For some income investors, the inflation trade is starting to take a bite. High-quality dividend stocks are losing favor with the market as interest rates rise.

The graph below illustrates the performance of dividend-paying stocks in the U.S., Canada, and Europe since July 2016, when government bond yields began to head higher.

During this period, dividend stocks in each area underperformed their respective broad market.

In Canada, however, dividend-paying stocks only narrowly lagged the broad market despite sharply higher bond yields.

Nevertheless, if these trends continue, then this will be a challenging time for all income investors.

So is it time to ditch your dividend stocks? No, we don’t think so.

In contrast to the conventional wisdom, dividend payers actually outperform non-dividend payers over the long term. And dividend growers do even better.

Based on past research, the sweet spot for this market-beating performance appears to be stocks that yield between 3% and 5% (See our article in the January issue of Canadian Edge, “When Yield Chasing Goes Wrong”).

At the same time, we don’t recommend just sitting tight. Income investors should review their holdings and consider selling high-yield stocks that have no prospect for near-term dividend growth. If yields keep rising, these stocks will take the biggest hit.

One Down, 11 to Go

Thanks in part to a stronger Canadian dollar, the Dividend Champions Portfolio had a positive start to the year, with a 3.5% gain in U.S. dollar terms in January. Over that same period, the broad Canadian market added 4.3%, the S&P 500 gained 1.0%, and the MSCI World Equity Index (excluding the U.S.) returned 3.3%.

Over the 22 months since its inception, the Dividend Champions Portfolio managed to beat its benchmark by 7.1 percentage points, as shown in the accompanying table.

Our top performer during January also happened to be our first buy of the year, AirBoss of America Corp. (TSX: BOS, OTC: ABSSF), which has added 12% since we recommended it via email alert on Jan. 3.

North West Company (TSX: NWC, OTC: NWTUF) climbed 6% after concluding the acquisition of a retail and wholesale chain in the British Virgin Islands.

A&W Revenue Royalties Income Fund (TSX: AW-U, OTC: AWRRF) rounded out the top 3, with a 4% gain. This stock has now risen 12% since we added it to the portfolio last October.

Bottom of the log for January was Suncor Energy Inc. (TSX: SU, NYSE: SU), with an 8% decline. However, given the stock’s strong rally during the fourth quarter, it was probably due for a correction.

The revival of the Keystone XL pipeline project is altogether good news for Canadian oil sands producers, particularly Suncor, as increased takeaway capacity will support the higher production targeted by the Canadian oil giant over the next few years.

CI Financial Corp. (TSX: CIX, OTC: CIFAF) dropped 5% during the month after strong gains in the preceding months. The company is a high-quality asset manager, but investors, including ourselves, remain concerned about the company’s ability to navigate the decline in mutual fund sales and the resulting pressure on fee income.

Overall, the Dividend Champions Portfolio’s strong return has boosted its performance since inception to within our targeted range of 8% to 15% annually. Although there’s more work to do, we’re comfortable that a portfolio of holdings that yield 3.5% and are forecast to grow dividends 6% annually should enable us to meet our long-term objective.

Healthy Addition

In January, we invested 4.0% of the Dividend Champions Portfolio’s cash position in a new holding, NorthWest Healthcare Properties REIT (TSX: NWH-U, OTC: NWHUF). We announced this purchase via email alert on Jan. 23.

Healthcare is one of the largest and fastest-growing industries worldwide, and NorthWest is well positioned to benefit from this trend for decades to come.

NorthWest owns and operates medical office buildings, hospitals, clinics, and aged-care facilities in Canada, Germany, Australia, New Zealand, and Brazil.

Operating and financial metrics have been improving over the past 18 months. Meanwhile, the quality of the REIT’s portfolio has been enhanced by several acquisitions and divestitures.

Investors have started to acknowledge these positive changes, and the unit price is up 20% over the past year. We believe that NorthWest’s strengthening fundamentals will continue to drive the unit price even higher.

Despite recent gains, NorthWest is still undervalued compared to its global peers. The REIT’s distribution currently yields an attractive 7.8%, and there’s potential for further distribution growth in 2017. We estimate NorthWest’s fair value at C$14, or US$11.