Adirondack chairs at shore of Lake of Two Rivers, Ontario

Canadian investors who seek potential capital appreciation in combination with a consistent stream of income from equities generally are comfortable with investing in dividend and income equity funds.

These funds offer the best of all worlds: the potential to benefit from gains in the equities without the same level of volatility typically associated with the broad-based equities market; and a higher level of income than that from traditional fixed-income investments in the current low interest rate environment.

That’s because dividend and income equity funds usually invest in the stocks of large, established companies that have steady revenue streams and cash flow, which enables those companies to pay consistent to increasing dividends. These stocks tend to be more stable and exhibit a lower level of volatility than is found in the broad market, thus providing greater downside protection during market downturns. In addition, dividend and income equity fund payouts receive favourable tax treatment compared with fixed-income distributions.

Les Stelmach, senior vice president and portfolio manager with Calgary-based Franklin Bissett Investment Management, a unit of Franklin Templeton Investments Corp., and manager of Franklin Bissett Canadian Dividend Fund, says the fund’s unitholders expect equity-like returns rather than low, fixed-income returns.

“There’s also an expectation of lower volatility over the course of time,” Stelmach says, compared with the S & P/TSX composite index because the fund is not a “straight-up equity fund.”

Stelmach, a “growth at a reasonable price” portfolio manager, uses a fundamental, bottom-up style to select stocks. “We don’t try to make big macroeconomic forecasts,” he says, “but rather tailor the portfolio to fit by looking at companies on their own merit that are trading at a discount to their intrinsic value.”

The Bissett fund invests solely in Canadian dividend-paying equities, even though its mandate permits investments in U.S. and foreign equities. All of the stocks in the portfolio were paying a dividend at the time they were acquired, with the expectation that they will continue to pay dividends at the current or higher rate over time. “The fund itself has a superior dividend yield to its TSX composite [index] benchmark,” Stelmach says.

To mitigate risk, Stelmach says, the Bissett fund is required to invest in a minimum of seven of the 11 sectors on the TSX at any one time. “Today, the fund is invested in eight sectors,” he says. At the end of 2019, the largest exposure was in financials, at 20 %. Other allocations were energy (17 %), utilities (16 %), consumer staples (10 %), communication services (9 %), real estate (8 %), industrials (6 %) and materials (5 %). The remainder was in cash.

One of the Bissett fund’s largest holdings is Enbridge Inc., which Stelmach regards as “a premier North American energy infrastructure company with a high degree of predictability to its business.” The company generates free cash flow that allows it to pay a current dividend yield near 6 %. Enbridge recently acquired Texas-based Spectra Energy Corp., which has given Enbridge “a really good footprint” in the U.S., says Stelmach.

Another major holding is Canadian National Railway (CN), an oligopoly in the North American railways industry that has very few competitors. Stelmach says the barriers to entry in the railways space are high because of high replacement costs and regulatory hurdles.

“It would almost be very difficult to foresee a situation in which a new company would form with the expectations of building a cross-national railway. I just don’t think it would happen, so that gives [CN] a lot of margin protection.”

Over the past year, Stelmach added Canadian Natural Resources Ltd. (CNRL) to the Bissett fund’s holdings “on expectations that the company is a real opportunistic acquirer of assets.” He says CNRL has an excellent operating record in terms of efficiency, which allows the company to generate significant free cash flow, which in turn is used to acquire more assets.

“So, in times of difficulty in the North American energy market,” Stelmach says, “[CNRL] is ready to acquire assets at discount — something that we like.”

CNRL also has an unblemished record of paying dividends to shareholders and has raised its dividend every year for the past couple of decades.

“Although the company operates in a sector that can sometimes be more volatile,” Stelmach says, “its size and operating and geographical diversification give it a lot of stability.”

On the other hand, Stelmach sold the Bissett fund’s holdings in Restaurant Brands International Inc. (RBI) over the past year. “We’ve seen the share price and dividend increase significantly,” he says, “but we had become increasingly concerned over not just one thing but the cumulative effects of changes in business operations, particularly at the Tim Hortons operations.”

