You can almost hear the dejected sighs of those Canadians who still look at their investment statements every month. While their funds may have climbed a little over the past three years, the market still has a long way to go before hitting its pre-recession footing, let alone the old momentum. Between Jan. 1, 2004, and May 20, 2008—when the S&P/TSX composite index peaked at 15,047—the Canadian market grew by 81.4%. Since then, it’s down 17.74%. In the past two years, the market has dropped about 8%.
Even novice investors can see it’s almost impossible to sustain a positive return from capital gains alone these days. That’s why so many have turned to dividend-paying stocks. Dividend payers are popular for two main reasons: they offer some return when growth stocks don’t, and most offer a higher yield than 10-year Government of Canada bonds, which pay about 1.8%. In other words, if an investor wants to make money in this market, she pretty much has to own an income-producing equity.
It’s the same story around the world. According to research firm EPFR Global, so far in 2012 about US$32 billion has been invested in high-yield and income equity funds, despite the fact the overall equity fund market saw a net outflow of $61.1 billion. This demand for yield has been both a blessing and curse. While investors are growing their returns, many of the companies buyers like have seen their prices shoot up awfully high. Investors can’t just pile into any decently paying stock anymore; you now have to look at whether valuations are attractive too.
Many investors, especially retirees who need money to live on, may not care whether their income-payer is well priced or not, as long as it has a good yield. But for the rest of us, that expensive stock’s share price will, at some point, fall. “There’s a tendency for stocks to revert back to the mean,” says Bob Sewell, president and CEO of Bellwether Investment Management, based in Oakville, Ont. “That’s more likely to occur in an overvalued stock than in something that’s found its bottom and is starting to recover.”
Two investments that have seen valuations swell are real estate investment trusts (REITs) and utilities. Investors have gravitated toward these two industries because they spin off cash and bring in regular, recurring revenues, which usually means the dividends are fairly safe. Both of these sectors have outperformed the S&P/TSX composite index over the past three years. Since Oct. 31, 2009, the S&P/TSX capped REIT index has climbed by 59.4%, while the S&P/TSX capped utilities index has jumped by 28.4%, not counting yield.
But while it’s possible these sectors will continue to do well for quite a while, investors are taking on more risk than they think, because both currently look overpriced. As soon as people move on to another hot sector, share prices could plummet. “It’s the herd mentality,’ says Barry Schwartz, vice-president of Toronto’s Baskin Financial Services. “Someone rings the bell, and those stocks will fall faster than they went up. They’ll drop 20% in a year, while it took a few years to rise by 30%.”
The best income buys are companies that pay a good yield but are also undervalued. With those, investors can make money from both dividends and capital gains. Attractively priced companies will also lose less than overvalued businesses in a sell-off. Fortunately, there are still a lot of sectors that have both characteristics. Jeannine LiChong, vice-president and portfolio manager with Toronto’s Gluskin Sheff & Associates, likes Canadian banks for one. They’re raising dividends—most of the banks pay around a 4% yield—they’re well capitalized, and they’re cheap, she says. The sector’s price-to-earnings ratio is about 10 times, while the S&P/TSX composite is trading at about 18 times earnings.
Schwartz likes U.S. tech companies for the same reasons. Brand names, like Cisco, Microsoft and Apple, are cash cows, they have clean balance sheets, they’re cheap—many trade below 10 times earnings—and, while yields aren’t as high as banks, there’s plenty of potential for dividend growth. Other attractively priced sectors with good yields include U.S. health care and financials.
Investors may also find more opportunities in smaller-cap stocks, says Les Stelmach, a portfolio manager with Calgary-based Bissett Investment Management. Many big-name dividend payers have seen valuations rise partly because they pay an appealing dividend, but they’re also perceived as being more stable. Small-cap stocks don’t have that brand recognition, so they’re not as popular as larger businesses. As a result, valuations are lower. That doesn’t necessarily mean they’re less stable, though.
Regardless of the sector or market cap, some sectors that look cheap have overvalued companies and vice versa. To find value, Sewell suggests starting with a target yield. Some managers only want companies with yields that exceed the S&P/TSX composite’s 3% payout, but Sewell sets the bar lower, with companies that pay 1.5%. More important than the actual yield, he says, is whether or not the business increases its dividend every year. Ideally, he likes a company to have upped its payout every year for five years or more. This increases the likelihood the trend will continue.
He also wants to see earnings and cash-flow growth. The latter is especially important because the more cash flow a company can generate, the more money it will have to cover its dividend payments. He then starts looking at valuations, such as price-to-earnings, price-to-cash flow and enterprise value-to-EBITDA, to determine whether the company is cheap or not. Compare the company to its peers and to its historical numbers, says Sewell. While lower multiples usually mean the company is undervalued, one company could be trading at 17 times earnings and still be the cheapest stock in its sector.
Schwartz takes a similar approach, but he begins by looking for companies that have a lower valuation than the S&P 500, then looks for businesses that pay a 2% yield or more. LiChong also wants to see a clean balance sheet. If an operation has too much debt, it may have to cut its dividend in order to put more cash toward interest payments. She also wants to see reasonable payout ratios, or the percentage of free cash flow that’s being used to pay investors. Some REITs have payout ratios of about 100%, which means they’re paying out all their excess cash. “It means you have no room for error, and there are things that happen in business that are beyond your control,” she says. In these cases, there is more risk that the dividend could get cut.
Ultimately, you want a company with a sustainable and growing dividend, and one that’s trading below its peers. If investors keep chasing yield, and ignore valuations, their dollars will be at risk. “As long as people want to buy income, they’ll keep propping pricier stocks up,” says Stelmach. “That will be true until it’s not. You really do need to look at more than just yield.”