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Can Dividend Stocks Compete With Bonds?

November 13, 2023 12 min 35 sec
Craig Jerusalim
CIBC Asset Management
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Craig Jerusalim, senior portfolio manager, Canadian equities at CIBC Asset Management.

Equities, especially dividend-paying equities that Canadians hold so dear, are getting severely punished as of late, and that’s largely due to the relative rise in bond yields.

The problems we see with rushing into these securities indiscriminately is the fact that we are just so early in this current economic cycle, and central banks are likely to continue with their hawkish commentary, even if we are in the final innings of interest rate hikes.

The reason for this, the need to remain hawkish, is the desire to ward off any re-acceleration of inflation, and avoid the boomerang that was experienced in the 1970s as inflation came down the first time. In any case, rate cuts are unlikely to materialize until more pain is felt, causing inflation to slowly head back towards central bank targets, and unemployment rates to slowly rise.

The good news is that we need not wait for bond yields to go back to zero before we see separation in the stronger, higher quality security that have fallen alongside the overly or poorly positioned lower growth funds. In fact, we’re unlikely to ever see interest rates back to zero outside of another black swan event like Covid.

What’s an investor to do?

In a stagflationary environment, you want to seek out companies that have low leverage, have strong pricing power or sustainable competitive advantages, have good growth characteristics, and reasonable valuations. The low leverage is obviously due to the rising cost of debt payments. The strong pricing power is to ensure that companies can pass along the inflationary cost to their own customers in order to maintain margins. The growth is relative to the scarcity of growth in a slowdown and starting valuations do have an impact on future expected returns.

Well, it is often a good trade-off to pay up for quality. We just don’t want to be overpaying for tomorrow’s growth today.

There are a few sectors that stand out with these characteristics, including the waste sector, self-storage, property and casualty insurance, and energy, and many other one-off companies that have become the proverbial babies being thrown out with the bathwater.

As for dividend-paying stocks, the key there is to examine sustainability of those dividends. And more importantly, to seek out the companies that can grow those dividends over time, as a way to separate themselves from their weaker peers, as well as from fixed income and money market securities whose interest payments are at best stagnant and offer no protection against inflation.

Dividend strategies rightfully fall out of favour when markets are skyrocketing higher, like they’ve done for much of the past decade. However, dividends become a much larger percentage of total returns when the market’s correct or moves sideways for an extended period of time, like they did in the late 2000 early 2010s. And similar to what we could experience for the next little while.

It is our view that we are in a new normal where interest rates are going to stay higher for longer. If, however, I’m wrong about that, and central banks do begin cutting interest rates faster and earlier than I expect, then we are likely to see a return to some of the higher yielding, higher growth sectors that have recently fallen out of favour with higher interest rates. That would be a return to the telecom sector, the utility sector, REITs, select financials; as well as the companies with long-dated cashflows, so those are typically the more expensive companies in the technology sector that have those long-dated cash flows. There would be a return to those companies. That’s not in our base case. However, even if that interest rate environment doesn’t change, we’re still trying to seek out the relative opportunities within those sectors to be able to differentiate ourselves, regardless of what the macroeconomic backdrop is.

The thesis is that stronger companies with the stronger balance sheets, and the better growth, and the better fundamentals, are able to survive any downturn and are best positioned to thrive once economic conditions improve.

Energy stocks have a lot of analogies to the tobacco stocks of the last few decades. Over the last 30 years, everyone knew that tobacco stocks caused cancer, and that there’s going to be declining trends in domestic markets, picked up by growth in emerging markets; and for many years, those tobacco stocks slowly grinded their way higher. However, when you incorporated the dividend payments on top of the price increases, many of those tobacco stocks compounded returns at close to 10% for nearly 30 years. Those are fantastic rates of return. And we think that the energy sector, the highest quality energy producers, like Cenovus, and CNQ, Tourmaline and Arc, have the ability to compound returns at similar rates.

And our thesis is based on four key points: supply, demand, starting valuations, and even ESG.

On the demand side, we know about the thesis that domestic markets in North America are eliminating internal combustion vehicles, moving more towards electronic vehicles, and that’s going to have a negative demand at the margin for oil consumption. However, that is more than offset by the continued growth in emerging markets — not just China, but India and other emerging Asian economies — such that the demand profile for energy is not going to peak for many years to come.

