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Burned by income trusts, David Marshall is thinking of investing in a little certainty right now.
Bank stocks, specifically Toronto-Dominion Bank and Royal Bank of Canada, have caught Mr. Marshall's eye. “What's that saying, widows and orphans stocks?” he said in an interview from his home in Cornwall, Ont. “These stocks are as solid as you can get.”
It's tough to find more reliable stocks than the big banks, but the dividends they pay generate annual returns of only 2.8 to 3.8 per cent right now. Trusts typically offer yields of 6 to 12 per cent or more, which explains why they became so popular in the first place.
To Mr. Marshall, a 69-year-old retiree from a job at a chemical company, the income flow from bank stocks is, in a word, terrible. “But you have to go with what you're comfortable with,” he adds. “I wouldn't want to have to go through what we went through on Halloween again.”
Oct. 31 was a day that will live in infamy for the seniors and other investors who used trusts to generate cash income and to make money from a hot income trust market. Shocking almost everyone, Finance Minister Jim Flaherty said trusts would be subject to a new tax beginning 2011. The trust market fell about 12 per cent in the days that followed and, while it has come back some lately, there's virtually no one who thinks trusts will go back to the golden years of 20-per-cent returns or more.
Trusts still have four years until the tax pinches the amount of money they have to pay out to investors, but much uncertainty lies ahead in terms of how these investments will perform and evolve. At the same time, there remains a large group of seniors and others who need a reliable source of investment income.
“The fundamental demand for income has not gone away at all,” said Garth Jestley, president and chief executive officer of Middlefield Capital, an investment firm that has packaged trusts into investment funds listed for trading on the Toronto Stock Exchange. “All of the factors that drove investors into income trusts are still present today, and demographics suggest that they'll be present in ever greater force as we go forward.”
So where do investors who own trusts go for yield if they want to branch out into something else? Dividend stocks like the banks are an option. Dave Jennings of Vineland Station, Ont., has been buying one-year guaranteed investment certificates, which along with bonds are other obvious trust replacements. Brian Dale in British Columbia said he's looking at preferred shares, which have declined in popularity in recent years.
Mr. Jennings, a 44-year-old who is on a disability pension, has a simple explanation for why he's been willing to settle for the 4-per-cent return offered by the GICs his broker has bought for him lately. “Fear — it's as simple as that. We don't know what's going to happen with trusts, and we don't want to put any more into the stock markets — they're high right now, although they may continue to go up. With GICs, we know where we stand with the principal.”
It's a basic rule that the safest investments offer the lowest returns, which means that trust-like yields from GICs and bonds are out of the question. There are some ways to maximize your returns from fixed-income investments like these, however.
Sheldon Dong, vice-president of fixed-income strategy at TD Waterhouse, said he thinks one-year GICs offer the best value right now. With short- and long-term interest rates almost identical at about 4 per cent, he sees little value in locking money in for a long period of time.
For investors who want to keep things safe and simple, Mr. Dong recommends the trusty old bond ladder, where you split your GIC or bond money evenly into one- through five-year terms. “If rates happen to be a bit lower a year from now you'll be reinvesting at a lower rate, but you've had a foresight to lock some of your money into today's rates. And if rates are a bit higher, you've got money that's maturing that you can invest at a higher rate.”
Mr. Dong believes the modestly higher yields available from provincial bonds are a better value than nominally safer federal government bonds. He says it doesn't really matter which province you choose because all offer good safety.
Corporate bonds offer higher yields still, but Mr. Dong is comfortable recommending only bonds issued by the big banks. The reason is that while other corporate bonds are still attractive, investors must monitor them regularly to ensure the issuing company remains in good financial health. Defaults are few among Canada's major corporations, but the example of Air Canada a few years ago shows they do happen.
Defaults are much more of a risk with high-yield bonds, which are issued by companies that aren't financially strong enough to qualify for top credit ratings and thus have to entice investors with higher interest rates. There are not a lot of high-yield bonds in the Canadian market — there are more in the United States — but one name that comes up a lot is Ford Credit Canada, the financing arm of Ford Motor Co. of Canada.
A Ford Credit bond that matures in March, 2008, can be had with a yield of about 5.4 per cent, while a bond maturing in March, 2009, yields about 6.1 per cent. Mr. Dong's view of these bonds: “Very dicey.” His reasoning is that interest payments by Ford Credit could be interrupted if Ford's financial difficulties worsened to the point where it sought bankruptcy protection. Mr. Dong thinks there's a reasonable margin of safety for these bonds in the year ahead, but the risk increases beyond that point.
Dividend stocks will appeal to investors who bought trusts not so much for yield but for the total return they provided through a combination of cash distributions and price appreciation. Consider the bank stocks that Mr. Marshall is looking at, RBC and TD. Both yield a bit less than 3 per cent right now, but their total returns for the past 12 months are about 22 and 15 per cent, respectively, because their shares have risen.
There are hundreds of blue-chip dividend-paying stocks listed on the Toronto Stock Exchange as well as U.S. and global exchanges. How do you find the best of them? The Calgary-based investment dealer McLean & Partners Wealth Management emphasizes not the yield of a company's dividend, but rather the company's track record for increasing its cash payouts to shareholders.
A high dividend yield — say anything about 5 per cent or more — suggests investors have a cautious view toward a company (as the price of a stock falls, its dividend yield rises). But dividend growth sends a message that a company is strong and healthy. “It says a company will be around through thick and thin, and that it will outperform over the long term,” said Ric Palombi, a portfolio manager at McLean & Partners.
Mr. Palombi said his firm looks for companies that have increased their dividends by more than 8 per cent every year. “Owning a stock that increases its dividend by 8 per cent a year is like getting an 8-per-cent raise every year,” Mr. Palombi said.
