Special Report: The Merits of Dividend Investing

November 10, 2011 Portfolio Advice & Investment Research

Report Prepared by: Ryan Lewenza, CFA, CMT V.P., U.S. Equity Strategist Martha Hill, CFA V.P., Canadian Equity Strategist

Highlights:

In this report we dig into the merits of investing in dividend paying stocks by examining the positive return and risk attributes associated with dividend payers, as well as providing a list of some of our preferred U.S. and Canadian dividend paying equities. Given our expectations for lower rates of return over the next few years, dividend paying equities could outperform with dividends likely to play a more important role in future total returns. As anecdotal evidence of this, we note that dividend payers within the S&P 500 Index (S&P 500) have outperformed non dividend payers by 5.50%, year-to-date. Looking at Canada (S&P/TSX Composite Index), the returns from dividend payers are even greater, outperforming non-dividend paying stocks by roughly 12%. Looking longer term, if a U.S. investor invested $100,000 in the S&P 500 in 1988 they would have roughly $527,974 today. That equates to a compound annual growth rate (CAGR) of 7.50%. However, if you include dividends over this period, an investor would have over $900,000, which equates to roughly a 10% CAGR. Similarly, Canadian investors who invested $100,000 in 1988 would have over $700,000 including dividends (8.9% CAGR) versus $397,000 (6.20% CAGR) if only looking at price return. When investing we also need to consider risk. On this front dividend paying stocks are generally lower risk stocks relative to non-dividend payers. We have found that the highest yielding stocks within the S&P 500 (4% and above) have the lowest betas (0.84 on average), which means they move less than the overall market. Conversely, stocks that do not pay a dividend or have a low dividend yield of less than 1% have higher betas than the market, at 1.23 and 1.31, respectively. Overall, our analysis shows that dividend paying stocks can enhance total returns for investors, with potentially lower risk.

This document is for distribution to Canadian clients only. Please refer to Appendix A for important disclosures.

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Special Report: The Merits of Dividend Investing

November 10, 2011 Portfolio Advice & Investment Research

Everything Old is New Again

As we will examine in greater detail in the following pages, dividends have historically accounted for roughly 40% of total returns for equities. However, dividends fell out of favour among many investors during the last bull cycle of the 1980s and 1990s, as U.S. equities returned consistent double digit price gains over that period. Low single digit dividend yields were largely inconsequential relative to the price returns delivered over this period. But as the saying goes everything old is new again and investors are once again recognizing the importance of dividends given historically low interest rates, the weak price returns over the last decade, and the increased volatility in the equity markets. In this report we dig into the merits of investing in dividend paying stocks by examining the positive return and risk attributes associated with dividend payers, as well as providing a list of some of our preferred U.S. and Canadian dividend paying equities. Exhibit 1: Record Low Interest Rates Are Pushing Investors Up On the Risk Curve to Dividend Payers
%

Government Bond Yields

With interest rates at near-record lows, investors are in search of yield.

% 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00

8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11
US 10-year Gov't Bond Yield CAD 10-year Gov't Bond Yield Source: Bloomberg Finance L.P. As of November 2, 2011

S&P 500 Dividend Yield

As the S&P 500 price level has declined since 2000, and dividends have been rising, the dividend yield has slowly increased over this period.

0.50 0.00 '96

Source: Baseline. As of November 4, 2011

'98

'00

'02

'04

'06

'08

'10

Market Outlook Before we examine the positive attributes of dividend payers, it is important to understand our longer term outlook, and how dividends play into this view. Our long-held view has been for a muddle through recovery, defined by short-term growth spurts followed by periods of deceleration, but with an overall below-trend growth outlook. As seen in Exhibit 2, U.S. nominal GDP growth has slowed consistently since the 1970s, and we expect this trend to continue over the next decade. Central to this thesis is continued global deleveraging, which we expect to persist in the years ahead. Its our view that the strong growth experienced in the 1980s and 1990s was in part driven by the massive debt accumulation in the U.S. and in many developed nations. Now its time to pay the piper. We expect individuals to slowly reduce their debt levels, while many governments are likely to follow with austerity measures becoming more pronounced in the years ahead. All of this could constrain equity valuations, which in turn, could result in a range-bound market over the next few years. Yes, we will see large cyclical swings in the market, up and down, but overall we see the equity markets trading largely range-bound, making alternative strategies (i.e., dividends, options, sector rotation) more important. Exhibit 2: Our Expectation for Below-Trend Economic Growth Could Result In a Range-Bound Market
12% 10% 8%
6.68% 7.93% 6.89%

