What investors should look for in dividend-paying stocks

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.

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

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

Coverage of the equity-income roundtable continues on Wednesday and concludes on Friday.

Q: What is the outlook for Canadian dividend-paying stocks?

Frost: The outlook for these stocks in 2017 is pretty good. Last year was a very good year, I’m uncertain that returns on dividend stocks in 2017 will be as strong as they were last year. Our view is that one of the best sectors in the short term is energy.

Robitaille: Energy does look good.

Frost: The outlook for the oil price for 2017 is positive. There’s the cut in production by OPEC (the Organization of Petroleum Exporting Countries). The economic data for the United States and internationally is looking better. Canada will ride the coattails of the stronger U.S. economy. If you look at the S&P/TSX composite high dividend index, it had, at the end of December, a 30.4% weighting in energy. That index did well in 2016 and it should do reasonably well in 2017. This high-dividend index produced a total return of 28.5% in 2016 versus 21.1% for the S&P/TSX composite index. At the end of December, the high-dividend index had a yield of 4.6% compared to a 3.1% yield for the S&P/TSX composite index.

Gibbs: Investors should reduce their 2017 return expectations for both these indexes. But the good news is that there is no euphoria in the system. On sectors, I’m not as much of an enthusiast for energy stocks. The world is finding different ways to produce energy. There are better businesses to invest in, as the energy companies take a lot of capital.

Q: Why did the S&P/TSX Composite High Dividend Index do so well in 2016?

Robitaille: In 2014 and 2015, dividend stocks in Canada and even globally significantly underperformed. A lot of this was predicated on the concern about the U.S. Federal Reserve Board finally raising rates. Then we had the first federal funds hike in December of 2015 and from January 2016 until the end of August last year, there was a significant outperformance of the Canadian dividend sectors, whether it was the telecommunications or utilities or the real estate investment trusts. After August, you had a shift to more cyclical stocks as the market started anticipating another fed-funds rate hike. The Fed increased its fed-funds rate in mid-December of last year.

Frost: The expectation was that four fed-funds rate hikes would follow shortly after the first increase in December 2015. This did not happen.

Robitaille: In September and October of 2016, there started to be pressure on dividend stocks with the REITs selling off, which was probably also a consolidation phase. But the telecommunication-services stocks and the utilities sold off as well. Then you had the Donald Trump election in November, which exacerbated this shift to cyclical stocks. Dividend stocks tend to underperform leading into the fed-funds rate hike and then they outperform once the rate hike occurs. This is because investors become more comfortable with the trajectory of the rate hikes and, if they share the current view that we’re still in a lower for longer rate environment, you’ll see dividend stocks outperform in 2017.

Gibbs: The lower for longer interest-rate theme is still appropriate. The aging demographics of the developed world means that people are going to try to increase their savings and reduce spending, which reduces inflation. There will also be an implied demand for dividend-paying stocks. The level of global debt balances is still very high. This puts a lid on spending. Finally, we’re going through a technology revolution. This is impacting a large number of industries and this keeps prices lower. It doesn’t mean that rates can’t increase, but they’re likely to still be much lower than they’ve been in the past.

Frost: There will be some inflationary pressures. Bond yields are likely to go up. But the high global debt level will put a lid on interest rates. The 10-year Government of Canada bond rate was recently 1.7%. About three months ago, it was 0.97%. The dividend on the S&P/TSX composite index is still comfortably higher than the current bond yield and, most importantly, there is the prospect of growth in dividends.

Q: Can we discuss the Trump effect on the equity markets?

Robitaille: There has been this massive shift to cyclical stocks since the Trump election. I think that this shift is quite overdone. Trump’s proposed fiscal stimulus measures have to be paid for somehow. There are a lot of Republicans who are not in favour of increasing the U.S. deficit. Therefore, Trump’s economic stimulus goals could get significantly watered down and U.S. economic growth prospects could be lower than the level that the equity market is currently looking for.

Gibbs: A key impact on the U.S. economy will be if the Republicans reduce corporate taxes. Also, regulation is going to be less under Trump than under the previous administration. This is positive for the banks in the United States.

Robitaille: It will also be a positive for energy-infrastructure companies and energy companies.

Q: Where does the U.S. Federal Reserve Board’s tightening program fit into all of this? What about the divergence between U.S. monetary policy and the Bank of Canada’s policy?

Frost: There will likely be two to three fed-funds rate hikes in 2017. We started the year at the target rate of 50 to 75 basis points. In Canada, the Bank of Canada has been using the Canadian dollar as its release valve to help the Canadian economy. The Canadian economy is going to show some signs of improvement in the first half of 2017.

Robitaille: You will continue to see this divergence between Fed monetary policy and Bank of Canada monetary policy. We’re unlikely to see a hike in the Bank of Canada rate any time soon, certainly not within the next 12 to 18 months.

Q: Which Canadian dividend stocks do well when market interest rates go up and which do not?

Frost: Stocks of companies that can grow their dividends in this environment will do well.

Robitaille: The equity market will start to differentiate between the companies that can grow their dividends and those that can’t.

Q: Let’s look at this sector by sector, starting with utilities, which are considered to be interest-sensitive.

Robitaille: Utilities companies can grow their dividends. For example, some of the large Canadian utilities such as Emera Inc. and Fortis Inc. are targeting strong dividend growth. Emera is looking at an 8% annual growth rate in dividends through 2019 and Fortis is targeting an average annual growth rate of 6% through 2021. Even if rates go up by as much as 100 basis points (one percentage point) this year, the growth in the dividend stream of these utilities and in many of the dividend payers should more than offset any kind of interest-rate pressure that we would expect to see.

Gibbs: I consider utilities to be a wonderful long-term investment. They are a contrarian play. The view seems to be that they are over-owned, overvalued and there is a need for caution. The companies do offer a lot of growth, but there are times when the stocks get too popular. For example, they were a safety trade after the Brexit vote on June 23 last year, and in July they got way too popular. But that shine has come off a little. A positive is that as interest rates go up, and given that this is a regulated business, over time this interest-rate increase will be factored into what they can charge.