As the head of the team managing the $4.5-billion Sentry Canadian Income, which focuses on North American dividend-paying stocks, Michael Simpson is navigating the challenges presented by rising interest rates.
Rates in much of the developed world have been edging up as economic growth and job creation gain strength, and the trend has set off stock-market jitters. This year has seen heightened volatility and some painful corrections in U.S. and Canadian stocks, particularly in the interest-sensitive, dividend-paying companies that populate Simpson's portfolio. Sentry Canadian Income suffered a 4.3% loss in the three months ended March 31.
"The interest-rate-sensitive stocks have been hit, but that means greater value has surfaced," says Simpson, senior vice-president and executive portfolio manager at Toronto-based Sentry Investments. "As a result of price drops, yields have risen on stocks." Simpson has managed the fund since it was launched in early 2002 and is responsible for its average annual return since inception of 10.7%.
The U.S. Federal Reserve is expected to raise its key lending rate another two times in 2018, following one hike in March and three hikes last year. Interest rates have also been moving up in Canada, Europe and Japan.
Any rise in interest rates puts downward pressure on bond prices, as well as dividend-paying stocks which are seen as a healthy income alternative in an environment where decent yields are hard to find in traditional fixed-income investments.
Simpson, who calls himself a "value-income" investor, believes some stocks have been oversold, and is relishing the fertile buying conditions created by falling prices. "U.S. growth could peak, and there's a chance we may not see all three of the anticipated interest rate hikes this year," he says. "The Fed will likely proceed cautiously, allowing time for the effects of rate hikes to kick in."
Meanwhile, lower prices have enticed him to deploy cash in some favourite long-term holdings including energy-utility companies 
Enbridge Inc. (ENB), with a recent dividend yield in mid-April of more than 6%, and AltaGas Ltd. (ALA), with an even fatter yield of 9%.
"We're seeing healthy yields for good companies," Simpson says. "Although there may be operational issues in some cases, the market has priced in too much bad news. When your goal is an overall portfolio return of 8%, and you're getting 6% from the dividend, you don't need a lot of capital gain."
He has also taken advantage of attractive prices to introduce some new holdings to the fund, including Allergan PLC (AGN), a Dublin-based global pharmaceutical company known for Botox; Applied Materials Inc. (AMAT), a Toronto-based semi-conductor company with a large share of sales in China; and Comcast Corp. (CCV), a U.S.-based telecommunications, cable and entertainment conglomerate that owns the NBC television network and Universal Pictures.
While Simpson prefers the valuations of U.S. financials to Canadian banks, he has added to his holdings in Bank of Nova Scotia (BNS), where he likes the potential of its Latin American business. He's also been taking advantage of pullbacks in Oracle Corp. (ORCL), a U.S.-based company specializing in database software, CVS Health Corp. (CVS), a U.S.-based healthcare and pharmaceutical giant, and Alimentation Couche-Tard Inc (ATD.A), a Quebec-based convenience-store and gas-station chain.
On a geographic basis, the fund is weighted 75% in Canada and 25% in the U.S., with Canadian exposure increasing in the past year as better bargains became available. In terms of asset mix, although the fund can go as high as 25% in bonds, it is currently 95% invested in common equities with less than 2% in fixed income. Within fixed income, the focus is on short-term corporate bonds, which are higher-yielding than government bonds and usually hold up better when interest rates are rising.
When assessing corporate financial statements, Simpson takes a hard look at the strength of the balance sheet, which he views as the "heart" of a company. "We keep a keen eye on debt to make sure it's manageable and also look for strong cash flow," he says. "The bottom line is the security of the dividend and potential for dividend growth."
Recent stock purchases have brought down the cash position of the fund to a 3% weight in mid-April from 7.5% at the beginning of 2018. "A lot of companies, including utilities, have been lumped into the category of interest-rate sensitive and punished by the market," Simpson says. "But the small magnitude of interest-rate increases pales in comparison to the rate at which many companies have historically been able to grow their dividends. Investors also benefit from the power of the dividend tax credit."
If a company can grow its dividend at a rate of 5% or 6% a year, stock investors will do a lot better than they could do in bonds or GICs, he says. For example, Fortis Inc.(FTS), a Newfoundland-based electrical utility, has enjoyed an annual dividend growth rate of 6.4%, Simpson says.
"We look for 'dividend champions,' that have a long-term record of dividend increases," says Simpson. "These are the kind of companies we can hold for the long term. We take advantage of any volatility by trimming a bit when they're expensive, and buying more when they're cheaper."
Sentry Canadian Income has a relatively modest portfolio-turnover rate of around 35% a year, Simpson says. Low turnover defers taxable capital gains and reduces trading costs, and can enhance returns.