U.S. Average Nominal GDP Growth By Decade

Source: Bloomberg Finance. PAIR. As of November 6, 2011 10.06%

S&P 500
1800 1600 1400 1200 Over the next few years we see the S&P 500 trading range-bound between 1,000 and 1,550

6% 4%

5.49% 4.10%

1000 800

2% 0% 1950-1960 1960-1970 1970-1980 1980-1990 1990-2000 2000-2010

600
Source: Bloomberg Finance L.P. PAIR. As of November 7, 2011

400 2006

2007

2008

2009

2010

2011

2012

2013

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Special Report: The Merits of Dividend Investing

November 10, 2011 Portfolio Advice & Investment Research

Returns Given our expectations for lower rates of return over the next few years, dividend paying equities could outperform with dividends likely to play a more important role in future total returns. As anecdotal evidence of this, we note that dividend payers within the S&P 500 have outperformed non dividend payers by 5.50%, year-to-date. Looking at Canada (S&P/TSX Composite), the returns from dividend payers are even greater, outperforming non-dividend paying stocks by roughly 12%. While past performance is no guarantee of future returns, clearly dividend paying stocks have shown their mettle this year. If we extend our time horizon, the positive impact of dividends on returns are even more telling over the long-term. In Exhibit 3 we calculated returns based on a $100,000 investment in both the S&P 500 and the S&P/TSX Composite since 1988 and found the results to be quite compelling for dividend investing. In particular, if a U.S. investor invested $100,000 in the S&P 500 in 1988 they would have roughly $527,974 today. That equates to a compound annual growth rate (CAGR) of 7.50%. Not bad, considering the challenges of the last decade. However, if you include dividends over this period, an investor would have over $900,000, which equates to roughly a 10% CAGR. Similarly, Canadian investors who invested $100,000 in 1988 would have over $700,000 including dividends (8.9% CAGR) versus $397,000 (6.20% CAGR) if only looking at price return. Clearly, dividends play an important role in total returns both in the short and long term. Exhibit 3: Positive Impact of Dividends to Total Returns for Canadian and American Investors
$100,000 Invested in the S&P 500 Index
$1,200,000 $1,000,000
$901,734 Cumulative Return
Cumulative Return

$100,000 Invested in the S&P/TSX Composite Index

$900,000 $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000
$397,206 $711,267

$800,000 $600,000
$527,974

$400,000 $200,000 $0 '88

Source: Bloomberg Finance L.P. Weekly data from Jan 1988 to Nov 2011

$100,000

'90

'92

'94

'96

'98

'00

'02

'04

'06

'08

'10

$0 '88

Source: Bloomberg Finance L.P. Weekly data from Jan 1988 to Nov 2011

'90

'92

'94

'96

'98

'00

'02

'04

'06

'08

'10

Price Return Only

Total Return

Price Return Only

Total Return

Focus on Dividend Growers Taking it one step further we looked at all the dividend paying stocks within the S&P 500 and divided them into quintiles, with the highest quintile being stocks with the highest dividend growth rates over the last five years, and the lowest quintile being the stocks with the lowest (or negative) dividend growth rates over this period. We found that over the last five years, the stocks with the highest dividend growth rates returned a cumulative average total return of 57.3% versus a loss of 36.8% for companies that cut or grew dividends at the lowest rate. The results are startling and reinforce the benefits of investing in dividend paying stocks, notably those that increase their dividends over time. Exhibit 4: Dividend Growers Deliver Greater Total Returns
% 80 60 40
24.75 21.33

Stock Retuns Organized By 5-Year Dividend Growth Rates

Of dividend paying S&P 500 companies, the high dividend growers have experienced the best 5year returns since Jan 2007.
57.32

20 0 -20 -40 -60 Quintile 5

-35.81

12.36

Source: Bloomberg Finance L.P. PAIR. As of November 1, 2011 Note: Returns are cumulative since January 2007 for S&P 500 dividend paying stocks.

