Dividend funds suffered last year along with other asset classes because of fears of the deteriorating economy. Although there are signs that markets may have bottomed, fund managers are generally defensive in their portfolio positioning.

“We are definitely in a bottoming process,” says Bob Swanson, lead manager of Fidelity Dividend Fund and vice president with Boston-based Fidelity Investments. “The question everybody is asking is: are we going to take out the November lows? We don’t think so. There are a multitude of things we are looking at.”

For instance, spreads of high-yield corporate bonds over U.S. treasuries had expanded to 2,200 basis points, dropped to about 1,600 bps and lately expanded to 1,800. “They didn’t re-test the highs,” says Swanson. “The same thing happens when you go up the curve in terms of credit quality.” Historically, wide spreads contracted and did not test new highs with a recent selloff.

“Equity markets seem to be holding their prior lows,” he adds. “So, that’s a couple of encouraging signs — so far.”

The economic numbers, however, will only get worse. “I don’t think it is going to be an average recession,” says Swanson. “I’m not sure if it will rank in the top five over the past 125 years. But it could be in the 20-month range.”

Because markets anticipate a turnaround by about four months, and the U.S. recession began in late 2007, the market lows may occur March-April. “We will muddle along for a while, and probably have some sharp rallies from the bottom, as people get back in. That will be met by selling pressure as they look to clean up,” says Swanson. “We will tread water for a while. We need some more time for things to work themselves out.”

Strategically, Swanson and his team became defensive in the fourth quarter, raised cash to 16% of assets under management and increased bond exposure. Since then, however, they have spent some of the cash and gradually reduced the bond holdings.

Now, 12% of AUM is in cash, 64% is in common equities, 14% is in income trusts and 10% is in bonds. “We are slowly going to reduce the cash and move back into equities, and sell some of the government bonds and retain the corporate bond holdings,” says Swanson. “The credit side of the equation looks very attractive. Up and down the capital structure, we’re seeing a lot of attractive instruments.”

Running a diversified equity portfolio with more than 100 names (vs about 370 on the bond side), Swanson likes Manulife Financial Corp. The insurer had been outperforming the banks and its peers — until last September. That’s when it tumbled because of concerns about unhedged positions within annuity products issued by John Hancock, its U.S. subsidiary.

“It got hit dramatically,” says Swanson. “But we take a longer-term perspective. Of the insurance companies, you want to be in Manulife. Even relative to other financials, it looks very attractive.”

A long-term holding, Manulife was recently trading at $20.40 a share, down from its 2008 peak of $41 a share. It has a 5.2% dividend yield.

Another large holding is Canadian Oil Sands Trust. Since the price of crude oil dropped to about US$40 a barrel, Canadian Oil Sands and other such companies have been under pressure to reduce their distributions. Until late January, Canadian Oil Sands had a 16% distribution yield.

“Our expectation is that it will have to be cut,” says Swanson. He had already reduced the position and moved into other energy names, including EnCana Inc. and Nexen Inc. “They are a little more geographically diverse and have lower costs of production.”

Canadian Oil Sands was recently trading at $20.50 a unit; its yield has been cut to 3%.



There are signs that markets are bottoming, says Stuart Kedwell, co-manager of RBC Canadian Dividend Fund and senior vice president with Toronto-based RBC Asset Management Inc.

“Some credit markets have improved,” he says, “and this is a necessary ingredient for a market bottom.” For instance, spreads between bankers’ acceptances and one-month treasury bills have narrowed to less than 100 bps from 250 bps.

But other signals are mixed; housing affordability is at 30-year highs. “Yet, you still have inventories at quite high levels,” says Kedwell, who shares duties with Doug Raymond, senior vice president with RBCAM. “In places such as California, lower prices are starting to clear the market. Activity is starting to pick up in a handful of places, but not on the whole.”

@page_break@Also, stimulus packages from the U.S. and Canadian governments are expected to have a favourable impact, although it’s uncertain when that will kick in.

