. Investors should have some understanding as to the tax implications and consequences of also placing stocks in accounts that may not be the best choice from a tax perspective. If unsure, seek the professional guidance of a tax specialist who understands portfolio tax management.

Tax risk, is the risk that the after tax return of an investment will fall short of the results needed to preserve spending power after inflation. Inflation has been a hot topic of discussion over the last year with governments and corporations trying to tackle the most efficient way of curbing the growth of inflation without disrupting the economy’s recovery from the pandemic. Although there have been a few small references to inflation issues made throughout this article, it’s a complex subject with many variables to consider and technically beyond the scope of this article.

Dividend investors that own shares of “eligible and non-eligible “ Canadian publicly traded companies are able to apply for the Dividend Tax Credit. The reason is because dividends are paid with “after-tax earnings and companies have already paid tax on these dividends. So in order to avoid double taxation, the Dividend tax credit offers relief to investors from this issue. Eligible and non-eligible dividends qualify for this credit, but dividends paid from foreign companies are not eligible. Corporations that are designated as issuers of eligible dividends, pay higher taxes, thus enabling the investor to “ inflate” their dividend based on federal and provincial percentages known as the ‘Gross-Up” which currently is 38%. Non-eligible dividends are taxed at a lower rate therefore, their Gross-Up is only 15% The investor pays a gross-up on the dividends received to return the dividend back to it’s pre-tax income since the corporation has already paid tax on it.

Because an investor has to pay taxes on the grossed – up amount of dividends, the Federal tax credit was designed to reduce the amount of taxes paid on these dividends, therefore; investors can claim this credit which is applied against the tax owed on the grossed-up dividends. 

If your portfolio holds U.S. stocks in a non-registered taxable account, there are U.S. withholding taxes that apply to any dividends earned. The default withholding tax on U.S. dividends is 30%. The Canada Revenue Agency ( CRA) will let you claim half of this withholding tax on your tax return, or 15%. This % is the amount agreed upon through the Canada U.S. Tax Treaty. This treaty allows Canadian investors to file the form W-8BEN, which declares their Canadian residency and their eligibility for the lower 15% tax rate on U.S. dividends. Up to 15% of the U.S. tax you pay on dividends can be claimed on your tax return as a foreign tax credit to offset any double taxation. Also note that foreign dividends are fully taxed at the investors marginal tax rate.

Dividends paid on U.S. stocks held in an RRSP are tax-free. RRSP’s are viewed by the Internal Revenue Service (IRS) in the U.S. as an account meant to provide tax-deferred pension or retirement benefits. On the other hand, Tax-Free Savings Accounts (TFSA’s) DO NOT fit this description and U.S. dividends earned within a TFSA are subject to withholding tax. Since TFSA earnings aren’t taxable when filing a tax return, the withholding tax cannot be claimed as a foreign tax credit and this part of the investment is “ lost”, however; it might be better to hold U.S. dividend payers in a TFSA rather than a non-registered account, reason being, although you loose the withholding tax, the remaining dividends and all capital gains will be tax-free. Dividend stocks that have increased in value and have produced capital gains are only taxed when the gain is “ realized”, in other words, when the investment is sold. Interest and dividend income that is held in a non – registered account is taxable in the year that it is earned.

Throughout the article, I have emphasized the importance of seeking financial advice when in doubt, but choosing the “ right” financial consultant is also a challenging task. Don’t rush, take your time and interview prospective consultants to find the right fit, see if your personalities are complimentary as opposed to conflicting. During the initial meeting, did the consultant listen to your goals and concerns and did they propose realistic and attainable solutions to meet your specific needs.? Did they establish a time schedule and allocate enough time to review and rebalance the portfolio as required.? Were they completely transparent with the fee schedule so there will be no “extra fee” surprises?

Once the investor has established a working relationship with the chosen consultant, they should ask themselves whether the consultant provided up to date and timely advise that has helped to add value to the growth of the portfolio. If not, schedule a meeting to determine the reasons why and discuss designing a corrective strategic plan to address these concerns.

The D.I.M.S. dividend portfolio strategy references the following four words and their importance for investors to take notice. Discipline, is a key attribute of all successful investors by having a detailed plan in effect and following it. Dedication; taking the time needed to thoroughly review the plan every 4-6 months( or when circumstances change) and to devote time to the investing process. Desire; to be financially independent and secure because of the benefits associated with astute investment planning and Determination; to be a successful investor despite market turbulence and to seek accurate, up to date information while avoiding much of the investment “ noise” before purchasing the stock. At the beginning of this article, I had stated that there are areas of investing that were not addressed. Not because they lack importance, just that the material covered was a personal choice and decision. Perhaps in the future, those areas can be addressed as well. 

Dividend Financial Advice

Dividend growth investing, if executed correctly, has the potential for long term growth and producing income. As a shareholder, owning stock of some of the best dividend companies available, and being paid to own them offers a sense of satisfaction of an investment job well done. Watching as the compounding dividends increase the portfolios value is a great feeling, after all, passive income has been and continues to be the ultimate goal. 

For Your Reading Pleasure , Consider The Following References: 

  1. Kelley Wright, Dividends Still Don’t Lie – Truth About Investing;
    John Wiley & Sons Inc.
  2. Geraldine Weiss & Gregory Weiss , The Dividend Connection – How Dividends Create Value, Dearborn Financial Publishing Inc.
  3. Marc Lichtenfeld, Get Rich With Dividends- A Proven System For Earning, John Wiley And Sons Inc.
  4. Joseph Tigue, Joseph Lisanti, The Dividend Rich Investor- Building Wealth With High Quality, Mcgraw Hill.
  5. Joseph Tigue, Standard And Poors Guide To Building Wealth With Dividend Stocks, Mcgraw Hill.
  6. David And Tdm Gardner , The Motley Fool Investment Guide
    Simon And Schuster
  7. Lawrence Carrel. Dividend Stocks For Dummies,
    Wiley Publishing Inc.
  8. Don Schreiber Jr., Gary E, Stroik, All About Dividend Investing
    Wiley Publishing Inc.
  9. Lowell Miller, Creating Wealth With Dividend Growth,
    Publishers Group
  10. Michael C. Thonsett, Getting Started In Stock Investing And Trading
    Wiley Publisher Inc.
  11. Michael Sincere, All About Market Indicators,Mcgraw Hill
  12. Michael Sincere, Understanding Stocks, Mcgraw Hill. 

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