Expect to find bank stocks among the holdings of any Canadian dividend and equity income fund, as financial services is by far the largest industry in the domestic market and is dominated by the dividend-rich Big Six. Beyond that, these funds – including some of the best performers – invest in a full range of industries, and not just in the traditional go-to sectors that offer income from equities.
Canadian dividend funds, like other domestic diversified equity fund categories, focus on total return – both dividends and capital gains. Above-average dividend yields, which are the defining characteristic of Canadian dividend funds, have proved to be a prescription for very competitive total returns compared with the much larger Canadian equity category.
Over the five years ended Jan. 31, the two categories were virtually neck and neck in performance. The average annual return for Canadian dividend funds was 4.8%, according to Morningstar Canada, versus 4.9% for Canadian equity funds. But over 10 years, Canadian dividend’s 9% average return surpassed Canadian equity’s 8.7%. Canadian dividend funds enjoy a more flexible geographical mandate, requiring only 70% Canadian equities to meet the category definition. For Canadian equity, 90% of the portfolio must be Canadian.
Not surprising, bank stocks are among the largest holdings in Beutel Goodman Canadian Dividend Fund. Financial services, recently at 39%, is the most heavily weighted industry in the fund.
“I think it would be difficult to build a dividend portfolio that is substantially underweighted in financials and still drive the characteristics we’re looking for,” says Steve Arpin, vice president, Canadian equities, at Beutel Goodman & Co. Ltd. in Toronto.
Arpin co-manages the $550-million Beutel fund, which is among the best long-term performers in its peer group, along with Toronto-based Mark Thomson, Beutel’s managing director of equities. At some point, Arpin adds, valuations of the banks could become a challenge. But for now, “the great thing is that they’re all really inexpensive.”
What is surprising for the Beutel fund’s category is that at the end of January, the fund, rated as four stars by Morningstar Canada, held no pipeline or utilities stocks, or any real estate investment trusts (REITs).
“We do not have to be in any sector if we choose not to be,” says Arpin. “We’re willing to not own significant dividend-paying areas of the market if we view them as not having sufficient discounts to business value, such that we can control our risk and generate that 50% return we’re looking for over a three-year period.”
Beutel’s portfolio managers will sell anywhere from one-third to all of a holding once a stock reaches the firm’s three-year total return target. This “sell” discipline applies to all of Beutel’s equity funds’ mandates.
A stock must yield at least 1.5% at the time of purchase to be held in Beutel Goodman Canadian Dividend. For the portfolio as a whole, the rolling yield on a three-year basis must be higher than that of the S&P/TSX composite index. Although the portfolio managers have the flexibility to invest in shares of smaller companies, the portfolio is very much large-cap in nature, and concentrated in fewer than 30 stocks.
Discounted cash flow is a key metric used by Beutel’s portfolio managers when selecting high- quality companies with strong competitive positions and shares must be trading below Beutel’s estimate of the value of the business. In the ailing energy sector, the Beutel fund holds shares in Calgary-based Canadian Natural Resources Ltd., a major oil and gas producer with what Arpin describes as having “ultra-long duration” and low-cost reserves in Alberta’s oilsands. Regarding energy stocks, he says, “When we see a sufficient discount to our estimation of their asset value, we will own them. But we’ve been, in general, underweighted in energy in Canada.”
Beutel’s portfolio managers do not necessarily select out-of-favour companies. For example, the Beutel fund holds Rogers Communications Inc., one of the strongest performers last year in what was generally a losing year for Canadian stocks.
“Notwithstanding the fact that Rogers has been an outperformer, we think it’s really the best in class of those communications companies in Canada,” Arpin says. “It just has a really high-quality network, it’s driving revenue growth and operating leverage. And [the stock] has a relatively low payout ratio relative to the rest of the companies. So there’s more ability for the firm to continue to grow dividends.”
The Beutel fund stays close to its 30% limit on foreign content and so has zero exposure to the marijuana-dominated Canadian life sciences sector. Instead, the portfolio managers invested overseas in London-based pharmaceuticals giant GlaxoSmithKline PLC. That company, one of the largest dividend-paying companies in the U.K., also provides vaccines and consumer health products.
