Low rates add to allure of dividend stocks

“There were businesses I would call ‘Covid winners,’ which were generally technology companies,” said Don Newman, portfolio manager with Fidelity Investments Canada ULC. “Unfortunately, most dividend payers fell into the category of ‘Covid losers.’”

Early in the pandemic, a number of Canadian companies either reduced or suspended dividends. Meanwhile, banks were ordered to halt both dividend hikes and share buybacks by the Office of the Superintendent of Financial Institutions (OSFI).

But some Covid losers are now beginning to look like winners.

Newman, who manages the Fidelity Dividend Plus Fund, said there were a number of good businesses that got “beaten up” last year and are now trading at attractive valuations and paying dividends of 4% or more.

Those kinds of dividend yields are nothing to sneeze at when 10-year Treasury yields are hovering at slightly more than 1.5% and junk bonds are yielding about 3.5%, Newman added.

“A 4% dividend in a good blue-chip stock that is trading relatively cheap to the market is a really good place to be right now,” Newman said.

The Fidelity fund held $2.15 billion in assets under management (AUM) as of Feb. 28. As of Jan. 31, 74.4% of the fund’s holdings were in Canadian dividend-paying stocks and 22.7% were in foreign dividend-paying stocks, with the remaining 2.9% in cash.

The Fidelity fund’s largest allocation is to the real estate sector (26.9%), followed by utilities (23.2%), communication services (17.1%) and energy (15.5%).

There are opportunities, Newman said, to find quality companies in sectors that got crushed by Covid last year, such as real estate.

One of the Fidelity fund’s real estate holdings is Indianapolis-based Simon Properties Group Inc. (SPG), which Newman described as a “Class A” shopping mall company with the “best mall assets in the entire U.S.”

SPG’s stock price dropped by about 40% last year, but the stock offers a dividend yield of nearly 5%, Newman said. SPG also has a strong balance sheet and quality assets, bolstered by the recent acquisition of Taubman Centers Inc., another Indianapolis-based mall company.

“Is the secular trend toward malls? No, probably not — there’s a lot of e-commerce. But as B and C malls go away, A malls are still probably a destination,” Newman said.

There also may be opportunities in the insurance sector, which “hasn’t done much over the past 10 years” as interest rates have dropped, Newman said. But insurers, he noted, have benefited from strong equities markets, and their earnings multiples should improve when interest rates eventually inch higher.

Toronto-based Sun Life Financial Inc. is among the Fidelity fund’s insurance holdings.

“[Sun Life is] a really good business with 14% [return on equity] and lots of excess capital, but it was still down last year and, I think, has a good amount of recovery business,” Newman said.

Strong companies in the energy sector, which got clobbered last year, also are poised for growth as the price of oil rises and cash flows return.

Calgary-based Suncor Energy Inc. cut its dividend last year and saw its stock price drop by about 40%, but Newman increased the Fidelity fund’s position in the company, which currently has a dividend yield of almost 3% and trades at approximately four times its cash flow.

However, not all sectors are poised for a rebound, which is why Newman decreased the Fidelity fund’s exposure to consumer staples.

Companies that sell consumer staples were huge beneficiaries of the pandemic last year, but Newman said he doesn’t anticipate surging sales of toilet paper and disinfectant wipes will continue as the world reopens. Consequently, he reduced the Fidelity fund’s position in Arkansas-based Walmart Inc.

“There will be a time when you buy consumer staples again as defensive, good-quality companies, but it doesn’t feel like right now is the time to be loaded up on consumer staples,” Newman said.

According to Chicago-based Morningstar Inc., Series A of the Fidelity fund returned 1.46% for the year ended Feb. 28, trailing the Morningstar Canada GR CAD index, which posted a return of 15.09%. The fund’s five-year return was 4.24%, and it’s been in the top quartile of its category for the past three years with a return of 5.68%.

While last year was hard on many dividend-paying stocks, the future looks promising, Newman said.

