As we move to the end of the year, investors often take time to examine their portfolios, and make decisions on whether to weed out certain investments, hold others, or even add to a few.
One thing that almost all investors check for? Dividends. Younger investors look for dividends to reinvest and grow their portfolios, while investors close to retirement, or recent retirees, use the cash flow from dividends as an additional income stream.
As a Canadian investor, 2018 has been a good year for dividends so far. The third quarter was record-breaking as dividends jumped 11.2% to US$10.2 billion on an underlying basis.
“Earnings growth for the TSX is expected to be 17% in 2018E, which has translated into strong dividend increases this year, encouragingly the dividend increases have been somewhat broad based as opposed to being concentrated in only one particular sector”, says Vivian Lo, senior portfolio manager, equities at Foresters Asset Management, who manages the Gold-rated imaxx Canadian Dividend Plus Fund Series F0.
While dividends have broken records in 2018, most experts expect payouts to grow at a slower pace next year.
“Current consensus expectations for TSX earnings growth is roughly 12% for 2019E, absent a major economic pullback or recession, however, earnings face mounting risks as the global economy slows and trade disputes continue to create uncertainty”, Lo warns.
She points out that in a rising interest rate environment companies may choose to re-prioritize the debt reduction, capital expenditures may increase to offset labour shortages, while energy-related capex is expected to remain muted.
“Some companies may prefer share buybacks over dividend increases as Canadian stock prices have declined over the last year despite rising earnings, resulting in some very low valuations in some cases. These factors combined with a slowing from 2018 earnings growth cause us to expect the pace and/or magnitude of the dividend increases to slow as well”, she notes.
We recently discussed US dividend stocks and today, we focus on Canadian stocks with a potential to grow their dividends.
“We focus on dividend growers in our portfolio as these companies tend to be high quality with a history of growing their earnings and cash flows, and also generally perform well both in periods of market strength as well as during periods of market volatility”, Lo says.
She further explains that from a risk mitigation perspective, dividends smooth out returns over the long term and provide downside support. Lo does not focus simply on high dividend yields, because she believes if the underlying fundamental operations of the company cannot support the high dividend, eventually it will be cut. High yielding companies are usually concentrated with a few sectors whereas dividend growers have a broader representation across different sectors, providing greater portfolio diversification.
Energy and Canadian banks in focus
The imaxx Canadian Dividend Plus fund series is overweight on Energy, with an allocation of a little over 22% to the sector, against a category average of a little over 17%.
“While we have been overweight the energy sector we have had limited exposure to Canadian crude oil or natural gas prices. We continue to have greater exposure to refiners and integrateds”, Lo says.
She expects the 2020 global maritime shipping rules to benefit refiners, and to play this theme, the fund owns US-based Marathon Petroleum (MPC). “The stock trades at a substantial discount to our estimate of fair value and does not reflect potential synergies and economies of scale to be realized as the operations are merged”, she says.
She adds that the fund has had little exposure to Canadian oil companies due to the large price differential between global and Canadian crude. “We do own Canadian Natural (CNQ), however, as it continues to demonstrate strong production growth, good management and admirable environmental stewardship” she says.
Another sector Lo likes is Canadian banks, as most provide dividend yields of over 4%, and manage to grow earnings by the mid to high single digits annually.
“We especially like The Toronto Dominion Bank (TD) and Royal Bank of Canada (RB), both of which are at reasonable valuations”, she says, pointing out that current weakness aside, they are both core holdings on a 2 to 5-year time horizon.
She is cautious on the Canadian consumer because despite good employment levels, consumers carry elevated household debt levels. “This is concerning as the Bank of Canada continues on its pace of hiking interest rates and reflective in our underexposure to this sector in Canada”, she notes.
Top stock picks
Lo’s first pick is Pinnacle Renewable Holdings (PL). The company is one of the world’s leading manufacturers and distributors of industrial wood pellets, which are used by global utilities and power generators. It has a 4.4% dividend yield.
“Pinnacle Renewables is in a strong competitive position as it is 1 of only 3 global suppliers of industrial wood pellets with low cost fibre source and a diversified network. Its long-term contracts (average 7+ years) provide predictable and visible cash flow streams”, Lo says, adding that it is trading at an attractive valuation level of 8x 2019e EV/EBITDA with its port asset and contracted cashflows providing good downside support.
She also likes three-star life insurer Manulife Financial Corp (MFC), which has a 4.6% dividend yield. It operates in the US, Canada and Asia.
“The company is trading at an attractive valuation near historical lows of 7.3x earnings and 1x book value. It recently raised its dividend by 14% and announced a share buyback for up to 2% of its shares outstanding. We expect future increases to continue in line with Manulife’s mid-term EPS growth target of 10%-12%”, Lo says.
Her third pick is funeral home service and cemeteries company Park Lawn Corp (PLC), which has a 2.1% dividend yield.
Lo likes it because “Death and taxes are the two unavoidable things in life, and Park Lawn provides good visibility on the former”. She notes that it adds good diversification to their portfolio as it is generally uncorrelated to other holdings. It’s also one of the few investment options in this industry. Additionally, the undeveloped land inventory also provides some asset protection.
