An Evolved Approach to Dividend Investing

Introduction
An Evolved Approach to Dividend Investing

Dividend investing has long been thought of as a reliable way to have potential growth and predictable income from regular dividend payments. For example, if you purchased 100 shares of a company at $10 per share for a total of $1000. If the company paid out an annual dividend of $0.25, you’d receive $25 in dividend income plus any growth or capital appreciation.

Over the past few months, so much has changed and in a relatively short time. When we think about what’s happened with the markets, we must remind ourselves that we’ve been here before and we’ve recovered. We’ll recover again, invariably with some bumps along the way.

When it comes to recoveries, freshest in our memories is the rebound from the global financial crisis of 2008-2009. Coming out of the ‘09 recovery, one area that really worked well was dividend-paying equities.There are some similarities to that situation today.

During ’09, investors sought out the relative safety of more mature and defensive businesses with strong balance sheets that were oversold. There was also extraordinary monetary policy intervention designed to support markets and push investors further out the risk curve to satisfy their yield objectives. Dividend stocks were an attractive option to fulfill the mandate and showed relative strength as a result.

Chart: Factor returns post 2008

Despite the difference in the catalyst (‘the great lockdown’), we believe there are similar circumstances playing out in the current market environment. Like before, corporate dividends are priced very attractively versus other income sources, such as government and corporate bonds. And of course, we are seeing central banks throw everything at credit markets to keep the wheels turning.

Yet this time around, it’s not just about dividend yields. There is greater risk around the uncertainty of a company’s willingness or ability to pay its dividend. In fact, any company that had been questioning its payout ratio or dividend policy over the past few years will consider “cleaning this risk up” under cover of a COVID-19 related decision.

What we’ve learned

Our research shows stocks that demonstrate persistence in raising their dividends tend to outperform over time. However, when the pandemic hit the markets and the economy, we heavily invested our time scrutinizing our dividend strategies to ensure we complement robust quantitative analysis of historical data with in-depth traditional fundamental analysis in our investment process with our Purpose Core Dividend Fund.

Taking a bottom-up look at the sectors and companies in our investable universe and after analyzing the impact of the changing world on dividend sustainability, here’s what we’ve learned:

  • Buybacks matter for dividend investors as does the ability to generate cash flow to pay out to shareholders
  • 90% of relevant companies had suspended their buyback programs
  • 20% of the companies in our universe had a high risk of suspending dividends

We took our findings and implemented a number of key changes to focus on the sustainability of dividends and we rebalanced the portfolio of our flagship equity income strategy, Purpose Core Dividend Fund.

What to consider for a strategic approach to dividends

Here are a few principle ideas:

  1. Look forward. It’s important to understand we are entering a new business cycle and to consider which industries and businesses will be strong or weak going forward, not just historically. Old economy businesses may be threatened as digitization accelerates, and leaders are making impactful strategic decisions about how businesses are run at a faster pace than ever before. Investors should select a stock for its ability to pay sustainable income today and far into the future.
  2. Don’t base your decisions on yield alone. In the past, it’s been relatively easy to select a company based on its dividend yield; today, there are many other aspects to consider. Having a focused strategy around identifying the quality of a business’s capital structure and its trends in revenue-generation and profitability is a necessary condition to success.
  3. Diversification matters. Ensure you don’t have too much single-stock risk or industry concentration when relying on dividend income. This is particularly true in Canada-only strategies where certain sectors (e.g. information technology or healthcare) are underrepresented. This can force investors to be overexposed to some sectors and into lower quality names in others as compared to investing through a slightly broader mandate.

We’ve seen a great deal of change within sectors such as energy (specifically within the oil patch), consumer discretionary (travel and tourism related businesses have slashed dividends), and even within the more defensive consumer staples sector (will blue chips such as Kraft Heinz and Sysco Foods be in a position to sustain distributions?).

Goldman Sachs recently reported that they expect aggregate dividends to decline by 23% in 2020 after a decade of consistent increases.

With some sectors and businesses affected more than others, security selection is more critical than ever in dividend investing. Today, we need to be incorporating several factors, aside from dividend income, such as earnings and profitability quality, the volatility of a stock and its price momentum.

Many of the results in our analysis are intuitive but there are a few that stand out:

  • Energy - With the collapse in energy prices, dividend investors should be very cautious around exploration and production companies, but midstream companies are probably OK.
  • Consumer Staples - Businesses that sell necessities have a higher chance of dividend sustainability going forward because their revenue is much more consistent.
  • Banks - Canadian Banks look attractive for dividend stability given strong dividend coverage ratios. Despite dividends being stable, banks may frustrate investors from a growth perspective, especially with interest rates likely staying near zero for the next few years.

The last thing that we see as really critical today for any dividend focused investor is risk management, which is something we’ve always placed a great deal of emphasis on here at Purpose.

Why Purpose Core Dividend Fund?

In our core Canadian dividend fund, the pursuit of greater sector-level diversification means using US names where the Canadian economy is underdeveloped or has limited exposure. In all fairness, this has served us well at times, but it’s also meant that sometimes we’ve lagged behind others.

Purpose Dividend Fund versus S&P/TSX Composite Index

Purpose Core Dividend Fund

  • Superior approach to portfolio construction:
  • Broader sector exposure
  • Selective use of US equities where the Canadian market is weak
  • Tax efficiency of a Canadian dividend portfolio

Our world is different this time and having strategies in place requires change. In particular, this includes:

  • Avoid high-yielding businesses that look attractive based exclusively on their backward-looking fundamentals and dividend growth
  • As Canadian investors, understanding that industry diversification matters. It’s critical to have tech, health care, consumer staples and discretionary names and often we have to find these names in the US to attain quality
  • Dividend stocks are still the bedrock of a sound portfolio and will lead in a recovery, but it’s important to recognize that the investment processes which thrived from 2009 to 2019 isn’t enough to avoid the fallout now

A great opportunity exists, but it requires a more holistic approach than just screening for high dividend yield or buying a passive index of the highest yielding companies to take advantage of it.

Author

Purpose Investments

Purpose Investments is where thoughtful Canadians invest. An asset management company with more that $9 billion under management, we create meaningful long-term success by focusing on our core values.

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