The major banks are classic dividend growth stocks. RBC, for example, has raised its dividend 14 times this decade, from 12 cents to the current 40 cents a quarter. If you paid the going market rate of about $15.50 for RBC shares in January, 2000 (this price is adjusted for stock splits), then your current yield would be just over 10 per cent.
Three dividend growth stocks that McLean & Partners likes right now are Astral Media Inc., Manulife Financial Corp. and Power Financial Corp., all of which have posted double-digit increases in their dividends over the past few years. The firm also likes global dividend stocks, including French company Veolia Environnement.
If you prefer to buy mutual funds rather than individual stocks, there is a small but growing number of funds that focus on dividend growth stocks. This week, Investors Group introduced Canadian, U.S. and European funds in this category. Another fund in this group is Franklin Templeton U.S. Rising Dividend.
Dividends are also available from preferred shares, which are a type of stock that offers a higher degree of certainty that you'll get your quarterly cash payments than common shares. The catch: Preferred shares don't generate much in the way of capital gains, and they can fall in value like a bond when interest rates rise.
The reason why preferred shares interest Mr. Dale is that they offer yields a little bit higher than bonds right now. For example, several of the big banks have preferred share issues yielding about 4.5 per cent.
A problem in buying preferred shares is that they're deceptively complex. “It's confusing for an amateur such as myself,” said Mr. Dale, a 74-year-old retiree. “I have been bitten a little bit buying preference shares before. That made me think, hmm, this is complicated stuff.”
Mr. Palombi of McLean & Partners suggests sticking to preferred shares issued by the big banks and other top-quality issuers. As an example, he mentioned the TD preferred series O shares, which pay $1.21 in dividends a year and currently yield about 4.6 per cent.
One thing to bear in mind with preferred shares is that your returns can be affected by the difference in the price you pay and the price you receive when the shares are redeemed. For example, the TD preferred O shares are currently trading at about $26.20 and can be redeemed by TD for $26 in November, 2010, and slightly less in the next few years.
If you buy preferred shares, mind their sensitivity to interest rates. These shares will fall in value if rates rise, and they can do modestly well if rates decline. “In a rising rate environment, you really have to be careful,” Mr. Palombi said. “But for the type of environment that we're heading into, I think preferred shares are going to do very, very well.”
One other option for yield-hungry investors is a type of income trust that for the most part is unaffected by the new tax coming in four years. It's the real estate investment trust, or REIT, which is a vehicle for holding commercial properties ranging from shopping malls and office buildings to apartments and hotels.
The lesson of recent developments in the income trust sector is that investors should never rely too heavily on one type of security to generate their income. Just as government action crushed the income trust market, rising interest rates can hurt bond prices and a bear market can maul dividend stocks.
Mr. Dale followed this advice and today he's able to say he did well in income trusts and has no complaints about how things worked out. “If I could I say one thing to any other investor, for God's sake diversify.”
One possible replacement for income trusts is a blue-chip stock paying a dividend, especially a dividend that rises consistently over the years. The Calgary-based financial advice firm McLean & Partners Wealth Management searches the world of dividend stocks to find the ones with the best record for increasing their quarterly payouts. Here are three Canadian names the firm likes right now:
1 | Astral Media (ACM.A)
Astral owns Canada's largest stable of English and French specialty, pay and pay per view television services. It currently has 17 television channels including The Movie Network, Viewer's Choice, The Family Channel and Teletoon. The company also operates 29 radio stations in Quebec and the Atlantic provinces, as well as being involved in outdoor advertising in Quebec and Ontario. Astral has increased its dividends 15 per cent annually over the past five years including a 33-per-cent boost in December. The company also announced that it will buy back up to 2.5 million class A and 154,741 class B shares. It may also be a potential candidate for industry consolidation. With no debt, a payout ratio of just 13 per cent, cash of $114-million and projected earnings-per-share growth of 9.8 per cent in 2007 and 10.2 per cent in 2008, we believe Astral has the strong financial position and commitment to continue to return cash to shareholders.
2 | Manulife Financial (MFC)
Manulife is a world-class financial services company. It is global in scope, with operations in Canada, the United States and Asia. It generates 30 per cent of its earnings outside North America. The company is the second-largest North American life insurer by market capitalization. Tremendous free cash flow generation with double-digit dividend growth (a five-year compound annual growth rate of 25 per cent) and only a 30-per-cent payout ratio, which speaks to the financial strength of the company and why we expect the double-digit dividend increases to continue. It also continues to look for acquisitions to expand its global footprint specifically in Japan and China. Since its initial public offering on Sept. 24, 1999, MFC has outperformed the TSX by over more than 200 per cent.
3 | Power Financial (PWF)
A holding company that directly owns 70.6 per cent of Great-West Life, 55.9 per cent of Investors Group and 27.1 per cent of Pargesa Holding SA, a European company that derives 95 per cent of its net asset value from four holdings: Total SA, Suez, Imerys and Lafarge. Most recently, it has been in the news over its potential purchase of Putnam Investments in the United States. Given Power Financial's successful track record of acquisitions, we expect the Putnam acquisition to be positive. Over the past 10 years, Power Financial's dividend growth rate has been 18 per cent annually, the shares over the same time period are up 23 per cent annually and the stock has outperformed the TSX by a staggering 519 per cent.
And here are two dividend stocks McLean & Partners see as being pricey right now:
1 | Enbridge (ENB): The stock is up 7 per cent since Oct 31. At current levels, Enbridge trades at a lofty 22.9 times earnings. We would look for the stock in the $35 range to establish a meaningful position.
2 | TransCanada (TRP): This stock too has had a pretty good run since Oct. 31. It trades at a forward price-earnings ratio of 22 per cent (historically expensive) and we would look for a $37 entry price.
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