Searching for high yields in a down market

John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.

With dividend stocks plunging as bond yields surge, many investors are understandably unhappy about the hit to their portfolios.

Not Leslie Lundquist. The co-manager of the Bissett Canadian High Dividend Fund is actually kind of enjoying herself.

"You're always happy when the markets are strong and you're making money and everything is working and people think you're a hero," she says.

"But it's a lot easier to be an investor and to make good decisions when the markets have pulled back, especially when it's something as broad as interest rate fears … it's much easier to go in to pick the stocks you like and buy more of them."

Formerly called the Bissett Income Fund and focused on income trusts, the fund changed its name in 2011 after new tax rules prompted many trusts to convert to corporations. The fund's mandate hasn't changed, however: It still looks for companies with above-average yields and which trade at attractive valuations.

The portfolio's average weighted yield is a hefty 6.8 per cent, which – after deducting the fund's management expense ratio of 2.48 per cent – produces a net yield of about 4.3 per cent for unit holders.

But there's more to picking stocks than choosing the highest yields. In keeping with Bissett's growth at a reasonable price (GARP) style, Ms. Lundquist's team calculates the intrinsic value of a stock based on discounted cash flow (DCF) analysis, a method that involves estimating all future cash flows and working backward to determine what they are worth in today's dollars. If a stock trades below its intrinsic value, it's considered cheap.

The search often leads to companies experiencing temporary problems that have driven the share price down. In some cases, she's even bought companies before or after a dividend cut because the stock offered a compelling value.

Investing in stocks with high yields and high payout ratios entails a certain amount of risk, of course, which is why buying at an attractive price and assessing the strength of the business are also paramount concerns.

"We're very well aware of the dangers of just stretching for yield and leaving any other valuation by the wayside," she says.

"We get it. This is not an easy thing. But that's what [co-manager] Les [Stelmach] and I have been doing pretty much all of our careers."

Here's a sample of the fund's holdings.

New Flyer Industries Inc.

• (NFI-T) Tuesday close: $10.92
• Yield: 5.4 per cent

Winnipeg-based New Flyer makes heavy-duty buses for transit authorities across North America. The company struggled during the U.S. recession and cut its dividend last year, but orders are once again pouring in and the stock is up sharply. Still, Ms. Lundquist isn't looking to add to her position, in part because the 5.4-per-cent yield is "actually a bit low" for the fund. But with a payout ratio of about 90 per cent of free cash flow – essentially the cash left over after capital expenditures – the dividend is sustainable, she says.

Medical Facilities Corp.

• (DR-T) Tuesday close: $14.97
• Yield: 7.5 per cent

Medical Facilities is based in Toronto, but its six surgical centres are located in South Dakota, Oklahoma, Arkansas and California. Unlike many former income trusts, the company maintained its distribution when it converted to a common share structure in 2011 and even raised it slightly in 2012. "It has a high dividend yield, a reasonable payout ratio [about 90 per cent of free cash flow], reasonable debt levels and it screens okay on a DCF basis," she says.

Morneau Shepell Inc.

• (MSI-T) Tuesday close: $13.60
• Yield: 5.7 per cent

As an administrator of pension and benefits plans, Morneau Shepell's business is "sticky"– when a new client comes on board, it tends to stay with the company for years. What's more, the company is able to cross-sell employee assistance programs to its pension clients. The payout ratio of about 85 per cent of free cash flow is "reasonable," but the stock has run up and "we've tended to be trimming more so than buying," Ms. Lundquist says.

Crescent Point Energy Corp.

• (CPG-T) Tuesday close: $36.31
• Yield: 7.6 per cent

Oil and gas producer Crescent Point is paying out more than 100 per cent of free cash flow, but could tap credit lines or pull back on capital spending to maintain the dividend, she says. The company has issued a lot of equity recently to fund acquisitions, and now investors are hoping to reap the benefits.

Wajax Corp.

• (WJX-T) Tuesday close: $30.10
• Yield: 8 per cent

As a heavy equipment distributor, Wajax is sensitive to economic swings. But the company – which cut its dividend in May and whose stock price has dropped 26 per cent this year – is "really, really cheap," Ms. Lundquist says. Buying the stock, which has a payout ratio of about 85 per cent of free cash flow, "is basically just banking future performance," she says.