Quintile 4

Quintile 3

Quintile 2

Quintile 1

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Special Report: The Merits of Dividend Investing

November 10, 2011 Portfolio Advice & Investment Research

Risk When investing we also need to consider risk. On this front dividend paying stocks are generally lower risk stocks relative to non-dividend payers. In defining risk we use beta, which is a measure of a stocks volatility in comparison to the market as a whole. The higher the beta the more volatile a security is in relation to the overall market (i.e., S&P 500). As seen in Exhibit 5, we categorized all the stocks within the S&P 500 by their dividend yield ranges, and captured the average beta among each category. The highest yielding stocks within the S&P 500 (4% and above) have the lowest betas (0.84 on average), which means they move less than the overall market. Conversely, stocks that do not pay a dividend or have a low dividend yield of less than 1%, have higher betas than the market, at 1.23 and 1.31, respectively. Essentially, high yielding stocks are less volatile than stocks that pay a low dividend or no dividend at all. Its important to emphasize that this only works up to a point, with very high yielding stocks being generally quite volatile, as the market questions the sustainability of the dividend and begins to price in a potential future dividend cut. Exhibit 5: Higher Dividend Yielding Stocks Generally Are Less Volatile
S&P 500 Stock Betas Organized By Dividend Yields
1.60 1.40 1.23 1.20 Beta (6-month) 1.00 0.80 0.60 0.40 0.20 0.00 0% 0-1% 1-2% 2-3% 3-4% +4%
Source: Bloomberg Finance L.P. PAIR. As of November 1, 2011

1.31

1.24 1.09 0.87 0.84

Dividend Yields

Conclusion Overall, our analysis shows that dividend paying stocks can enhance total returns for investors, with potentially lower risk. Given our view of continued choppy equity markets, we believe investors should be positioned defensively with a focus on large-cap, high quality companies that pay dividends. In the pages that following we provide our best dividendpaying U.S. and Canadian equity ideas.

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Special Report: The Merits of Dividend Investing

November 10, 2011 Portfolio Advice & Investment Research

Exhibit 6: U.S. Equity Yield Ideas

Sector Health Care Name MERCK & CO. JOHNSON & JOHNSON MEDTRONIC Cons. Staples KRAFT FOODS PEPSICO PHILIP MORRIS INTL Telecom AT&T CENTURYLINK Utilities ENTERGY SOUTHERN COMPANY Energy CHEVRON TOTAL S A ADR Industrials EMERSON ELECTRIC GENERAL ELECTRIC Financials JPMORGAN CHASE & CO ANNALY CAPITAL MGMT Technology INTEL MICROSOFT Materials VALE SA ADR BHP BILLITON ADR Source: Baseline. As of November 8, 2011 Ticker MRK JNJ MDT KFT PEP PM T CTL ETR SO CVX TOT EMR GE JPM NLY INTC MSFT VALE BHP Price $34.47 $64.86 $35.11 $35.48 $63.66 $71.20 $29.46 $37.54 $68.89 $43.96 $108.86 $52.70 $52.13 $16.48 $35.02 $16.54 $24.75 $27.16 $26.47 $80.07 Div 5-Yr Div Forward Yield Growth Rate P/E 4.40% 0% 8.7 3.50% 9% 12.8 2.80% 18% 9.9 3.30% 4% 14.5 3.20% 11% 14.2 4.30% 14.2 5.80% 5% 12.3 7.70% 63% 20.9 4.80% 8% 11.4 4.30% 4% 16.5 3.00% 8% 8.4 6.00% 6% 7.6 3.10% 7% 14.4 3.60% -22% 11 2.90% -38% 7.7 15.20% 29% 7.2 3.40% 12% 9.8 2.90% 12% 9.6 2.60% -4% 5.7 2.50% 20% P/B 1.9 2.9 2.1 1.6 4.2 34.2 1.5 1 1.5 2.2 1.9 1.6 3.6 1.4 0.8 1 2.7 3.7 1.6 4.6

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Special Report: The Merits of Dividend Investing

