|
It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price. - Warren Buffett. |
Canadian Stocks
Dividend Growth Investing
Because of the poor breadth in the Canadian market, direct stock ownership is an attractive alternative for some investors. It allows better control of taxable events, and has no ongoing management expense ratio if the stocks are appropriately selected. However, it also needs more work to select and monitor the stock portfolio.
Individuals requiring retirement income may wish to consider a type of value investing called "dividend growth investing" - i.e., purchasing companies that are growing their dividends. The investor who uses dividend-growth investing for his Canadian portfolio is attempting to obtain a tax-advantaged and inflation-indexed return that is greater than that available with real-return bonds, not trying to beat an index. The dividend-growth approach is followed at Dividend Growth. An excellent reference to the technique is "The Single Best Investment", by Lowell Miller.
The principal behind the technique is that increasing revenues lead to increasing earnings, which lead to increasing dividends. The increasing dividends, which can grow at a rate that exceeds the inflation rate, then provide an inflation-indexed source of income. In addition, choosing only companies that have a history of paying increasing dividends eliminates high-risk companies like Bre-X. Dividends must come from real earnings, not speculative hype.
Desirable companies have several characteristics:
- Good financial health. The company's bonds should be rated BBB or better by DBRS and Standard and Poor's. To access the Standard and Poor's ratings, select Region: Canada from the top navigation bar. Choose the Credit Ratings List under the Fixed Income tab on the menu on the left. Use the filter or the alphabetical settings to find selected companies.
- A consistent record of dividend increases.
- A maintainable dividend payout ratio (generally less than 50%; less than 60% for utilities).
The dividend rate associated with desirable stocks is usually greater than average, but less than the maximum available on candidate stocks.
The Gordon Equation
The fundamental formula for estimating future returns is known as the Gordon Equation or Gordon Growth Model:The assumptions used in the Gordon Equation include a constant growth rate (which is only applicable if the company is in a mature market) and a constant market valuation. Since these assumptions are not likely to hold perfectly, the equation should be used as a rough guide only - do not take it too literally. Nevertheless, it suggests that, as a class, stocks with high dividends will usually have lower growth rate than stocks with lower dividends. In fact, a very high dividend yield is often a danger sign, and suggests that a company has something wrong with it.
As of this writing (February, 2002), candidate stocks would generally have a yield of 2.5-4%. A portfolio of these stocks offers a much better yield than that available with any Canadian ETF.
Finding Candidate Stocks
A good starting point for possible stocks is the Dow Jones Canada Select Dividend Index. Value favourites listed at the Value Investigator may also be considered. Dividend Growth also has a list of stocks. Prospective investors should note that considerably more screening and monitoring is usually needed for smaller stocks; individuals uncomfortable with stock analysis should stick to large-cap stocks, low-cost mutual funds, or ETFs.
A good site for checking prospective companies is Corporate Information, which allows a moderate amount of free access. Desirable companies should show graphs with consistently increasing earnings, dividends, and share price. Fictitious examples in a similar format to the graphs found at Wright are shown below:
The dividend growth stock shows a consistent pattern of growing earnings per share (eps) and increases in the dividends per share (dps) [the bottom two lines; the price should generally trend up as the earnings and dividends trend up]. Companies showing such a consistent pattern can be found particularly in the financial and utility sectors. Erratic earnings, such as in the cyclical stock, are undesirable; find another company. Company information can also be found at Globeinvestor, Advice for Investors, and Canadian Shareowner (which also operates a low-cost investing program). Company filings, including annual reports, are online at Sedar. A stock screener is available at Stingy Investor, which also lists Canadian Dividend Reinvestment Plans (DRPs).
Additional Considerations
Some additional points to be considered in establishing a portfolio of dividend-paying stocks are:
- Diversify effectively by selecting stocks from several different operating sectors such as: banks; non-bank financials; power generation; telecommunications; and pipelines.
- Each individual stock should generally make up at least 1%, and preferably 2-5%, of the portfolio.
- Consider trimming individual stock holdings if they grow to more than 10% of the portfolio and either selling or adding more if they fall below 1%.
- Avoid overconcentration of stocks in a particular sector such as banking or telecommunications. Limit sector weights to 15-20% of the portfolio.
- Remember that companies in "parent-daughter" relationships such as Atco - Canadian Utilities or Power - Power Financial - Investors Group/Great West Lifeco depend on cash flow from the daughters to the parent, and will not move independently. Holding both parent and daughter is usually inadvisable.
- Because the interests of the family may not coincide with those of the shareholders in family-controlled companies, and further difficulties may arise over matters of succession, limit your exposure to any family-controlled group.
- Recall that holding subordinate-voting shares when a company has multiple share classes exposes you to all of the risk, while giving the controlling shareholder a 'free ride' with other people's money. That's a much better deal for the controlling shareholder than for you.
- Although the banks usually make a substantial profit, they will occasionally be hit with loan losses. Some banks will usually be hit more than others, but it is impossible to tell which ones in advance. Consider dividing the portfolio allocation amongst three or more bank stocks.
- Recall that the regional banks, including the two Quebec-based banks, offer greater risk than do the five national banks.
- Use "limit bids" when trading stocks in lightly-traded companies like Canadian Utilities.
- Select stocks from the three different dividend paying cycles to even out cash flow.
The recommended "income" (i.e. dividend) portfolio of a major Canadian brokerage had the following composition in September, 2003:
- Two major banks.
- Two non-bank financial companies.
- Two pipeline companies.
- Two electrical power generation utilities.
- Two telephone utilities.
This approach provides good diversification, although the dividend growth opportunities for some stocks may be limited. Although the individual companies in any such "recommended" list would be expected to change periodically, the candidate list of (large-cap and mid-cap) stocks is relatively short.
A list showing the dividend-paying cycles of several stocks from the financial and utility sectors is given here. Investors wishing further diversification may also find additional stocks in the consumer or manufacturing sectors. Resource-based companies are usually cyclical and make poor dividend-growth stocks.
Note that Canadian equities should only form one part of a properly-diversified portfolio. Also, because of the narrow breadth of the Canadian market, the dividend-growth investor will undoubtedly wind up being significantly weighted in Canadian banks. This is all right as long as the investor realizes that the banks, by themselves, do not allow adequate diversification, even if they might form a significant part of the Canadian holdings. For proper diversification, the investor should include equities from the US and international markets, as well as bonds.