The best defence is good value

This broad-brush approach to investing in defensive dividend-paying stocks "is a case of a rising tide lifting all ships, even though some ships are more seaworthy than others." He cautions that stocks of companies offering high dividend yields, but with little or no dividend growth prospects, could be vulnerable when interest rates pick up.

To O'Brien, the big Canadian chartered banks continue to offer both dependable dividend-growth prospects and better valuation metrics than many of the defensive dividend-payers.

Canadian bank stocks have been fairly lacklustre over the past couple of years, says O' Brien. One reason, he says, is that there is a concern about the impact of a weakening Canadian housing market on their domestic retail operations.

Shares of the Big Six banks, says O'Brien, are currently trading at a price-earnings multiple based on estimates for their fiscal year ended October 2013 of 10.5 times, and 9.9 times for fiscal 2014. In contrast, the 10-year P/E multiple on forward estimates is 11.7 times. The average dividend yield for the Big Six is 4.3%.

Michael O'Brien

At TDAM, O'Brien, who is head of the core Canadian-equity team, is responsible for some $6 billion in assets for a large number of institutional and high-net-worth mandates at the firm. His mutual-fund mandates include TD Canadian Equity, TD Canadian Blue Chip Equity and TD Balanced Income.

TD Canadian Blue Chip, (assets $1.2-billion) with 43 names, has 33 holdings with market capitalizations greater than $10 billion. The top 10 holdings account for almost 57% of this fund, which is benchmarked against the S&P/TSX 60 Index. The fund has a modest foreign content.

O'Brien's approach is to target the most attractive industries and then to invest in those companies with the best growth prospects that trade at a reasonable valuation. At the end of February, TD Canadian Blue Chip had 38.4% in the financial sector, 25.6% in energy and 11.3% in materials, the three biggest sector weightings in the S&P/TSX 60 Index and in the fund. Some 32% of the portfolio is in the big banks. The largest weighting in the portfolio is Bank of Nova Scotia BNS at 8.6%. Scotiabank, says O'Brien, has raised its dividend in 42 of the past 45 years. Founded in 1832 with its roots in the Maritimes and in international trade, the bank has a different business mix from its Canadian peers. "It has a significant international business with a focus on Mexico and Latin America -- Chile, Columbia and Peru."

These countries are forecast to have a gross domestic product growth of 5% a year versus 2% for developed North America. Also, "the emerging economies are less 'banked' than Canada and therefore offer more scope to successful banks expanding there." The stock, says O'Brien, has traditionally traded at a premium to the other Big Six banks.

Bank of Nova Scotia currently trades at a multiple of 11.5 times earnings per share estimates for the fiscal year to October 2013, and 10.6 times estimates for fiscal 2014. This compares with its 10-year P/E multiple on forward earnings of 12.4 times.

In addition to Scotiabank, O'Brien favours Toronto-Dominion Bank TD and Royal Bank of Canada RY. "These three banks have commanding scale and good market share and are better placed than their rivals to deal with a slowdown in domestic banking." At the end of February, TD represented 7.7% of the fund and Royal 7.2%, as the second and third largest holdings, respectively.

		Bank of Nova Scotia	Royal Bank of Canada	Toronto-Dominion Bank
	April 8 close	$57.03	$59.44	$80.71
	52-week high/low	$61.84-$50.26	$64.92-$48.70	$86.20-$75.70
	Market cap	$68.2 billion	$86.3 billion	$75.0 billion
	Total % return 1Y*	7.2	8.5	0.5
	Total % return 3Y*	8.1	3.8	6.3
	Total % return 5Y*	7.6	8.1	8.2
	*As of April 8, 2013 Source: Morningstar

In the Canadian consumer-discretionary sector, a smaller-cap retailer that O'Brien considers offers good growth prospects is Dollarama Inc. DOL. The company (market capitalization $4.8 billion) is a dominant player in the dollar-store niche, says O'Brien. "This is a healthy, growing retailing segment, and Dollarama is a significant and successful player in the business."

O'Brien reports that he was patient in buying the stock. "It had had a good run and it was important to get the valuation right." The stock trades at 18.5 times forward earnings-per-share estimates, "which is not cheap, but it is a great business."

In the industrial sector, O'Brien is enthusiastic about the prospects for the railways over the long haul. "It is a secular story." The railways, he says, will benefit from the improvement in the global economy and global trade. They are currently benefitting from the shipment of oil by rail, he adds, but this will abate when the proposed pipelines come on stream in three to five years."

O'Brien favours Canadian National Railway Co. CNR. "The company is a consistent, stable earnings grower and good at returning some of its free cash flow to shareholders." The stock, he says, had had a good run, with valuations reaching levels that were well above its historic valuation, so I trimmed some of my holding."

In the defensive area of the Canadian equity market, O' Brien continues to be selective and to look for "quality, seaworthy companies in the rising tide for dividend-paying stocks."

The telecommunications-services company Telus Corp. T warrants attention, he says. "It has strong fundamentals and good growth prospects." Its core wireless business is "healthy" and it has completed its substantial capital investment in its wire-line business, "to ensure that it remains competitive in this area." This segment is rapidly adding subscribers, he says, and is expected to contribute to earnings per share and free cash flow fairly soon.

In May 2011, Telus committed to raise its dividend by 10% each year for two years and "it is expected to renew its pledge to increase its dividend this coming May for another two years," O'Brien says. The valuation on the stock is in line with that of its Canadian peers, he adds.