Equity income roundtable: Part 1

 Michele Robitaille, senior portfolio manager at Guardian Capital LP, which is a sub-adviser to the BMO Guardian family of funds. Robitaille is a senior member of Guardian's equity-income team, which manages a range of funds, including BMO Guardian Monthly High Income II and BMO Guardian Growth & Income.

Leading the discussion was Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and concludes on Friday.

Q: Have Canadian dividend-paying stocks outperformed the market as a whole in the year to date?

Lough: Investors in these stocks have been more insulated from the volatility in the market and the declining markets. Good dividend-paying stocks protect investors on the downside.

Robitaille: So far this year, the S&P/TSX Composite Index has underperformed the S&P/TSX Equity Income Index. The dividend yield on the latter is around 5.5% versus 3.2% for the composite. In the macro environment that we're in, equity income will continue to be a very attractive place to be. These stocks should continue to outperform.

Gibbs: This has been a wake-up year for Canadians. The big weighting in the composite in energy and materials has hurt the index. Also, investors in Research in Motion Ltd. (RIM/TSE) have had a tough time. Investors are making capital preservation a priority and saying that they are comfortable with a 4% to 6% dividend yield and looking for a little capital appreciation beyond that.

Lough: A number of studies have shown that dividend-paying stocks have not only produced better returns over time, but that they are a lot less risky. The risk-adjusted returns are much better than from the non-dividend-paying stocks.

Michael Lough

Robitaille: I agree. A lot of this has to do with the characteristics of dividend-paying companies. They tend to be more mature in their product life cycle. They generate a significant level of sustainable cash flow and tend to have a conservative payout ratio.

Gibbs: There is the demographic aspect to these stocks. Investors are looking for more income from their investments. You are going back to a time when you buy a stock for its dividends. The caveat is that you do have to do your homework on whether the dividend is sustainable. Buying Yellow Media Inc. YLO because of its dividend yield would have been a disaster.

Robitaille: We have gone through a couple of decades when the market was focused on growth, and dividends went out of style. In the tech-boom bubble, the focus was on growth and capital gains. With the volatility in the market, the bear market of 2008 and 2009 and the current downturn in the market, there is a renewed focus on dividends. The companies are also recognizing that dividend payments add appeal to their stock.

Q: If investors are chasing dividend-paying stocks, what is that doing for the valuations?

Lough: There is a small premium for some of the good dividend-paying stocks relative to stocks that pay lesser dividends or no dividends at all. But, if you look at those dividend-paying stocks relative to bonds, the dividend yields are much higher than the yields on bonds.

Gibbs: If you look at the price/earnings ratio on these dividend-paying stocks, they certainly look quite expensive. Take BCE Inc. BCE for example.

Robitaille: I own it.

Lough: So do I.

Michele Robitaille

Gibbs: A growth investor will probably look at it and consider it overvalued on an enterprise value to EBITDA [earnings before interest, tax, depreciation and amortization] and on a price/earnings basis. But most investors who own the stock want it for its dividend, which is more than 5%. This will grow a little every year. But if you sell BCE, what do you replace it with? To Michael's point, these dividend-paying stocks remain very cheap on a dividend-yield and free-cash-flow-yield basis relative to a risk-free government bond. If interest rates go up, you could see some pressure on these stocks.

Lough: It would really take a big rise for interest rates to challenge good dividend-paying stocks.

Robitaille: Most portfolios are positioned more defensively because of the macro environment. There is a lot of uncertainty. The market is being driven by headline news out of Europe. This changes from hour to hour. Also, the modest outlook for global economic growth is part of the reason why interest rates are low. It is also part of the reason why opportunities in more growth-oriented areas, such as cyclical stocks and materials, are considered to be riskier.

Gibbs: I think that dividend-paying stocks are in a structural bull market. You can go through periods when they are overbought on a short-term basis and they retreat. But when, say, RioCan Real Estate Investment Trust REI.UN and Calloway Real Estate Investment Trust CWT.UN or a BCE come under pressure, then investors buy more. Investors are sitting on cash.

Lough: Investor demand on the sidelines is important. When the good-quality REITs come to market with a new issue because they want to buy additional properties, the units are no longer priced at a discount to the current market price. In the past there would have been a 5% discount.

Q: So, are the higher-quality Canadian dividend-paying stocks expensive?

Robitaille: A lot of these stocks are close to fully valued, but not overvalued.

Jason Gibbs

Lough: The typical total return for the stock market over time is somewhere in the 6% to 8% range per annum. If you can get a stock that has a dividend yield of 4% or 5% or 6%, you only need modest capital appreciation of, say, 2% to 4% to get an average long-term total return. The dividend-paying stocks that we are talking about will be able to show growth in that range. From a long-term perspective, the high-quality dividend-paying stocks remain attractive.

Gibbs: These stocks are cheap relative to the return on a risk-free investment. Even Enbridge Inc. ENB, which always looks expensive, still has close to a 3% dividend yield, which is about the S&P/TSX Composite Index's dividend yield. Enbridge is going to grow its dividend at about 10% per year. If you hold on to it and watch that dividend compound, you can argue that the stock is cheap. We could have a long period of low interest rates.

Q: We're almost a year into the change in tax treatment of income trusts. Can we summarize the results?

Robitaille: The majority of trusts have now converted. That chapter is behind us.

Gibbs: Most of the trusts have maintained their distributions as corporations. The weaker trusts were largely eliminated a few years ago. Many of the converted trusts still don't pay tax.

Robitaille: A lot of them, in particular the former energy trusts, have significant tax pools.

Lough: The good converted companies are going to continue to pay high distributions. Investors are comfortable with dividend-paying companies paying out a high percentage of their cash flow as dividends. This is a positive for the equity market. We are seeing better overall management, as these companies are not under pressure to find growth and perhaps, at times, make mistakes in doing so.

Robitaille: We have long said about the equity-income space is that it does impose a capital discipline.

Gibbs: The conversion to conventional corporations created a wider investor base for the former trusts.

Robitaille: They have become part of the broad-based Canadian equity index.

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