“[Dividend stocks are] a segment [of the market] that has probably been ignored for the past year, and things are getting better. Valuations are cheap and yields are good.”

canadian banks’ share prices got pummelled during the Covid market crash, but they’ve bounced back. In fact, the pandemic created an environment in which banks can thrive, according to Colum McKinley, senior portfolio manager with CIBC Asset Management.

McKinley, one of the portfolio managers of the CIBC Monthly Income Fund, noted that banks have consistently outperformed the broad Canadian market over the past 50 years. Last year was an exception, but banks still offer dividend yields in excess of 4%.

“In a low interest rate environment, that’s incredibly attractive,” McKinley said.

But there are other reasons bank stocks are attractive to dividend-seeking investors, such as their large capital reserves. OSFI’s halt on bank dividend hikes and share buybacks resulted in banks building the capital on their balance sheets.

“We think in late 2021 or into 2022, we’ll see OSFI release that constraint, which will allow the banks to accelerate dividend growth,” McKinley said.

Banks also have been very cautious in building up substantial loan-loss provisions, McKinley added. Over the past few quarters, banks have added $30 billion in reserves for bad loans to their balance sheets. Meanwhile, household savings rates have skyrocketed.

“There’s a disconnect, in that banks have taken these big reserves for future losses on loans, yet individuals’ balance sheets have never been better,” McKinley said. “The savings rate is going to support future bank earnings as [banks] unwind some of their reserves.”

The CIBC fund is a balanced fund, with about 60% of the portfolio invested in dividend-paying equities and roughly 40% allocated to predominantly investment-grade fixed income. The fund held $4 billion in AUM as of Feb. 28.

As of Jan. 31, approximately 31% of the CIBC fund’s portfolio was invested in Canadian equities, while 16% was allocated to U.S. equities and about 8% was invested in international equities. The fund’s largest sector weighting is in financial services (30.36%) — five Canadian banks are in the fund’s top 10 holdings — followed by energy (11.1%) and industrials (10.5%).

McKinley increased the CIBC fund’s positions in the Big Five Canadian banks, each of which reported increased profit that exceeded analysts’ expectations in the first quarter.

McKinley also increased the CIBC fund’s position in another of its top holdings: Toronto-based Brookfield Asset Management Inc., which invests in alternative assets such as real estate, renewable power and private equity.

“We looked at Brookfield and thought of it as a company that’s well positioned to take advantage of the uncertainty we’re seeing in the market,” McKinley said. “In our conversations with management, that’s what they were thinking about: ensuring that they use this crisis to enhance future value for shareholders.”

Saskatoon-based Nutrien Ltd., a provider of potash and fertilizer to the agriculture industry, is another company in which McKinley recently increased the CIBC fund’s position. Nutrien is expected to generate slightly less than $2 billion in free cash flow next year — money that could be put toward dividend hikes and share buybacks as well as acquisitions to grow the business.

“Corn prices and soybean prices have skyrocketed, so farmer economics have improved substantially,” McKinley said.

The CIBC fund is overweighted in the pipeline and midstream space of the energy sector — an area of the market that has “attractive valuations and great dividend yields,” McKinley said.

One such holding is Gibson Energy Inc., a Calgary-based midstream company that currently offers a dividend yield of 6.5%.

“What’s interesting about that yield is the cash flows that pay that dividend are all from long-term contracts,” McKinley said.

Indeed, midstream companies generally enjoy stable cash flows backed by long-term contracts with exploration and production (E&P) companies, “and the balance sheets for those E&P companies are getting stronger as the price of oil continues to move higher,” McKinley noted.

According to Morningstar, the CIBC fund returned 7.79% for the year ended Feb. 28, trailing the Morningstar Can Neut Tgt Alloc NR CAD index, which returned 9.26%. The fund has been in the top quartile in its category for the past five years, returning 7.36%.

With rock-bottom interest rates here for the foreseeable future, dividend stocks have become increasingly enticing, McKinley said.

“I think in today’s low interest rate environment, where traditional fixed income simply isn’t generating the returns it has in the past, the stability of dividends becomes even more important,” he said.