Canada and China Grow Dividends in Q32020

The coronavirus pandemic disrupted life everywhere, even reaching members of an endangered tribe in the secluded Andaman Islands with some testing positive for COVID-19. It’s concerning for investors to see this kind of reach, but should investors be worried about severity? Not as much.

My colleague Ian Tam, who is the Director of Investment Research for Morningstar Canada, found that using the concept of the “pain index”, the COVID-19 bear market goes down in history as one of the least painful on record, lasting a total of about 120 trading days with a maximum drawdown of about 34%.

Though stocks have recovered, the impact of the virus on markets was uneven and saw dividends suffer disproportionately. The August 2020 Janus Henderson Global Dividend Index report found that global dividends fell by UD$108.1 billion to US$382.2 billion in the second quarter of 2020. The headline 22% decline was the worst since the index launched in 2009. Europe and the UK were worst affected, but North American dividends were more resilient, with Canada holding the region up. Canada and China were the only two major countries to post underlying dividend growth in Q2.

What Worked for Canada?
“In Canada, where the pandemic has been milder than for its larger neighbour, the picture was even stronger. Only three companies in our index cut or cancelled dividends” said Jane Shoemake, Investment Director, Global Equity Income at Janus Henderson. 

But it isn’t as simple as that.

“When you say that Canadian dividends are rising, it is imperative to ask in what sectors or industries, because energy has not seen growth, in fact, there are cuts. But if you look at non-commodity, non-cyclical sectors, then yes, there has been some growth,” said Srikanth Iyer, Managing Director and Head of Systematic Strategies at Guardian Capital.

Jon Palfrey, Senior Vice President & Portfolio Manager at Leith Wheeler Investment Counsel agrees with Iyer. “Most of the dividend growth in the TSX has been concentrated in a few sectors over the past year. As you might expect, most banks and insurers have managed to continue to grow their dividends, with the Big 5 on the order of about 5 to 8%,” he warned.

“The big question is what will happen in the US and Canada in Q4, when companies reset their dividend payments for the following four quarters,” Shoemake said.

That is a question on most investors’ minds – what will happen next? Another question that also causes some worry, is will dividends be cut?

The Storm Has Passed for Dividend Cuts
Of the three companies in the Janus Henderson index that cut dividends, Shoemake notes that the largest was Suncor Energy (SU), but adds that this was unrelated to COVID-19 – the company warned on profits last year and has halved its payout since. Canadian banks in particular have so far proved very resilient and have not been under pressure from their regulator to cut payouts like those in Europe, the UK, Australia and other parts of the world. On the contrary, most Canadian banks increased their dividends. Canada’s total payout rose 4.1% on an underlying basis, once lower special dividends and a weaker Canadian dollar were factored in,” she says. 

“The storm has passed when it comes to dividend cuts,” Iyer says, adding that capital has been reallocated to companies and businesses that are well-positioned to do well going ahead, towards areas like digitization. Iyer is confident that companies that embrace digitalization of their processes will benefit and be the dividend growers of the future. “10 years from now, I expect that there will be a change of guard. The dividend growers of the future will not be the dividend payers of today, and I expect Technology to be a powerhouse,” he says.

Leith Wheeler’s Mike Wallberg points out that it’s tough to forecast cuts but adds that management teams and boards are generally incentivized, when thrust into crises as they found themselves in March and April, to act quickly with respect to dividend cuts.

“There are a few reasons for this. One is that it is prudent to conserve cash when the outlook for the business has been altered dramatically or becomes opaque. The other is that in “normal” times, dividends are more than cash for investors – they contain a signalling element. A dividend cut in otherwise normal times may ‘signal’ a negative outlook for the company and potentially a black mark for management. This is why companies strive so hard not to cut dividends if at all possible,” Wallberg explains, adding that when markets are tumbling, cash flow is drying up and everyone else is cutting, it is generally the optimal time to cut if you think you’ll need to.

“For that reason, it’s likely that the majority of the major cuts have already come. Should we see a dramatic second wave and with it, a return to the economic shutdown of round one, however, all bets are off,” he adds. He also notes that the federal wage subsidy program has helped buoy the fortunes of the industrial economy and most companies actually reported better-than-expected results in the recent quarter.

This is not to say that risks are non-existent.