Stelmach decided that the “shares no longer traded at a significant discount to what we thought they were worth” and divested the position. Recent management changes and messages from the company could cause Stelmach to reconsider investing in RBI in the future.

Don Newman, portfolio manager with Fidelity Investments Canada ULC in Toronto and manager of Fidelity Dividend Class Series fund, says the fund invests primarily in companies that pay dividends or are expected to pay dividends as well as fixed-income securities and other securities that are expected to distribute income. The fund does so by investing directly in securities or by investing in units of other funds.

Newman uses a bottom-up, fundamental approach for stock selection and portfolio construction. The Fidelity fund invests in quality companies trading at reasonable valuations that he believes have strong potential to maintain and grow their dividends over time.

Newman places a high value on the quality of a company, its ability to generate free cash flow and evidence of improving earning power. Among the most important factors in security evaluation, he says, is the strength of the company’s balance sheet. He manages his “active allocations within the [Fidelity fund’s] portfolio to ensure that sector or industry allocation will not overwhelm return contribution from security selection.”

Newman favours “fundamentally strong companies with solid growth prospects that trade below their intrinsic value.” His investment style takes into consideration the cyclical nature of market and economic cycles. He emphasizes earnings growth potential in early- and mid-cycle periods, while focusing on valuation in later-cycle periods and periods of elevated downside risk.

Newman typically sells positions on indications of a material change in fundamentals or when valuation is, in his view, fully realized. He also may sell or reduce investments in certain stocks if he finds a more compelling, better valued substitute investment.

The Fidelity fund’s current asset mix comprises 57 % in Canadian equities, 10.5 % in foreign equities, 11.3 % in fixed-income securities and the remainder in cash. The fund’s portfolio has 27.3 % exposure to financials, 19.3 % to energy, 17.8 % to utilities, 8.7 % to communication services, 7.5 % to real estate, 7 % to materials, 3.2 % to consumer discretionary, 2.9 % to information technology, 2.2 % to consumer staples, 2.1 % to health care and 2 % to industrials.

The Fidelity fund’s benchmark is a combination of indexes: the MSCI Canada value capped index, comprising 75 % of the benchmark; a blend of four S & P/TSX industry groups (telecom services, utilities, oil & gas storage and transportation, and REITs [market cap weighted]), at 15 %; the FTSE Canada universe bond index, at 5 %;, and the S & P U.S. REIT index (Hedged CAD), at 5 %.

One of the Fidelity fund’s major holdings is Toronto-Dominion Bank (TD), which, Newman says, “is a high-quality bank led by a good management team with a good track record at risk management. [TD is] more diversified outside of Canada than some of its peers.”

Another major holding is TC Energy Corp., a pipeline company that Newman views as “a defensive business with a stable growth outlook that has a lower risk profile of assets than that of its peers.” TC Energy also has a history of increasing its dividends and currently provides a 4.2 % dividend yield, which is higher than the average dividend yield of stocks on the TSX.

Over the past year, Newman has increased exposure to the utilities sector, as he found attractive entry points with a few stocks that he believes to be undervalued relative to their future potential. “Although exposure to the utilities sector was increased over the past 12 months, and the fund has a higher-than-benchmark exposure,” Newman says, “sector weightings are driven by fundamental stock selection, as opposed to relative sector bets.”

Over the past year, AltaGas Ltd. was added to the Fidelity fund’s holdings. Newman believes that the company’s management team can execute well and improve the company’s fundamentals over time.

Over the same period, the Fidelity fund’s position in Edison International was sold because its “risk/reward profile” became less attractive and better opportunities were found elsewhere.

Looking ahead, Newman remains cautious about the overall stock market environment: “The global economy has been decelerating, with earnings growth expectations having moderated from last year.”

Newman adds that stock markets have seen expansion of multiples, as opposed to earnings growth. “That means when shareholders realize that earnings cannot grow to their high expectations,” he says, “earnings expectations will have to come down.”

The resulting contraction of multiples will intensify volatility, says Newman, who adds: “When expected returns are lower than average, the [Fidelity fund] portfolio’s risk will be kept below average.”