Why a Dividend Investing Strategy Just Got Even More Powerful

One of the things I love about economics is how seemingly small decisions can have massive unforeseen consequences.

I thought about that on Tuesday as Canada’s ruling Liberal party released its government’s 2024 federal budget. The overall theme of the budget was plenty of increased spending as the incumbents reacted to how poorly they’re doing in recent polls.

It’s a standard playbook — you throw money at all sorts of different special interests, hoping to essentially buy key votes. Pretty much every government in the past 50 years has tried some version of it.

No, the interesting part was this government continues to follow through on its promise to more aggressively tax wealthy folks. This budget raised the capital gains tax inclusion rate from 50% to 66% — but only for people who book more than $250,000 in capital gains in a given year.

Y’all have already heard all about this, so I won’t go over the details. This isn’t a tax newsletter. It’s a dividend investing one.

Besides, we have something much more interesting to talk about. Here’s why I think the unintended consequence of this budgetary move is very good for dividend stocks in Canada.

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Accessing cash in retirement

For active investors, there are essentially three ways to access their cash in retirement. They can:

1. Borrow against the value of their portfolio (or their house)

2. Slowly sell shares over time to fund life expenditures

3. Collect the dividends while keeping their shares

Many growth investors or other anti-dividend folks are firmly in camp two. They want to take long-term positions in excellent growth stocks, ride them for multiple decades, and then slowly sell off shares as life dictates.

Dividend investors have long had issues with such a strategy, pointing out that the market doesn’t always cooperate. These kinds of stocks can trade at massively high or stubbornly low valuations depending on market sentiment. Market sentiment doesn’t care about my retirement or yours or anyone else’s. Therefore, it’s very possible an investor might be forced to sell such a stock at a trough valuation.

Or, more likely, an investor would throw in the towel at a trough valuation.

The budget forces folks to embrace another weakness in the strategy. Say you’re a retiree with $3M in stocks. One position is worth $1M because it did exceptionally well over the years.

This isn’t super far-fetched, either. Concentration happens pretty naturally in a lot of growth portfolios. Just one winner, bought in size over the years, can easily achieve such a result.

Say this hypothetical investor is cruising along, 55-years-old, looking forward to a somewhat early retirement. They have a good job, a spouse that’s making nice money too, and things are good.

Suddenly, out of the blue, a competitor makes an offer to acquire that $1M position. They offer a 30% premium, management accepts, and the deal is done.

Now, instead of being able to sell off the position in a gradual, piecemeal fashion during retirement, they’re hit with a massive tax bill. We’re talking hundreds of thousands of dollars — especially if the position was acquired decades earlier at a much lower cost base.

How dividend investing solves this

Another common criticism against a dividend-focused investing strategy is those quarterly payments create a lot of taxable events, and many investors would rather delay such events as long as possible.

But now, with the capital gains rate going much higher, I’m just not sure delaying delaying capital gains makes much sense.

Remember, instead of reinvesting all of their profits back into the business, a dividend stock pays investors a portion of the profits. This creates a taxable event — unless the stock is held in a RRSP or TFSA.

Before this budget, it was debatable whether an investor was better off to pay the tax now or defer the tax. Dividends tend to be taxed at a pretty attractive rate here in Canada — at least compared to other sources of income — but there were also pretty compelling reasons to invest in growth stocks and let them compound.

Now? It’s pretty clear there are some significant advantages to creating a taxable event today, rather than taking the chance of a much bigger taxable event later on. Especially considering the tax rules around dividend investing haven’t changed.

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What’s the outcome?

I firmly believe this announcement will change the way at least some Canadian investors put their money to work.

Dividend-paying stocks suddenly got a whole lot more attractive than some of the alternatives.

We already saw the first consequences of this new tax. Several long-term compounders sold off on the Toronto Stock Exchange on Wednesday, including TFI International (down 6%+), Canadian National and Canadian Pacific Railways (both down close to 2%), WSP Global (down 1%), and FirstService Corporation (down almost 1%).

This all happened when the overall market was positive, too.

It throws a bucket of cold water on real estate investing, too. There are countless Canadians who got wealthy by slowly buying rentals in markets like Toronto or Vancouver. They collected rents for years, watched their properties soar, and laughed all the way to the bank.

These folks are suddenly facing a much higher tax bill, especially once you consider the recapture on years of depreciation costs.

Normally, your author is no doomer, and most of the time I wouldn’t even consider changing my entire investing strategy based on one budget, especially one passed by a government desperately looking to stay in power. The logical conclusion to all this is some other party gets elected, immediately puts the capital gains tax back to where it was, and we all move on.

But I’m not sure that’ll happen this time. Canada is running some pretty serious deficits. It’ll take years for a more fiscally responsible government to get the budget back to something resembling balanced. Ottawa kinda needs the taxes raised by changing the capital gains rules. It’s enough to seriously doubt any they’ll-change-it-back-immediately theory.

Besides, if I’ve learned anything about government in my 20+ year investing career, it’s that they just about always find a way to disappoint you.

The bottom line

By making taxes much higher for certain investors, the federal government has inadvertently made dividend investing all the more attractive.

This should entice thousands of investors to at least consider more dividend stock exposure in their portfolio. The small tax penalty of getting paid today now looks pretty attractive versus a potentially much larger tax penalty in the future.

This could be the very event needed to kickstart a lot of dividend stalwarts, cheap stocks that have been left for dead by investors who were much more interested in growth.

Or it could be a giant nothing burger, and investors will continue to pile into expensive growth stocks. After all, increased capital gains taxes are a tomorrow problem, and humans are generally pretty good at ignoring tomorrow problems until they have no other choice.

The government inadvertently put in a pretty powerful incentive driving people towards dividend stocks. I think many investors will change their behaviour as a result.

Will it actually happen? We’ll see. But it’ll be fascinating to watch.