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FABRICE TAYLOR

The overlooked path to dividends Add to ...

Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement.

When they think of dividends, most investors think of big, mature companies that crank out regular, stable payouts but whose stock prices don’t move much.

While that’s fine for the most conservative of investors, there are ways to get yield while also having a shot at some price appreciation. One is to buy smaller companies that, while not in a hyper-growth stage, are still expanding even as they pay out relatively large proportions of their income. These are riskier firms – it’s not like throwing money at BCE Inc. But if you take the time to understand the business, you can avoid the pitfalls and earn an outsized return.

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The first rule is to keep it simple.

If you don’t understand the business, stay clear. Take Just Energy Group Inc. as an example. It sells energy contracts but its business isn’t particularly clear. The balance sheet is loaded with derivatives (to some degree necessary in this business) that make it difficult to follow the money. This is compounded by the company’s growth strategy, which was to acquire competitors using debt, and then to explain its adjusted earnings by excluding a variety of costs, including that of replacing customers. That makes no sense. The stock did well for a long time but is crumpling now on the back of a dividend cut and other issues.

The opposite of that would be something like Boston Pizza Royalties Income Fund. Not surprisingly the firm is in the restaurant business. It collects royalty payments from franchisees. It’s a pretty simple business, and easy to understand. You can do a lot of your due diligence by going to a restaurant and eating a pie.

This is not a hyper-growth business, but the stock has given us a return of 39 per cent in about a year. Interestingly, while the dividend contributed 7.5 percentage points, a rising stock gave us the rest. Investors have earned this capital gain. First and foremost, the price of reliable dividends has gone up as investors have fled the safety of bonds and GICs looking for better yield. In other words, Boston Pizza’s dividend stream has gone up in value by dint of rising demand. This phenomenon is likely to continue as long as interest rates stay low, and in my opinion that’s a long time.

Also, the business does eke out gains, adding net new restaurants that contribute more royalties. The dividend was increased by 4 per cent last month – not an awe-inspiring gain but certainly one that inspires confidence, which helps the stock price go up.

Second, smaller companies often provide investors with new and unique business models.

Alaris Royalty Corp., for instance, was a solid investment for us. The company buys royalties from private non-resource firms and pays out effectively all of its income. The management team is very lean and top-drawer, with an uncanny ability to find attractive investments. A recent example was a tobacco testing company that had a major investor – a private equity fund – that wanted out. Alaris wrote the company a cheque in return for a royalty, which allowed management to buy out the investor.

Alaris’s royalties come off the the revenue line so aren’t impacted by costs. But they’re also collared, meaning the royalty payment will rise as revenues do but only to a point, giving the company’s owners an incentive to work hard. The royalty payments are also protected to a degree if revenues fall, which is good for Alaris’s shareholders. The stock gave us a total return of 70 per cent. Most of that was capital but the rising stock price would not have been possible without the dividend, which is also rising. The stock is a little too rich for me now but it’s one that I’d love to own again because the business gets better by the day.

Finally, I’ve always been fond of trying to find broken companies on the mend.

With dividend stocks, that means those that reduced or eliminated dividends but whose fortunes are starting to turn around. One that I’m recommending in my newsletter currently is New Flyer Industries Inc., a Winnipeg-based bus manufacturer that fell on hard times because of the recession. Since its customers are governments, largely municipal ones, sales and prices obviously fell, resulting in a fairly big dividend cut last year.

Since then a big player – Orion International – has exited the North American market and New Flyer bought its parts business. The company more recently attracted an investment by a Brazilian bus maker at a big premium to market. This is not a very complicated business and it’s pretty stable, so it’s fairly easy to look back at its history to see how far the business can rebound. My bet is that the dividend will start to rise again and that will produce those big capital gains we’ve seen elsewhere.

In short, dividends are great but they don’t have to be stodgy investments. Smaller companies can give you both income and a sizable return.

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