Income-paying equities: Securities-selection criteria in a low-return environment

Michele Robitaille, managing director and equity-income specialist at Guardian Capital LP, a sub-advisor to the BMO family of funds. The Guardian equity team’s mandates include BMO Monthly High Income II.

Jason Gibbs, vice president and portfolio manager at 1832 Asset Management LP. Gibbs is a senior member of the firm’s equity-income team, which has a wide range of mandates including Scotia Canadian Dividend.

Peter Frost, senior vice president and portfolio manager at AGF Investments Inc. His responsibilities include two income-oriented balanced funds: AGF Monthly High Income and AGF Traditional Income.

The roundtable was convened and moderated by Morningstar columnist Sonita Horvitch, whose three-part series concludes on Friday.

Q: Will the Canadian equity market do better than the U.S. equity market in 2016?

Frost: I don’t think that Canada has ever underperformed six years in a row. But there’s always a first.

Robitaille: For Canada to do better, the uptick in the oil price doesn’t need to be from US$30 to US$60. If we could even get close to a US$50 price, there would be a fairly nice corrective bounce. The Canadian equity market has been unusually volatile in sectors that you wouldn’t expect, such as in utilities. These stocks had a negative total return in 2015. The market is lacking direction and leadership, because it’s facing so many headwinds. The market tries to go risk on and then gets nervous and it’s back to risk off.

Gibbs: The utilities stocks held in much better in early January.

Frost: It’s fascinating how volatile the utility stocks have been. The stock of electric utility Fortis Inc. (FTS) is a case in point.

Gibbs: On the outlook for the Canadian equity market, one-year predictions are impossible. From a long-term perspective, investors should expect a lower-return world. It’s back to good old-fashioned stock-picking and getting paid to wait in quality dividend-paying stocks. In general, the Canadian equity market could produce give-or-take 5% per annum total return over the next several years. You can do a lot better with good stock-picking. A plus is the current market psychology. There’s absolutely no euphoria surrounding stocks. It’s better to buy into skepticism than into euphoria.

Frost: In a low-return environment, dividends become an important part of the total return. The dividend yield on the S&P/TSX Composite Index is 3.5%. Over time, dividend-payers outperform both the market as a whole as well as non-dividend-payers.

Q: Time to discuss your portfolios and disciplines.

Robitaille: We look at the underlying workings of the individual companies that we’re investing in and the industry that the company is operating in. We spend a lot of time meeting management teams, not only at the upper-management levels. We do have a macro overlay for portfolio-construction purposes, looking at areas such as commodity prices and interest rates. BMO Monthly High Income is a Canadian equity portfolio with no foreign content.

Gibbs: Scotia Canadian Dividend is a predominantly big-cap fund. There is foreign content. We look for quality stocks trading at a reasonable price. We want to own the best-in-class businesses in a good industry. We look for free cash flow, strong balance sheets, high barriers to entry and businesses that have been around for a long time. Then you have to ensure that you pay the right price for that. The old saying is that offence wins games and defence wins championships. In this business, you have to protect capital.

Frost: AGF Monthly High Income and AGF Traditional Income are balanced funds. Looking at the equity component, Monthly High Income is focused on dividend yield and Traditional Income is focused on dividend growth. There is foreign content in both funds. At every month-end, I screen about 3,500 stocks based in Canada, the United States and elsewhere. I construct a stock portfolio that has mostly equal weights in individual stocks. I don’t focus on the sector weights in the Composite, so I have more equal weightings in the sectors.

Q: Let’s tackle the Canadian dividend-paying universe by key sectors, starting with the financials. This sector includes real-estate companies and real estate investment trusts.

Gibbs: Scotia Canadian Dividend has 33% in the financial-services sector. Banks represent 17% of the portfolio. The biggest bank weights are Bank of Nova Scotia (BNS), Toronto-Dominion Bank (TD) and Royal Bank of Canada (RY). I have been modestly adding to the banks, nothing too aggressive. As we said before, the banks are attractive. There was a big divergence in the performance of the major banks last year.

Frost: Those banks that were perceived to be commodity/emerging-market related came under pressure.

Gibbs: Further in the financial-services sector, the insurance companies represent 7% or 8% of Scotia Canadian Dividend. This weighting has stayed relatively static.

Robitaille: On a price/earnings-multiple basis, the insurers are more expensive than the banks.

Frost: The projected earnings growth for the insurers is a little higher than the estimates for the banks.

Gibbs: The rest of the financial-services weighting in Scotia Canadian Dividend is real estate. I only own one Canadian REIT in this fund, RioCan Real Estate Investment Trust (REI.UN). I took down the weighting in REITs and real-estate companies a little over the past year.

Q: The S&P/TSX Capped REIT Index with a negative total return of 4.7% outperformed both the Composite and the High Dividend Index in 2015.

Robitaille: With the REITs, the profile of earnings is stable because in most cases they are based on long-term leases.

Gibbs: There is a bifurcation in the Canadian REIT universe. Some of the REITs with office portfolios in Western Canada have their challenges. The high-quality REITs are fine.

Q: Michele, what are the financial-services holdings in BMO Monthly High Income?

Robitaille: We have about a 16% weight in banks. We’ve been gradually increasing our weights there over the last quarter. We also own some life insurers, property and casualty insurers such as Intact Financial Corp. (IFC), and asset managers.

Q: Manulife Financial Corp. (MFC) is a top-10 holding in BMO Monthly High Income.

Robitaille: More than 40% of Manulife’s net operating earnings are coming from wealth management, and the growth trajectory for that is good. Its Asian business has been growing quite nicely. Its traditional Canadian and U.S. businesses continue to do well. Manulife is on track to meet its 2016 earnings target and there will be continued strong growth beyond that.

Q: Michele, what about REITs?

Robitaille: We have about 14.5% in REITs, which relative to our history is fairly low. We’ve been adding selectively to our REITs over the course of the last year. Again, as Jason says, you have to be careful where the underlying properties and geographic exposures are within those REITs. We added Allied Properties Real Estate Investment Trust (AP.UN) in the third quarter of 2015. This was based on what we believe was an attractive valuation. It traded down to a discount to its net asset value for the first time in a long time.

This August, Standard & Poor’s will break out real estate as a new sector. There will be 11 sectors. The real-estate weighting will be around 4% in the Composite. You could get a real-estate company going in the S&P/TSX 60 Index. The result of all this will be that more generalists will become interested in the sector.

Q: Peter, financial services?

Frost: As I mentioned, we have more of an equal weight in the sectors, so the financial weightings in both AGF Monthly High Income and AGF Traditional are lower than those of Michele and Jason. We like the asset managers. We’re bullish on equities long-term. In Monthly High Income, I recently bought back asset manager Gluskin Sheff + Associates Inc. (GS), after the stock price corrected.

Q: Bank of Nova Scotia is a top-10 holding in both these AGF balanced funds, as is Manulife.

Frost: I agree with Michele’s comments about Manulife. Scotiabank is the biggest holding among the banks in both portfolios. Long-term, we like its growth profile and its geographic exposure. In the interim, its exposure to South America is tough for the bank. But, long-term the demographics and growth profile of those countries will be positive for Scotiabank.

Q: What is the prospect for dividend increases at the banks?

Frost: The Canadian banks are going to continue to increase their dividends, probably in the mid-single-digit range. It will probably mirror their earnings growth profile.

Robitaille: That’s still a decent increase. A 5% increase in dividends, year over year, makes for a meaningful difference over time.

Editor’s note: This is part two of a three-part equity-income roundtable.