November 10, 2011 Portfolio Advice & Investment Research

Exhibit 7: Canadian Equity Yield Ideas

Sector Telecom Name BCE CAD TELUS A CAD SHAW COMM 'B' CAD Utilities FORTIS CAD EMERA CAD Energy TRANSCANADA CAD ARC RESOURCES CAD ENBRIDGE CAD CRESCENT PNT ENR CAD Industrials SNC-LAVALIN GRP CAD CANADIAN NATL RW CAD CANADIAN PAC RLW CAD FINNING INT'L CAD WAJAX CAD Financials TORONTO-DOMINION CAD BANK NOVA SCOTIA CAD ROYAL BNK CANADA CAD INTACT FINANCIAL CAD RIOCAN REIT CAD Source: Baseline. As of November 8, 2011 Ticker BCE-T T'A-T SJR'B-T FTS-T EMA-T TRP-T ARX-T ENB-T CPG-T SNC-T CNR-T CP-T FTT-T WJX-T TD-T BNS-T RY-T IFC-T REI.UN-T Price $39.90 $51.73 $20.49 $33.74 $32.30 $41.19 $25.37 $35.35 $43.46 $52.01 $80.62 $62.75 $23.22 $38.03 $73.80 $52.70 $46.42 $59.00 $25.13 Div Yield 5.20% 4.50% 4.50% 3.40% 4.20% 4.10% 4.70% 2.80% 6.40% 1.60% 1.60% 1.90% 2.20% 6.30% 3.60% 3.90% 4.70% 2.50% 5.50% 5-Yr Div Forward Growth Rate P/E 9% 12.8 9% 18% 12.1 9% 19.5 9% 19.1 -2% 17.7 -20% 23.9 11% 23.4 4% 64.9 22% 16.1 11% 15.5 7% 15.4 10% 12.4 -19% 10.7 6% 10.7 4% 11.3 4% 10.5 7% 10.7 1% 16.8 P/B 2.7 2.9 2.9 1.7 2.6 1.8 2.3 3.5 2.2 4 3.2 2.1 3.1 2.9 1.7 2.2 2 2.2 1.5

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Special Report: The Merits of Dividend Investing

November 10, 2011 Portfolio Advice & Investment Research

Appendix A Important Information

Full disclosures for all companies covered by TD Securities can be viewed at https://www.tdsresearch.com/equities/coverage.disclosure.action Research Dissemination Policy TD Waterhouse makes its research products available in electronic format. TD Waterhouse posts its research products to its proprietary websites for all eligible clients to access by password and distributes the information to its sales personnel who may then distribute it to their retail clients under the appropriate circumstances either by email, fax or regular mail.No recipient may pass on to any other person, or reproduce by any means, the information contained in this report without the prior written consent of TD Waterhouse. Analyst Certification The TD Waterhouse Portfolio Advice & Investment Research analyst(s) responsible for this report hereby certify that (i) the recommendations and technical research opinions expressed in the research report accurately reflect the personal views of the analyst(s) about any and all of the securities or issuers discussed herein and (ii) no part of the research analyst's compensation was, is, or will be, directly or indirectly, related to the provision of specific recommendations or views contained in the research report. Conflicts of Interest The TD Waterhouse Portfolio Advice & Investment Research analyst(s) responsible for this report may own securities of the issuer(s) discussed in this report. As with most other TD Waterhouse employees, the analyst(s) who prepared this report are compensated based upon (among other factors) the overall profitability of TD Waterhouse and its affiliates, which includes the overall profitability of investment banking services, however TD Waterhouse does not compensate analysts based on specific investment banking transactions. TD Waterhouse Disclaimer The statements and statistics contained herein are based on material believed to be reliable, but are not guaranteed to be accurate or complete. This report is for information purposes only and is not an offer or solicitation with respect to the purchase or sale of any investment fund, security or other product. Particular investments or trading strategies should be evaluated relative to each individuals objectives. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance. This document does not provide individual, financial, legal, investment or tax advice. Please consult your own legal, investment, and tax advisor. All opinions and other information included in this document are subject to change without notice. The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. TD Waterhouse Canada Inc. and/or its affiliated persons or companies may hold a position in the securities mentioned, including options, futures and other derivative instruments thereon, and may, as principal or agent, buy or sell such securities. Affiliated persons or companies may also make a market in and participate in an underwriting of such securities. TD Waterhouse represents the products and services offered by TD Waterhouse Canada Inc. (Member Canadian Investor Protection Fund), TD Waterhouse Private Investment Counsel Inc., TD Waterhouse Private Banking (offered by The Toronto-Dominion Bank) and TD Waterhouse Private Trust (offered by The Canada Trust Company). TD Securities Disclaimer TD Securities is the trade name which TD Securities Inc. and TD Securities (USA) LLC jointly use to market their institutional equity services. TD Securities is a trade-mark of The Toronto-Dominion Bank representing TD Securities Inc., TD Securities (USA) LLC, TD Securities Limited and certain corporate and investment banking activities of The Toronto-Dominion Bank. Trademark Disclosure Bloomberg and Bloomberg.com are trademarks and service marks of Bloomberg Finance L.P., a Delaware limited partnership, or its subsidiaries. All rights reserved. All trademarks are the property of their respective owners. / The TD logo and other trade-marks are the property of The Toronto-Dominion Bank or a wholly-owned subsidiary, in Canada and/or in other countries.
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