Choosing Dividend Stocks Amid Rising Rates

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Colum McKinley

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Colum McKinley, senior portfolio manager, CIBC Asset Management

In a rising rate environment the characteristics of good dividend paying stocks remains the same. We want to continue to look for well managed companies with a sound strategy that are leaders in their business, that have a great management team that are focused on generating long term returns for shareholders. Those are the businesses, we like them in all environments, but they’re the businesses that… What the characteristic that makes them good dividend payers is they generate excess cash flow, excess free cash flow. That free cash flow, after they’ve reinvested in the business, after they’ve paid down debt, they can use that to pay dividends or to buy back shares. To return capital to shareholders.

So even in a rising rate environment, those characteristics continue to remain true. In the Canadian marketplace, there are some great sources of dividend yields today. Two of them that I would highlight, the first is what I’d call a traditional source of solid dividends and that is the Canadian banks. Canadian banks generate dividend yields today of around four and a half percent. We know over time that has consistently grown. They’ve grown those dividends by about in the mid single digits over time. So that has compounded the returns to shareholders. We know they’re well capitalized businesses, so they will be able to weather… We are going to have some economic uncertainty here in the near term, they will be able to weather that. So we don’t worry about the long term issues they could face in their loan books. We know they’re well provisioned and they’ve anticipated challenges and have the balance sheets to navigate any uncertainty. So we think the banks are going to continue to be a great source of dividend income and dividend growth over the coming years for Canadian investors.

The second area is one that I would call a somewhat non traditional source of dividends, and that is energy stocks. If we look at some of the great energy companies in Canada, and I’ll use Canadian National Resources as an example, so CNQ. Energy companies over the last three to five years have found and developed an incredible amount of discipline on their capital programs. So gone are the days when energy companies would continue to drill, drill, drill looking for the next big growth opportunity.

What they’re doing now is they’re managing their existing businesses very prudently. They are investing to sustain growth, but they are taking excess cash flow from excess cash flow being generated because of high commodity prices, but also the discipline and focus on operations that they have today. They’re taking that excess cash flow and they’re returning it to shareholders.

So we’ve had a period of time where the EMP companies, exploration and production companies, have been strong dividend growers. So CNQ as an example pays in excess of 4% dividend today and is in the process of paying a special dividend. We think this is going to be the first of likely many special dividends for CNQ. Management has signaled that as they continue to generate excess cash flow, they’re going to continue to grow their base dividend and return excess capital to shareholders through the special dividends.

So we think the E&P Companies like CNQ, are exceptionally well positioned in a strong commodity environment. If they maintain this discipline that we’re seeing, they’re going to be some of the fastest dividend growers in the Canadian marketplace.

For dividend payers, we’re always conscious of the risks and this is where we focus in and do in depth fundamental analysis on all of the companies that we invest in. We’re looking for unanticipated or future challenges in the business that are going to diminish their ability to increase dividends over time or even challenge today’s dividend.

So part of what we do as investors is look for that margin of safety in the underlying business, focusing on buying good companies, allowing great management to do what they’ve done in the past, but being very conscious of potential risks that could affect the underlying business.