Sentry Canadian Income fund looks for dividend champions

Christopher Davis: Hi, I'm Christopher Davis, with morningstar.ca. I am here today with Michael Simpson. He is the manager of the $3.5 billion Sentry Canadian Income Fund. It's been a top performer relative to its Canadian dividend and income peers. So, it's a real pleasure to have you today, Michael.

Michael Simpson: Well, thanks Chris, it's great to be here.

Davis: Well, your hunting ground dividend paying stocks have been really popular in recent years. Investors are starved for income and investors really like the stability of dividend paying stocks, especially with all that we have been through in recent years. So, I don't know, if you could just talk about the relative attractiveness of dividend paying stocks, they’re certainly more expensive than they used to be, but do they still represent a good value?

Simpson: Sure. So, first of all everyone should know that in the United States about 80% of the S&P 500 companies in their index pay dividends. In Toronto the number is similar, a bit smaller about 77%. So, people should think of dividends in terms of their whole market, in terms of the whole economy.

It's not just your traditional utilities and telecom stocks and we also focus not only on dividend stocks, but companies that can grow their dividends and what we call at Sentry Investments, the dividend champions. So, although the market has risen and some sectors are more expensive than others, we tend to look at a wide variety of sectors for investing in dividend paying companies.

Davis: Are there any sectors where dividend champions are emerging?

Simpson: Well, absolutely. We're finding the technology sector both in Canada, United States, we're seeing dividend champions. We're seeing OpenText recently announce a dividend increase. We're seeing companies in the consumer [sector] — Couche-Tard recently announced a new dividend increase and also in the waste management industry, you have very disciplined management where they continually raise their dividend every year.

Davis: You mentioned technology and one of your top holdings is Microsoft and there has been no shortage of news coming from Redmond, over the past week or two. The CEO, Steve Ballmer, announced he's going to be stepping down within the year and they announced their acquisition of Nokia's mobile business. I'd like to know, what your take is on those items.

Simpson: Yeah. So a lot of news coming out of Microsoft, so Steve Ballmer has been a very powerful, forceful CEO, and in a year's time there'll be a new CEO. Recently also, Microsoft announced that they'll be acquiring the handset business from Nokia. There has been a little controversy over that because they're paying $7.2 billion. However, Microsoft has a huge amount of cash; this is all coming from their international cash.

The acquisition is controversial because it won't be accretive in year one or year two. But it gives Microsoft an important leg in the Asian markets where price is more important and they'll be able to develop new phones at a lower price. In our view [they’ll be better at this] then [a company like] Apple and then they will be price competitive with Samsung.

So, although the market did not like the news, we are sticking with Microsoft. We are getting a company that generates huge free cash flow, trades at about 10.5 times earnings and we know that we will get share buybacks and dividend increases every year.

Davis: A lot of dividend-oriented funds in Canada have heavy weightings in financials, especially banks. All of the big Canadian banks, RBC, TD and the like, are rival dividend payers. But yet when you look at your portfolio, your financial stake is relatively light — you don't see the big Canadian banks in your top holdings. Can you talk about why that is?

Simpson: Sure. So, in Canada, we've had a pretty good recovery off the 2009-2008 lows. We have concerns about consumer debt levels in Canada. We have concerns about housing prices. So, we're starting to see banks' consumer lending slow. Although we haven't seen loan losses spike, we do think eventually over the next 24 months you'll start to see loan losses increase as consumers [are] faced with high debt levels.

We are starting to see mortgages rise slightly and there could be less employment growth in the construction sector, as the condo building boom slows down. So for these reasons there are some banks that are offsetting that with exposures in the U.S. We do have a position in Royal Bank. But those are our concerns. So, on a price-to-book, price-to-earnings, Canadian banks and their growth profile, in our view they're not as cheap as some banks in the U.S.

Davis: Would you anticipate possibly on the other side of this, once all of the potential bad news you're talking about — Canadian debt levels and a slowdown in construction. Once that news is reflected in the Canadian bank stock prices, would you perhaps revisit your [position]?

Simpson: Yeah. We have owned Canadian banks in the past. So, once we see a reflection in earnings, once we see a reflection in the stock price, we'd re-look at this sector. It's a very strong industry; it's an oligopoly. At times they're constrained for growth in Canada and they have to look outside. But once there is a price adjustment, we'd look at the sector again.

Davis: Right. Well when you look at your fund, it's been really successful for quite a long period of time and in our business a successful track record attracts a lot of assets. And you’ve certainly had that, about $3 billion over the past four or five years has come into your fund and you have dealt with that by investing in more larger names. You've expanded your mandates to invest in more U.S. stocks. I am just wondering, if you could explain how you will still be able to maintain the same level of performance with a bit different portfolio?

Simpson: Sure. So, the history of the Fund, the Fund is over 11-years-old; it will be 12 years in February 2014. So originally the fund was primarily in income trust, where they were just primarily in Canada. But over time we've been looking to the U.S. We can go up to 49% in the U.S.

So as there is, larger companies in the U.S., as Americans tend to focus more on growth, higher growth companies. Some of the companies that we like that are good, that will only grow at the rate of the economy are trading at very good valuations from anywhere from 10 to 14 times earnings, which we think is reasonable.

So, we look there. We will also look for an overreaction or an overcorrection in some of the Canadian interest sensitives. It's not known with certainty where interest rates will go in Canada. The Bank of Canada seems certain that they want to keep short-term rates low. But the bond market can also influence where rates are.

So we're re-looking at the REIT sector. We're not diving in headfirst. But we're picking away on some names that we own and we like and we think if there's further weakness will add to our position in some of the interest sensitive sectors.

Davis: Now, pretty much of your tenure at this Fund it's been a great environment from an interest rate perspective, maybe not from other perspectives. So, we only see a record, your record among an environment of declining and low rates, you may have an environment of rising rates. How do you see your fund fairing in that sort of environment?

Simpson: Sure. So, first of all in that 11 year period there were brief periods, although brief, 18, 20 months where rates rose. But we see our defense the way we manage our style as helping us cope through difficult times. First of all we're focused on companies that can raise their dividends. We're also focused on companies that generate free cash flow and most importantly companies that have a good balance sheet.

Having a strong balance sheet allows you to withstand shocks, whether they're internal or external. And companies with a good balance sheet have the flexibility to raise their dividend and to pursue growth initiatives where they can earn more than their cost of capital. So, I think the focus on a balance sheet, rising dividends and strong management will allow us to still look at companies that can help the Canadian Income Fund perform.

Davis: Well, thank you very much for joining us today, Michael.

Simpson: Well, thank you, Christopher. It's nice to be here.

Davis: I am Christopher Davis, with morningstar.ca.