Canadian dividend funds racked up another solid year in 2006, thanks to strong demand for dividend-yielding stocks and a backdrop of steady macroeconomic conditions. Although fund managers are generally optimistic about the year ahead, they expect returns will be a little less robust.

“We still have some good tailwinds with us,” says Doug Warwick, lead manager of TD Dividend In-come Fund and managing director of Toronto-based TD Asset Management Inc. “We’ve had a secular decline in interest rates since 1980 that has helped valuations. The demographic changes in Canada are also very positive; we have an aging population with a higher propensity to save. And we have governments at the federal level that have been very fiscally responsible for the past 12 years. That has reversed our debt-to-GDP ratio from around 70% to 32%.”

As the supply of federal debt has declined, investors have turned to provincial and corporate bonds. But the choices for income-seeking investors are generally shrinking these days, largely because of conservative fiscal policies and healthier corporate balance sheets. “Investors are seeking returns some way,” says Warwick. “The focus has been on dividend-paying stocks these past few years.”

Financial services, especially the banking sector, has been a primary driver of dividend funds. “With the banks focusing on the consumer, and less so on the corporate sector, their earnings are far less volatile [than in the past],” he says. “But the investors’ perception of the banks has lagged this very favourable change in fundamentals. I think we’ll continue to get good returns.”

Warwick anticipates an 8% return, based on a blend of stocks and quality income trusts and REITs.

From a structural viewpoint, Warwick and co-manager Michael Lough, vice president at TDAM, have allocated 62.9% of the fund to equities, 11.5% to income trusts, 5% to preferred shares, 18.1% to bonds and 2.3% to cash. Notably, the fund is dominated by a 44.4% weighting in financial services stocks, with much smaller weightings in energy and telecommunications (4.9% and 4.7%, respectively).

The largest holding in the 58-name portfolio is Royal Bank of Canada — largely because of price appreciation, as he and Lough try to have equally weighted positions in the Big Five banks. “RBC has done better relative to its peers for the past couple of years. As a result, the weighting of RBC increased dramatically,” says Warwick, adding that the portfolio is rebalanced with new cash flows. A long-term holding, the RBC stock trades at $54.70.

The same approach applies to CIBC, whose stock was battered two years ago by its Enron Corp. involvement. The managers built up the underperforming position in anticipation of better times, which eventually came. It trades at $102, up from $80 a year ago. “In a small way, we kind of average into the banks that underperform,” says Warwick. “Generally, the banks are able to turn things around.” Both banks are yielding more than 3%.

On the telecommunications side, Warwick likes Telus Corp. While he expresses concern about growth in the sector, given that prices for long-distance services keep falling, he believes that Telus is better positioned to overcome this challenge. “It has a similar legacy [to Bell Canada] but because of its acquisitions, it has a much higher percentage of mobile in its earnings mix,” says Warwick. A long-term holding, the stock is trading at $56.50, compared with $45 a year ago, and yields 2.7%. “There is room to take the dividend a lot higher,” he adds, noting the firm could grow its revenue by 8%-10%.

This year could prove challeng-ing, says Dom Grestoni, manager of Investors Dividend Fund, and senior vice president and head of North American equities at Winnipeg-based I.G. Investment Management Ltd. “With the mounting concern about slowing economic growth that will probably challenge earnings growth, if there’s a year I would pick, it’s this one,” he says. “We will get closer to the 6%-8% returns we’ve been using as a guideline for a few years. It wouldn’t be a stretch.”

By way of a backdrop, Grestoni notes, long bond yields will probably be in the 4%-4.5% range for most of the year, and there could be some relief at the short end of the yield curve later in 2007. “Those rates are still positive,” he says. “They won’t pose significant competition to high-quality dividend-oriented stocks that have the ability to keep growing their dividends.”

@page_break@Given that financial services firms are yielding 3%-3.5%, if they maintain their five-year growth rate, they could be very attractive to investors who want to be more defensive.

As for dark clouds in the form of the U.S. economy going into a slump and the U.S. dollar coming under further pressure, Grestoni is not too concerned. There appears to be ample global liquidity and savings, he says, that is willing to finance the U.S. current account deficit. “Buyers of all types are ready to buy any and all the requirements of the U.S.,” he says.

