There’s risk in that yield

“Get paid to wait” has become the mantra of many advisors these days who recommend clients load up on dividend- and income-yielding securities that will keep them in the market and pay them until prices recover. But investors need to be wary, as distributions are not as stable as they once were.

Traditionally, income trusts and dividend-yielding equities have offered predictable income distributions and a nice upside potential on the share value of the security. Investors will likely have to choose one or the other for the near term — a stable dividend or upside growth potential.

Most forecasts are calling for earnings growth to be “moderate” at best. Companies may be able to sustain their dividend, but the earnings growth going forward may be small. By the same token, some companies are looking to shore up their capital reserves by cutting distributions.

On Friday, the stock market was taken aback by the announcement that General Electric was cutting its dividend, after previous assurances that it was committed to that payout.

In the income trust market — which well before the downturn had its prices savaged by government plans to increase tax on distributions — payouts have been disappearing quickly. A report by Scotia Capital released last week shows that 40% of the income trusts it tracks have cut distributions since last September.

Getting paid to wait takes on a different tone in this environment. If an investor is not careful, he or she may just be waiting, minus the pay.

There are common shares offering dividend yields at historical highs, but as Juliette John, the senior vice-president of Bissett Investment Management and manager of the Bissett Dividend Income Fund, points out, it’s the market that determines yield. Right now, yields are high simply because the share prices are low.

“It’s really important to remember that it’s the company that sets the dividend; it’s the market that sets the yield. Those two can be fundamentally opposed in terms of how they view stability,” she says. “A company can view a dividend as being entirely stable, but the market may feel otherwise. It is an incredibly challenging environment for many companies. It really has become an open season on companies’ having to reevaluate their dividend policies and look at potentially cutting them.”

Investors in search of yield have to put more work into finding stable sources of income. Maximizing yield and return might require using an active manager who can find those securities that will offer predictable sources of distributions.

“You essentially end up with a bottom-up analysis. You can’t just rely on the Canadian marketplace to pay you a dividend. You have to go sharp-shooting, looking for those companies that are fundamentally stable and are well capitalized enough to pay those distributions,” says Dale Harrison, the co-manager of PH&N’s Dividend Income Fund. “Based on those factors, you cannot look at the majority of the energy and materials sectors. There will be some companies in that space which will obviously continue to pay a distribution. With that, you’re basically making a call on global commodity prices.”

Harrison says dividend stability increases as you move into sectors dominated by monopolies or at least companies that have steady cash flows.

“If safety of distributions is your highest priority, you’re probably going to want to take refuge with corporate bonds, which are certainly attractive these days, or preferred shares,” he says. “From a common equity perspective, you’re going to be looking at holding stock from industries that are fairly stable, such as utilities, telecoms, pipelines and, to a much lesser degree these days, the financials.”

Financials are drawing a lot of attention. Most of Canada’s big financials, including the big five banks and the big insurers, are core holdings of most Canadian portfolios. Many are now offering historically high yields and a history of steady dividends that has gone unchanged since the Second World War.

Unlike utilities and other predictable dividend-yielding stocks, banks also offered more than a decade of steady share-price growth. Investors are cautioned to temper their expectations on the growth potential of these stocks, even if the banks don’t cut their dividends.

“We like companies that offer sustainable free-cash flows and have cash to offer dividends or share buybacks. We’re staying away from the sectors that don’t have those parameters. Financials are tending to be issuers of equities these days, as opposed to buyers,” says Ara Nalbandian, president, Highwater Capital. “I don’t expect meaningful earnings growth over the next few years for many Canadian financials. It’s going to be a struggle to maintain current levels of earnings.”

Harrison points out that Canadian banks are in a difficult position because investors very much view their dividend yield as a sign of their strength. It isn’t outside the realm of possibility that they avoid cutting a dividend to the detriment of preserving capital.

“The Canadian banks haven’t reduced their dividends since World War II. They view them as being indicative of the strength of their core earnings power and their core franchises. Basically, the current mentality has been that to reduce the dividends would be an admission of permanent impairment of the core earnings power of the entity,” he says. “Confidence is so important for a financial intermediary’s business. Cost of funds is related to confidence. Nobody wants to admit weakness. The most visible way to show weakness is to cut your dividend. They don’t have that mentality in the United States, but we certainly have it in Canada.”

John emphasizes that investors who want an iron-clad distribution from the banks should be aware that there are opportunities available in preferred shares, which she holds in her fund.

“CIBC has come to market with preferred shares yielding 6.5% with very attractive reset terms. The common stock is yielding about 8.1%. We completely expect that dividend yield will be lower in the future on the common stock because the share price will increase the level of volatility. Then preferred shares do make a lot of sense: they are less volatile, and they still contribute a fairly decent total return,” she says.

It’s dividends that have historically proven to be the hallmark of a strong company, John says. She believes those companies that can afford to offer dividends through this downturn will be comparatively well positioned going forward.

“Companies that pay dividends are typically those companies that have more stable earnings growth over the course of an entire cycle. Dividend growth is an indicator of a company’s confidence and growth in their future earnings power,” she says. “If an investor holds companies with stable higher earnings growth, they are going to end up with companies that reward investors with higher shareholder value over time.”

(03/02/09)