“There are puts and takes on everything,” says Kedwell. “Three months ago, it was all puts. Now there are both.”

As well, Kedwell believes that valuations are attractive. “The S&P 500 composite index is two standard deviations away from fair value, and the S&P/TSX index is one standard deviation,” he says. “So, when people ask: ‘Has the market bottomed?’ it would be nice to say it has. But we don’t know for sure. The question is timing.”

Raymond points out that many stocks have not dropped much lower lately. “Once stocks start not going down any more, as bad news rolls in, it piques our interest,” he says. “I don’t think we can say with certainty that there isn’t another leg down, because the recession could end up being deeper. But there are signs that the rate of deceleration is slowing.”

Rather than taking a top-down view, Kedwell and Raymond are mainly bottom-up stock pickers looking for mispriced names. “We try not to say what will happen, rather what can happen,” says Raymond. “We are trying to get exposure to outcomes that we feel are reasonable at a time when the market is pricing them at a much lower probability — or for free. Right now, hope is on sale.”

From a strategic viewpoint, the managers have divided the 50-name portfolio into three buckets: 35% of the fund’s AUM is in financial services, 25% is in resources firms with long-life reserves and 25% is in large-cap companies with stable businesses and barriers to entry. There is also about 15% in cash.

Joining Toronto-Dominion Bank and Manulife in the first bucket is Brookfield Asset Management Inc. Last fall, its managers began adding significantly to the fund’s position in the conglomerate (which has real estate, timber production and hydro-electric facilities) as it came under pressure.

“There were days when we were paying only for the hydro facilities; the rest was free,” says Kedwell, noting the stock was trading at a 35% discount to net asset value. “The property area is challenged by the downturn. Nevertheless the company sits on three strong legs.”

Brookfield recently traded at $19.70 a share, down from its 2008 high of $37 a share. It has a 3.4% yield.

On the resources side, the managers believe the odds are reasonable that oil prices will inevitably rebound. “Longer term, oil prices could be meaningfully north of current levels,” says Raymond. “There is potentially a wonderful opportunity there.”

One favourite is Imperial Oil Ltd. “It has a wonderful collection of long-life assets and a very strong balance sheet,” he adds. The stock was recently trading at $40 a share, down from its 52-week high of $62 a share. It has a 1% dividend yield.



Gil Lamothe, a portfolio manager with Industrial Alliance Investment Management Inc. in Toronto, oversees IA Clarington Dividend Growth Fund. He is largely a bottom-up investor who believes there are still risks.

“There could be more bad investments and derivative-type instruments, whose values are unknown or perhaps nil, being carried at something other than that. The balance sheets continue to be questionable and at risk. That is the ongoing concern,” says Lamothe. “We saw the depth or reach of these tentacles this past year, and what they imply; there could be even more. Even though we may have seen the worst, they can still be material and affect the markets.”

A value-driven investor, Lamothe notes that the market is cheap by conventional measures: “Problem is, these are unconventional times. You can go into a stock that looks like good value. But it can still come under extreme selling pressure for reasons that are not fundamental.”

Running a portfolio of about 45 names, Lamothe is focusing on companies that meet the test of discounted cash-flow models, have strong balance sheets and management, and pay dividends. At the same time, he is risk-averse and does not take overly large sector bets. Lamothe has 29% of the fund’s AUM in financial services stocks, 28.5% in energy, 13% in materials, smaller weightings in utilities and telecommunications, and 7% in cash.

One favourite financial services name is TMX Group Inc. The firm, which runs the Montreal and Toronto stock exchanges, has “very good cash flow,” says Lamothe. “There was a perceived risk that an alternate trading platform was going to compete and take market share away from it,” he adds. “Its view as a growth stock has been tarnished. To me, it’s somewhat of a value stock.”

The stock was recently trading at $32.90 a share, down from its 52-week high of $48 a share. It yields 4.9%. “It’s fairly valued,” says Lamothe. IE