Rising valuations pose equity-income challenge

Guardian's Michele Robitaille trims energy holdings.

Sonita Horvitch 14 May, 2014 | 6:00PM
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Michele Robitaille, managing director and equity-income specialist at Guardian Capital LP, says that the environment for dividend-paying securities should continue to be positive this year, as interest rates are likely to remain benign.

"Ultimately rates will rise, but the long-term case for dividend payers remains intact," she says. "Dividends have been a larger and more reliable contributor to stock returns than price appreciation over the past 40 years." Also, she says, those businesses that are growing their dividends "will continue to be well placed in a rising interest rate environment."

The shorter-term challenge in the equity-income space, Robitaille says, is that valuations across the board have risen sharply over the past couple of quarters. This covers "everything from real estate investment trusts (REITs) to banks to utilities." Energy producers and more particularly energy-infrastructure companies have also seen valuations increase substantially, she says. "Energy ran hard in the first quarter of 2014 and energy-infrastructure stocks ran even harder."

Currently, says Robitaille, valuations on REITs, an important focus for Guardian's equity-income team, are still reasonable and their fundamentals are solid. "But the prospect of rising interest rates does represent a headwind for REITs, in contrast to the banks and insurers which stand to benefit from this," she says. (REITs are classified as part of the financial sector.)

As for the major Canadian banks, Robitaille says that they are increasing their dividends and continue to produce steady increases in earnings per share of 5% to 7% per year. They also offer good dividend yields. This makes for a total return from bank stocks of about 10% per year.

Robitaille notes that bank stocks had a strong run in the second half of 2013. "The expansion of P/E multiples on the stocks was one of the key drivers of bank performance." Multiples are now at 11.5 to 12 times forward earnings-per-share estimates, "which is in line with historic averages," she says. "Thus we do not expect any further P/E multiple expansion on bank stocks."

So far this year, the Canadian equity-income market is performing in line with that of the broader market, says Robitaille. In the first quarter of 2014, the S&P/TSX Equity Income Index produced a total return of 5.6% and the S&P/TSX Capped REIT Index a total return of 5.8% versus that of the S&P/TSX Composite Index of 6.1%.

For the 12 months to the end of March, the equity-income index's total return of 17.1% modestly outperformed the Composite at 16%, while the REIT Index produced a negative total return of 1.7%.

Michele Robitaille

Robitaille says that REITs "had a huge correction in 2013."Investors "overreacted," she says, following the discussion last May about the U.S. Federal Reserve's proposed reduction in its fixed-income securities purchasing program. Bond yields rose by 100 basis points. The Fed began its tapering program in 2014 "and it is proving to be modest." Bond yields have retreated for the year to date, she says, and "could go lower."

Canadian REITs have rebounded strongly this year, says Robitaille. The 2013 correction in these securities was clearly overdone, she says. "They were trading at a 9% to 10% discount to their net asset value in the fall of 2013 versus their historic average of a 5% premium to net asset value." Robitaille reports that she "selectively" added to REITs last fall.

Guardian Capital (assets $16.2 billion) is a sub-adviser to the BMO family of funds. The equity-income team is responsible for managing a number of BMO funds including BMO Growth & Income and BMO Monthly High Income II.

At the end of March, BMO Monthly High Income (assets $1.7 billion and 41 names) had 37.1% in financials, the biggest sector weighting in the fund. This weighting included 14.2% of the portfolio in banks, 15.5% in REITs and 7.4% in other financials, predominantly insurers. The second-largest sector weighting in the fund was energy at 32.9% with 20.5% of the portfolio in energy producers and 12.4% in mainly energy-infrastructure companies.

The Guardian equity-income team targets businesses with sustainable competitive advantages that can generate high levels of free cash flow to support stable and growing dividends or distributions over time.

Two REITs that Robitaille added to last fall are Boardwalk REIT BEI.UN and Chartwell Retirement Residences CSH.UN. Both are long-standing holdings in the fund.

Boardwalk currently owns and operates some 225 properties with 35,277 residential units. It has a particular strength in Western Canada, says Robitaille. Boardwalk has considerable development opportunities within its existing portfolio of properties, she says, "through the addition to existing properties and the development of raw land holdings." The REIT is "conservatively managed and is moving the needle slowly on new development." Boardwalk is also growing its distributions to unitholders.

Chartwell Retirement Residences manages a complete range of seniors' housing communities in North America from independent living to long-term care. "The demographics are most favourable for its business," says Robitaille. President and CEO Brent Binions is focused on improving "the operating efficiency of these communities rather than chasing growth." He is, for example, selling and consolidating the REIT's U.S. operations, "which represent a material portion of Chartwell's offering."

Boardwalk REIT Chartwell Retirement Residences
May 12 close $63.45 $10.68
52-week high/low $66.98-$53.19 $11.64-$8.95
Market cap $3.0 billion $1.8 billion
Total % return 1Y* 1.6 -0.3
Total % return 3Y* 12.9 12.1
Total % return 5Y* 19.6 22.0
*As of May 12, 2014
Source: Morningstar

Turning to the banks, Toronto-Dominion Bank TD is the largest holding in BMO Monthly High Income. Also in the fund's top-10 holdings are Bank of Nova Scotia BNS, Royal Bank of Canada RY and Canadian Imperial Bank of Commerce CM.

Of the non-bank financials, the biggest holding in the fund is Manulife Financial Corp. MFC. "We bought this stock in late 2012, when the interest-rate and stock-market environment was less favourable to the life insurers," says Robitaille. "Capital markets have improved substantially since and the easy money has been made on these stocks," she says. "There now needs to be core earnings-per-share growth to drive these shares," she adds.

Manulife is well positioned in Asia, says Robitaille, and its Canadian operations are doing well. "Also, its asset-management division is a significant contributor to its earnings."

Turning to energy, Robitaille reports that she has been trimming her holdings across the board, particularly in energy-infrastructure stocks. "Some of these names had a big run in 2013 and in the first quarter of 2014 and are up 18% to 20% year-to-date."

Specifically, Robitaille has taken some profits in Pembina Pipeline Corp. PPL, AltaGas Ltd. ALA and Keyera Corp. KEY. These still remain significant holdings in the fund and were among its top 10 at the end of March. "The trimming of these holdings reflects our commitment to prudent risk management."

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Sonita Horvitch

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