Designed to generate tax-efficient income with a minimum of volatility, the Investors fund’s asset mix has gone through a gradual change. In the past 15 years, it has shifted from an emphasis on preferred shares and bonds toward a emphasis on common equities. Today, there is 74% in common stocks, 5.5% in preferred shares, 20% in Government of Canada bonds and a small cash weighting.

Running a concentrated equity portfolio of 25 names, Grestoni is a value-oriented investor who focuses on companies that have consistency in earnings and cash-flow generation — in good times and bad. “When I look at companies today, when dividend growth has been important, it’s difficult not to be a champion of the Canadian financial services sector,” Grestoni says. Noting that the top holding, RBC, accounts for more than 9% of the fund, he adds, “I’m asked, ‘Am I comfortable with that?’ I say, ‘Why wouldn’t I be?’ Here’s a company that has grown its earnings tremendously over the past decade, has a consistent ROE of almost 18% in the past three or four years, and has increased its dividend steadily. And it has still less than 40% payout, which means it has room to grow. I’m not sure I can find a better investment in Canada.” The stock, which yields 3.2%, is trading at $54.70. Grestoni has a 12-month target of $60.

Another favourite is Enbridge Inc., a partially regulated business that mainly transports oil. “With the growing importance of oil to the North American market, it is now the premier oil pipeline in Canada and is into most parts of the U.S. If we continue to grow our oil exports, which is almost guaranteed to happen with oilsands production, Enbridge will be in a very good position to continue as the primary mover of energy,” says Grestoni.

A long-term holding, the stock trades at $38 and yields 3.2%. “The stock is at fair value now,” he says, “but there’s a good chance it could trade at $40 in three to six months if interest rates stay stable and short-term rates start to fall. Some of that short-term money may find it attractive to take a dividend at 3.2%.”

A defensive approach may be appropriate now, says Juliette John, manager of Bissett Dividend Income Fund Class A and vice president of Calgary-based Bissett & Associates Investment Management Ltd. “Going forward, equity markets will be less buoyant than in the past few years,” she says. “Earnings growth was a major contributor to returns in the past, but we could be into a more challenging period. There will still be earnings growth, but not at the levels we’ve seen. Returns won’t be as easy to come by.”

Noting that companies will be facing increasing cost pressures in the form of rising labour and materials costs, John says, “The easy money is behind us.” Moreover, even if central banks cut interest rates, which may happen some time later this year, it won’t be a significant boost to corporate performance.

“In the meantime, our approach is to be more defensive,” she says. “We’re focusing on companies that have steady earnings growth rather than those that are more cyclical in nature. And their dividends will provide downside protection.”

From a strategic viewpoint, John has about 75% of the fund in common equities, 22% in fixed-income, consisting mainly of investment-grade corporate bonds, and 2.5% in preferred shares. While many of the top holdings on the 60-name equities side include blue-chip financial services names such as RBC, John also likes smaller names such as IGM Financial Inc.

The largest fund company in Canada and a member of the Power Corp. group, IGM “is a solid operator and has excellent cost control,” she says. “It also has a 20% ROE, a clean balance sheet and trades at a reasonable price/earnings multiple of 16.”

A long-term holding, the stock trades at $50.90 and has a 3.5% dividend yield.

In the search for stocks outside the traditional financial services arena, John has focused on mid-cap names such as Reitmans Canada Ltd. A womenswear retailer that owns brands such as Smart Set and Penningtons, Reitmans “has little debt on the balance sheet, has raised the dividend twice and has a 40% payout ratio.” Bought in late 2005 at about $16, the stock is trading at $23. Its current dividend yield is 2.8%. John has no stated target.

Another favourite is Russel Metals Inc. The firm operates metals service centres, markets tubular steel to the oil and gas industry, and distributes steel products.

It is also known as a consolidator and may make further acquisitions. Bought about two years ago at $18, the stock is now at $27.70 and yields 5.8%, making it one of the highest-yielding stocks on the S&P/TSX composite index. IE