Arpin says investing outside Canada enhances the quality of the Beutel fund’s portfolio and provides holdings in sectors in which quality businesses are lacking in Canada. The portfolio managers also may engage in what Arpin calls “valuation arbitrage,” exemplified by the fund’s holding in New York-based wireless giant Verizon Communications Inc. “The valuation of Verizon and the franchise quality,” he says, “are attractive versus the pricing that’s available to us right now in Canada.”
Jennifer McClelland, vice president of Toronto-based RBC Global Asset Management Inc. and lead portfolio manager of RBC Canadian Equity Income Fund, wants to ensure that the $3.1-billion fund is well diversified by sector and by individual company. She says the financial services industry and the energy sector – Canada’s two biggest stock categories – will always be significant components of the RBC fund’s portfolio because the firm’s sector constraints for the fund require the portfolio managers to stay within plus or minus 10 percentage points of the S&P/TSX composite index weightings.
“Outside of financials and energy, there aren’t many sector [and industry] holdings that are over 10%,” McClelland says. “There’s a lot of leeway around there within the mandate.”
For the RBC fund’s portfolio as a whole, which currently holds about 90 names, McClelland aims for a yield that’s more than 1.25 times the yield of the S&P/TSX composite index. But there’s no minimum yield required for any one holding. This flexibility “allows you to own some names and some sectors that don’t have big dividend payers,” McClelland says.
In fact, the RBC fund can hold individual stocks that currently don’t pay dividends, provided “there’s a path to a dividend in the near future.”
For example, says McClelland, the RBC fund bought shares in its long-time holding in Boralex Inc. before the Montreal-based developer and operator of renewabel energy projects began paying dividends. The early purchase of shares in Boralex by the RBC fund’s portfolio managers, anticipating that the growing company would pay a dividend, proved to be a bargain.
McClelland focuses on companies with dividend growth that is underpinned by very visible and growing cash-flow streams in order to mitigate the risk of rising interest rates: “Companies that can continue to execute on their growth strategies, even as rates go higher, and are not as restricted are the types of companies we look for,” she says.
Enbridge Inc., the Calgary-based pipeline operator, is “a classic name in a rising-rate environment right now for us, and a big name in Canada,” McClelland says. She likes that the company has long-term contracts that will support dividend growth. “There’s no commodity risk within its cash-flow stream.”
Among oil and gas producers, McClelland’s top holding in the RBC fund is Calgary-based Suncor Energy Inc., which has both upstream and refining operations. “It is delivering double-digit free cash-flow yields at very weak commodities prices. It has a dividend model that’s sustainable, regardless of the worst-case scenario in commodity prices.”
About 10% of the RBC fund portfolio is held in a basket of about a dozen REITs, which McClelland regards as a good diversification tool: “Given the size of the fund, I like to have a pretty large collection of them to make sure I can build a healthy position for the overall group.”
Although the RBC fund, rated four stars by Morningstar Canada, isn’t far from having a purely Canadian mandate, its portfolio includes some foreign companies. McClelland emphasizes industries such as health care, technology and consumer goods, in which there aren’t a lot of high-quality, dividend-paying companies to choose from in Canada.
Among the RBC fund’s non-Canadian holdings is Deerfield, Ill.-based Mondelez International Inc., a global provider of snack foods. One of that company’s attractions, says McClelland, is that about 40% of its revenue is derived from fast-growing, developing markets.
The RBC fund’s largest single industry weighting is financial services, led by banks, with Royal Bank of Canada, Toronto-Dominion Bank and Bank of Nova Scotia among the fund’s recent top holdings.
“I think the banks are pretty reasonably valued, given the environment they’re facing today,” McClelland says. “We’re expecting a slowdown in consumer lending, a slowdown in the economy, and their business models are pretty well positioned for that.” She cites “very solid balance sheets” and the banks’ pursuit of growth opportunities outside Canada.