Canadian dividend funds mounted another strong performance in 2005, despite concerns about rising interest rates and a strengthening Canadian dollar. Yet fund managers are divided over the funds’ prospects for 2006. Some managers remain positive, others are cautious and a third group is looking outside Canada for opportunities.

The optimist camp includes Doug Warwick and Michael Lough, co-managers of TD Dividend Growth Fund. “We’re not concerned about rising rates,” says Warwick, managing director of Toronto-based TD Asset Management Inc. “The U.S. Federal Reserve Board has raised rates to 4.5% from 1%, and will probably do so a few more times. Bank of Canada has also increased rates. Yet, during this time, we’ve seen five-, 10- and 20-year yields rally.”

Warwick is confident that if an economic slowdown occurs, the central banks will manage it well. Several demographic factors work in the central banks’ favour: an aging population; growing demand for investment income; pension funds facing growing liabilities; and an improving debt/GDP ratio reducing governments’ need for debt despite strong demand for federal bonds.

“With less supply than demand, that favours lower interest rates,” says Lough, vice president of TDAM. “To me, there is a huge need for assets that provide income, but there is a growing scarcity. That explains why we think our funds are well positioned.”

Strategically, Warwick and Lough have allocated about 55% of the portfolio to financial services stocks, primarily banks. On a sectoral basis, the balance of the fund is invested 23% in energy, 6.8% in telecommunications and 3.6% in materials. There are also small holdings in sectors such as utilities.

Significantly, the top 10 names, half of which are banks, account for 68% of the fund. Although 80% of the fund comprises common stocks, income trusts — dominated by Canadian Oil Sands Trust — account for 17% of the fund. Another key factor, says Lough, is that as long as banks yield about 3% and long-term government bonds fetch 4.1%-4.3%, bank stocks are still attractive.

“Right now, banks are yielding a lot more than the historical trend, which is about 2%,” Lough says. “For them to yield that 2%, stock prices would have to rise dramatically. There is room for growth in bank stocks.” He adds that banks are much better at managing business risk; they have 18%-20% returns on equity, and their Tier 1 capital ratios have improved dramatically in the past few years, allowing them to increase dividends.

“But the market does not fully appreciate the merits of the banks,” says Warwick. The banks are trading at 13 to 14 times earnings, compared with the overall market’s rate of 16 times.

Bank of Nova Scotia is among the top holdings. “It has an international growth strategy and has emerged as the most significant bank in many Caribbean countries,” says Warwick. Its Mexican banking arm, Scotiabank Inverlat, he adds, is poised for rapid growth and could be as big as its Canadian retail operations in five years.

“Mexico has a younger population,” he says. “Its utilization rate is much lower than Canada’s and GDP growth is fairly strong. You can see very attractive growth in that market.” A long-term position, Scotiabank recently traded at $46 a share and yields 3%.

In a similar vein, he and Lough favour Royal Bank of Canada, Bank of Montreal and Manulife Financial Corp.

Another top holding is BCE Inc. The stock has been a laggard because of concerns about long-distance competition, among others, but the managers note its 4.5% yield and express confidence it will turn around once management completes its promised restructuring plan. “If we can get a 4.5% yield, and a 10% bump in the stock price, that’s a good return,” says Lough.

Martin Anstee, manager of Stone & Co. Dividend Growth Fund and vice president of Toronto-based Stone Asset Management Ltd. , is concerned that long-term rates may rise, putting pressure on dividend-paying stocks.

As well, he anticipates lower economic growth and worsening fiscal and current account deficits in the U.S. “The U.S. hasn’t solved the problem by raising interest rates so far. The deficits have not disappeared. It has to be more proactive by reducing economic growth and lowering the pace of consumer spending,” he says.

Anstee expects an eventual slowdown in the U.S. housing boom, a key economic driver.

@page_break@Bank of Canada doesn’t have the same economic backdrop, he admits, but cautions it will inevitably be under pressure from interest rate trends south of the border: “If the yield curve inverts in the U.S., it is very hard to avoid. And investors will look at U.S. bonds as alternatives, so money could leave Canada and switches could be made to U.S. short-term bonds. That will put pressure on rates.”

From an investment standpoint, Anstee notes that valuations are high and it is difficult to find attractive stocks. “It’s hard to see double-digit increases in earnings this year, especially in the U.S. We might in Canada, because of the commodities sector. Overall, though, the market is fairly valued. From my viewpoint, it is very hard to find companies at decent prices.” Last year’s 20%-plus performance numbers will be difficult to sustain, he adds, and returns will more likely be in line with historical norms of 10%-12%.