Then on the supply side, we really had a change in mentality when the price war happened that sent oil below zero for a short period of time. What that changed is investors started demanding that companies no longer be judged based on their growth but be judged based on their profitability. And that caused many of the shale producers to stop their growth-at-all-cost strategies, and that allowed OPEC to once again become the swing producer in oil, meaning that they’re more likely to keep oil in a tighter range over time. There’s going to be a high volatility in short-term pricing; but longer-term pricing is more likely to stay in a $70-90 range, given that OPEC is able to be the swing producer, and increase that supply when oil gets close to $100, and then maybe cut back if oil falls back down to the low $70s if demand warrants it. But it does need more stability in price; and that is very good for the Canadian producers who, unlike the shale producers that keeps putting money into the ground to maintain their production, the oil sands formation is one where these companies had to spend tens of billions of dollars, but now benefit from 50-year mine lives with very low decline rates.

Their cost per barrel today are in the $20-30 range, which means that the excess that they have per barrel is very lucrative; and considering most of them are reaching their debt targets, close to 100% of that excess free cashflow is coming back to shareholders in the form of dividends and buybacks.

Then valuations. Now, we’re off of the trough levels that we saw over the last couple years, but we’re still well below average multiples for many of these producers, even though their balance sheets are much stronger than they’ve ever been, they’re returning money to shareholders, they’re not investing in corporate M&A unless they want to. They’re no longer doing it because they need to. Our thesis is not based on any multiple expansion. Even if multiples stay where they are, it’s going to be the cashflow growth that’s going to result in those dividend payments going up and returns to shareholders.

Then the final point is ESG. You don’t always immediately think that ESG is a reason to own Canadian stocks. However, when you think about carbon-emitting companies and the need to reduce greenhouse gases, energy production is a global problem, it’s not a local problem; and any barrel of oil produced in Canada means one fewer barrels of oil being produced in countries like Venezuela, Nigeria, Iran, Iraq, where not only are the environmental standards much worse, but so are the social and governance standards. So I think every barrel of oil produced in Canada is a net benefit to the world.

Within the financial sector, we’re seeing a big discrepancy between the fundamental go-forward lookout for the banks versus the insurance companies. Specifically the P&C insurance companies, as well as the reinsurance, like Fairfax Financial, Isura, Intact, where the fundamentals really benefit from the hard market that they’re seeing today, which means that they’re able to continue to raise prices. The P&C companies also benefit from higher interest rates because they’ve got shorter duration books, and they’re able to reprice their business faster, and their investment portfolios are benefiting from higher interest rates today.

All to say that relative to the banks, which are very cheap right now, the P&C companies have a much better risk return profile, from our vantage points. Even though the banks are trading at very attractive price-to-earnings ratio, have very attractive dividend yields in the 7% range, we’re just too early in the cycle to be interested in going overweight to Canadian banks.

When you take a very long-term view of the banks, there is nothing wrong with buying a Canadian bank that operates in a strong oligopoly when they’re trading sub-nine-times earnings, 7% dividend yields, and have underperformed for close to three years now. The general rule over the last 40 years is Canadian banks outperformed eight out of 10 years. Given the cheap valuation, and the high dividend yields, and the recent underperformance, it is fine to be investing in these companies for the medium and long-term.

We have to be a little bit more tactical. Given that we are so early in this credit cycle, we’ve only started to see the provision for credit losses start to work their way off of trough levels, but we have a long way to go before those credit losses hit mid-cycle levels and begin to slow down.

Plus, given the higher interest rates, we’re only now starting to see loan growth beginning to slow, and capital-level requirements are only going up from a regulatory point of view, which does negatively impact future earnings potential.

Then with fourth quarter reporting coming over the course of November and into December, we are expecting some significant restructuring charges from many of the banks, which the banks call one-time in nature, but it does depress current quarter earnings only to help earnings in future quarters.

So we think that might be a better entry point, although realistically we have to wait for some of the trends that I just talked about to start to play out before we would get more optimistic on the Canadian banks.