By Les Stelmach and Ryan Crowther
Franklin Bissett Investment Management
It’s no secret that yields on fixed income investments have been in a prolonged slump for decades, challenging both individual investors to meet their income needs and institutional investors like pension funds and insurance companies to deliver on their obligations to retirees.
While some investors have moved further out the fixed income risk spectrum in pursuit of higher yields, others are diversifying their income sources by adding to their investments in shares of dividend-paying companies.
Dividends are playing catch-up
Despite recovering economic conditions, dividend-paying stocks lagged the overall market in 2021. Given continued uncertainties directly and indirectly related to the COVID-19 pandemic, dividend growth in general reflected some conservatism. Many factors influencing earnings growth in 2021 were sector-specific. Some industries continued to deal with subdued demand compared to pre-pandemic levels, while in other cases, regulators prohibited dividend increases at the onset of the pandemic.
Lately, however, dividend payers’ shares have performed well for several reasons:
- Despite rising inflation, supply-chain pressures and labour shortages, corporate fundamentals have generally remained supportive as revenues, earnings and profit margins have continued to perform well.
- Valuations for many dividend stocks are firmly anchored to those fundamentals, insulating them somewhat from market concerns over valuations in a higher-rate environment.
- In addition to many companies initiating, restoring or raising their dividend payouts, the share prices of many dividend-paying stocks benefited from market momentum in a “best of both worlds” environment.
- Market sentiment has shifted in response to signals from both the U.S. Federal Reserve and the Bank of Canada indicating a faster pace of interest rate increases in combination with quantitative tightening.
Dividends likely to grow
The average earnings per share growth for the Canadian S&P/TSX Composite and the U.S. S&P 500 Indices spiked last year. Dividend increases were broad-based throughout the year. Barring any major economic setbacks, we expect continued steady dividend growth from companies across many sectors. Average cash as a percentage of total assets held by constituents of the S&P/TSX Composite Index is at levels not seen in more than 20 years: another positive development for dividend growth.
In Canada, we are finding certain sectors particularly attractive:
Financials: Banks are an example of dividend growth held back by regulators from the pandemic’s onset. In 2021, even though earnings grew, dividends were temporarily constrained; however, this restriction was lifted last November. Most recently, we have seen the Canadian banks increase dividends between 10% and 25%, but we believe there could be room for further increases. Banks retain excess capital, and at the very least, we believe the group will resume their annual pattern of increases from this point. In our view, Canadian banks are on very solid footing and offer some of the most attractive valuations.
Commodity-related: Commodity prices are high as economic activity resumes from pandemic lows, which is positive for the energy and materials sectors, and by extension, industrials. We have seen a remarkable recovery in oil prices since the precipitous drop in the spring of 2020 when the global economy shut down in response to the spread of COVID-19. At that time, a number of energy stocks had their dividends cut as the depth and duration of the economic downturn were unknown.
Since then, the oil and gas sector has staged a dramatic comeback, with higher prices boosting cash flows. Along with the recovery of prices, we also have seen a significant pick-up in dividends. Companies are employing various dividend strategies. Some prefer methodical increases to the base dividend level at a rate sustainable under a range of commodity price scenarios; others are considering variable dividends or periodic special dividend payments on top of the base dividend level. We believe boards and management teams are exercising a certain degree of caution to avoid being vulnerable if oil or gas prices experience a sharp decline in the future.
Real estate: In certain property categories (primarily retail), real estate investment trusts (REITs) had to absorb higher vacancies and deferred rent payments from tenants as stores were temporarily closed due to pandemic restrictions. These stresses often manifested as flat cash distribution profiles or, in some cases, temporary reductions in distributions. Although it’s too early to be certain of a return to historical norms across all property classes, we are seeing encouraging signs in rents and occupancy, and we note some REITs are again raising distributions.
Utilities and telecoms have maintained their dividends throughout the pandemic and we expect their dividend growth trajectories will be in line with historical experience.
Risks and opportunities
Consistent and growing dividends are characteristic of higher-quality, established companies that by definition tend to sit comparatively lower on the equity risk spectrum. It’s important to remember that like any stock, they are subject to equity market levels of volatility; but stable to growing dividends can reduce part of that risk as investors continue to receive income distributions even in a volatile market. In a rising market environment, investors could benefit both from the dividend yield and a higher stock price.
Risks to dividends vary with the different businesses. Higher inflation could act as a drag, but for the most part, the areas of the market we focus on either have the ability to pass through cost inflation (REITs, utilities, telecom) or have products with sales prices correlated with inflation (commodities).
Will rising interest rates diminish the appeal of dividend stocks? Not in our view. When assessing prospective holdings for our dividend portfolios, we seek long-term secular growth tailwinds. At the same time, we are mindful of financial leverage and balance sheet structure, which can help mitigate the impact on dividends from rising interest rates. We would still expect a growing trajectory of earnings and cash flows to underpin dividend growth over time. For regulated companies with higher levels of debt in the capital structure ― such as utilities ― higher rates generally would be captured in regulated return frameworks.
*Source: Morningstar Research Inc., as of December 31, 2021. All rights reserved.
FRANKLIN TEMPLETON DIVIDEND FUNDS
Franklin Bissett Dividend Income Fund This 4-star Morningstar-rated* fund aims to provide high current income by investing primarily in Canadian and American dividend-paying preferred and common stocks and, from time to time, bonds up to a maximum of 25% of the fund’s total assets. The fund may invest in foreign equity or fixed-income securities. Franklin Bissett Canadian Dividend Fund The fund seeks long-term capital appreciation by investing primarily in dividend-paying or income-producing Canadian securities, including common shares, income trust units and preferred shares. Portfolio managers look for quality companies at reasonable prices that have a proven ability to deliver a consistent and growing level of dividends over time.
OTHER DIVIDEND-ORIENTED FUNDS AVAILABLE TO CANADIAN INVESTORS
Franklin U.S. Rising Dividends Fund This fund invests in companies with a track record of substantial and sustainable dividend growth. Periods of market uncertainty often highlight the importance of investing in high-quality companies led by strong, experienced management. Franklin Liberty QT Global Dividend Index ETF (FLGD) This exchange-traded fund seeks to provide investment results that closely correspond, before fees and expenses, to the performance of its corresponding underlying index, LibertyQ Global Dividend Index. The underlying LibertyQ Global Dividend Index includes stocks from developed and emerging market countries with high and persistent dividend income that have favourable exposure to the quality investment-style factor.
Les Stelmach, CFA, is a senior vice president and portfolio manager at Franklin Bissett Investment Management, and based in Calgary. He is co-manager of Franklin Bissett Energy Corporate Class (2011), Franklin Bissett Canadian Dividend Fund (2012) and Franklin Bissett Dividend Income Fund (2012). Mr. Stelmach’s analyst responsibilities include coverage of the energy sector.
Ryan Crowther, CFA, is a vice president, portfolio manager at Bissett Investment Management is co-lead manager of the Bissett Dividend Strategies, including Bissett Canadian Dividend Fund (2011) and Bissett Dividend Income Fund (2011). Mr. Crowther’s analyst responsibilities include coverage of the Materials sector. Mr. Crowther joined Bissett in 2008 as an equity analyst and was appointed to his current role in June 2011.
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