Running a 40-name fund and holding about 8% cash, Anstee has invested about 33% of the portfolio in financial services, 25.5% in energy, 12.7% in materials, 12.5% in industrials, 6.8% in media and cable, and the balance in sectors such as consumer discretionary. There is also about 18% in income trusts.

In January, he made some changes and increased his position in Canadian Pacific Ltd. “It got too cheap and there was too much of a gap between it and Canadian National Co.,” says Anstee. “People sold [CP] down because of concerns about its coal shipments [for Fording Canadian Coal Trust].”

He paid $48 a share for CP; the stock recently traded around $55 and yields 1%. “It was a buying opportunity. The key thing is buying quality. But you have to be patient,” says Anstee, who takes a total return approach. He anticipates an 11%-12% return on the stock in the next year.

Another favourite is Power Financial Corp. Although it’s a diversified firm, it derives the bulk of its revenue from Great-West Lifeco Inc. “This is a more liquid way of acquiring Great-West, which is thinly traded.” Anstee says. Great-West’s shares have fallen behind those of its competitors, Manulife and Sun Life Financial Inc. , but its valuation is more attractive. It also boasts a 20% ROE, which is several percentage points higher than those of its peers.

Bought at an average price of $30 a share, Power Financial recently traded at $33.70 and yields 2.8%. “There has been a consistent increase in dividends, and I can see another 10% rise,” says Anstee. He expects total return over 12 months could be about 12%.

David Taylor, manager of Dynamic Canadian Dividend Fund Ltd. , is also bullish, but not necessarily about the Canadian market.

He has allocated 36% of the fund to foreign stocks, in part because of the fund’s substantial inflows in the past year and the dearth of cheap domestic stocks. “It’s very difficult to find beaten-up, value-oriented, dividend-paying stocks,” says Taylor, who is vice president of Toronto-based Goodman & Co. Investment Counsel Ltd.

Indeed, he raised the foreign content to 30% a year ago for the same reasons. To protect investors, he has hedged the 15% U.S.-dollar exposure back into the C$. The remainder, in currencies such as Australian dollars, is unhedged.

As a value manager, Taylor considers most sectors in Canada too expensive. “Utilities are overpriced; if you look at the banks, even though the growth rates look modest, the stocks are trading at the high end of their historical valuations,” he says. Similarly, he thinks oil and gas stocks are “fairly” priced and is maintaining an underweighted 12% exposure in the sector, in stocks such as Petro-Canada and Talisman Energy Corp.

Noting that analysts originally raised their estimates for oil and gas prices, and that stocks have followed suit, he remarks: “With the pullback in prices, especially [for] gas, a lot of analysts will have to revise their numbers. I don’t see much value on the oil and gas side yet.”

Running a 40-name fund and adopting a more defensive stance of late, Taylor has taken a shine to base metals and materials stocks because they were trading at discounts to oil and gas stocks. In the past six months, he has made Inco Ltd. and Australia’s BHP Billiton Ltd. into core positions. The latter, he notes, is the world’s largest diversified mining company and is undervalued despite major capital expenditures.

“It has a significant asset presence, but [that’s] not reflected in the valuation because about 20% of its assets are not in full production,” he says. BHP’s zinc production has the most promising demand characteristics. “Once the properties are in full production, there will be a 25% upside in the stock within a year.”

Bought at AUS$23.50 a share three months ago, BHP recently traded around AUS$25 and yields 1.5%. “Its payout ratio is low. There’s a good chance it will increase.”

Taylor has a minimal 9.5% Canadian bank weighting, but has a total 20% financials weighting. He favours foreign stocks such as Citigroup Inc. , South Korea’s Kookmin Bank and Bank Rakyat, one of Indonesia’s top banks.

Comparing those banks with Royal Bank, Taylor says: “By the end of the day, it’s all about loan growth and risk of default. I don’t care if it’s RBC making loans to Canadians or Rakyat making loans to Indonesians. It’s all about what price you pay for equity and return on equity.”

Citigroup, he notes, has a 22% ROE, trades at twice book value and yields 4.3%. In contrast, Royal Bank has an 18% ROE, 2.7% dividend yield and trades at 3.2 times book value. Bought last fall at US$45 a share, Citigroup recently hit $46. “If it ever gets back to three times book, there is a 50% upside.” IE