Risks Still Exist
Janus Henderson’s best case now sees global dividends falling 19% in 2020 on an underlying basis, equivalent to a 17% headline decline, yielding a best-case total of US$1.18 trillion, while the worst-case sees an underlying fall of 25%, equivalent to a 23% headline decline. That would generate a total global payout of US$1.10 trillion. “This means that not only has the uncertainty for the year diminished but the mid-point estimate has improved by two percentage points too. Even so, 2020 will be the worst year for dividends since the global financial crisis,” Shoemake says. 

Iyer points to his own process to help identify risks. He manages the Guardian Capital Global Dividend fund and the Horizons Active Global Dividend ETF. “When deciding on dividend players, we look for consistency in top-line revenue growth and overall margin strength, this helps us keep an eye on what’s likely to happen with the dividends,” he said. He also points out that it is important to look for specific sub-industries within sectors, and then evaluate each subsector, because a sector as a whole may not be all good or all bad. “For example, within industrials, transportation logistics is good, airlines are bad. You need to be careful in deciding where you stay long, and what you avoid,” he says.  

He looks at Canadian banks as an example. “Laurentian Bank of Canada (LB) did cut dividends, but that was the only one. We have an AI-based system that predicts the likelihood of dividend cuts. At the peak of the COVID-19 market downturn, around March-April, there was a 50% chance that Canadian banks could cut dividends. That has come down to 20-25%, though pre-COVID, that rate was around 3-4%. Which the threat of cuts is certainly elevated as compared to pre-COVID levels, that threat id coming down rapidly. Also, remember that a probability of a cut is not a certainty. This number indicates the distress in financial services, but the stress level is coming down fast. The strongest of the banks are Royal Bank (RY) and the Toronto Dominion Bank (TD). The probability of a dividend cut has come down from 40% for Royal Bank to around 20.2% currently, while for TD, it has come down from between 45% to 50% to around 27-28% at present. While that is still high as an indicator of distress, there has been and continues to be a drop in stress levels,” he explains.

Top Dividend Sector and Stock Picks
For strong dividends going ahead, Iyer likes top tier banks, especially RBC and TD, Canadian tech companies, and industrials. The sectors he feels should be avoided are consumer discretionary, energy, office-based infrastructure, commodities and leisure, “I would call them no-goes,” Iyer said. 

His top dividend pick is Open Text Corp (OTEX). “Open Text could be one of the Canadian FAANGs. I can’t believe how strong its cash flow is. We expect OTEX to have a forward earnings growth of 16.8%. It has a dividend yield of 1.2%, and we forecast dividend growth at 3-4%. Our models indicate the probability of a dividend cut at 10%. We like the company’s overall characteristics, and at present, while it is above our target price, we believe it has reasonable valuation as compared to its U.S. peers.,” he says.

Next is Enghouse Systems (ENGH). “This enterprise software company fits well within our digitization thesis. We forecast earnings at 20%, it has strong overall margins and has a dividend yield of 0.75%. Its dividend growth last year was 22%, and we project growth of between 10-11% this year. It has a 6% probability of a dividend cut,” he says.

Finally, his last pick is Telus (T). “Within telecom, we like Telus. We think the company is well-positioned for 5G, and has a story. In a word, Telus is resilient. In terms of a dividend cut, pre-COVID the probability was 2%, it rose to a peak of 25% and is now between 15-16%,” he says. Telus is the only one of his picks covered by Morningstar analysts. It is currently trading near our analyst Matthew Dolgin’s fair value estimate. “Telus’ second-quarter revenue didn’t significantly differ from our forecast, and its EBITDA margins were lower than we projected. We expect many of the COVID-19-induced headwinds to persist throughout 2020, so we’re maintaining our $26 fair value estimate, leaving Telus modestly undervalued,” Dolgin says.

The Leith Wheeler Canadian Dividend Fund has a total return focus, as Palfrey believes that overly focusing on yield can lead you to companies that overpromise on payouts, and so in the strain to maintain them, they have to compromise on growth. Value traps often fall in this bucket. “The total return approach means share price growth is a key focus – so we’re looking for quality businesses run by capable, aligned management teams who are good at allocating capital to generate a high return on invested capital. Perhaps somewhat counterintuitively, this sometimes means owning companies that carry a lower dividend because they’re so good at reinvesting cash to grow their business – and we’d rather they do that,” he says.

“Examples of excellent allocators of capital, which we own in the fund, are Toromont Industries (TIH), Royal Bank, Canadian National Railway (CNR), and Hydro One (H). For investors looking specifically at yield, banks and life insurers are trading at slightly higher than normal yields relative to their history, and are more likely than the average TSX company to be able to maintain them, so you may want to consider Financials,” he adds