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John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.
The bad news is that a lot of dividend stocks have tumbled in price.
The good news? If you have cash to spend, you can pick up some deals.
"Some high-quality stocks only get cheap during market corrections," said Anil Tahiliani, portfolio manager with McLean & Partners Wealth Management in Calgary. "We've been sitting on quite a bit of cash because we're waiting for opportunities to come to us."
When hunting for dividend stocks, Mr. Tahiliani follows a few simple rules. First, he exercises caution with high-yielding stocks. A juicy yield may look enticing, but it can be a red flag that the business in trouble. Anyone who invested in Yellow Pages Income Fund (now Yellow Media), TransAlta or AGF learned that the hard way. Not every high-yielding company is an accident waiting to happen, but "a high yield means you have to do your homework," Mr. Tahiliani said.
Second, he pays close attention to the company's payout ratio. Many investors look at dividends as a percentage of earnings, but because earnings are open to accounting manipulation, he prefers to examine the payout ratio based on cash flow. The lower the payout ratio, the safer the dividend.
Third, he won't invest until he thoroughly understands the business, including its key growth drivers and risks. The best dividend growth companies are those with "a strong business model based on a competitive advantage, pricing power, a unique product or service or a [favourable] industry structure," he said.
Finally, Mr. Tahiliani limits his exposure to commodity producers.
When commodity prices were surging, many producers hiked their dividends, creating the illusion of stability. But companies in sectors such as energy, base metals and agriculture "have no or limited control over top-line revenue growth since this is driven by global commodities prices," he said. "As soon as the commodity down cycle begins, dividends are quickly cut or eliminated as companies try to conserve cash flow."
The following three dividend growth stocks meet all of his tests, and they are trading at valuations he considers attractive.
TransCanada Corp. (TRP-TSX)
Price: $43.31, up $1.17
Yield: 4.8 per cent
TransCanada's shares have skidded about 24 per cent in 2015, as investors reacted to the energy slump and the U.S. government's rejection of Keystone XL. But the pipeline operator and power producer has little direct exposure to commodity prices and, in a sign of confidence, recently extended its 8-to-10-per-cent annual dividend growth projection by three years to 2020, citing $13-billion of projects that will begin contributing to cash flow by 2018. Through the first nine months of 2015, TransCanada paid out just 31 per cent of cash flow as dividends, Mr. Tahiliani said. He considers the stock inexpensive, with a 2016 EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization) multiple of 10.9, well under the five-year average of 13.5. (For more on EV/EBITDA, read my column at tgam.ca/EDqG.)
Fortis Inc. (FTS-TSX)
Price: $38.09, up $1.21
Yield: 3.9 per cent
Fortis's shares are off nearly 10 per cent from their February peak, in part reflecting concerns that the U.S. Federal Reserve is poised to raise interest rates, Mr. Tahiliani said. But he considers the electric and gas utility operator attractive for several reasons: It sports an above-average yield of 3.9 per cent; 96 per cent of its assets are regulated, which contributes to stability of its cash flow; and the company expects to boost its dividend at an annual rate of about 6 per cent from 2016 through 2020, fuelled by recent acquisitions, new projects and a five-year capital spending plan of $9-billion. Fortis paid out 22 per cent of cash flow as dividends through the first nine months and the stock trades at a 2016 EV/EBITDA multiple of 10 compared with a five-year average of 11.5.
Bank of Nova Scotia (BNS-TSX)
Price: $60.83, down 6¢
Yield: 4.6 per cent
Even in a struggling economy, Canadian banks are raking in massive profits: On Tuesday, Bank of Nova Scotia reported fiscal 2015 earnings of $7.2-billion, or $5.67 a share, up 4.4 per cent from a year earlier on an adjusted basis. Mr. Tahiliani likes Scotiabank because it has the most international exposure of the Big Five. "It kind of gives you defence with some offence. When emerging markets start to pick up again, they should participate," he said. Yet its price-to-book value ratio of about 1.5 is the second-cheapest of the Big Five and is lower than its five-year average P/B of about 2. In recent years, Scotiabank has raised its dividend twice annually, including increases totalling 6 per cent in 2015.
Disclosure: The author personally owns shares of TransCanada, Fortis and Bank of Nova Scotia, and holds TransCanada and Fortis in his Strategy Lab model dividend portfolio.
John Heinzl