Now might be a good time to rethink dividend investing in Canada

Yield-focused funds and rate-sensitive sectors have materially underperformed the Canadian stock market index since the start of this year. (denphumi/Getty Images/iStockphoto)

Dividend investing in Canada has taken an unrewarding turn of late, as investors anticipate the first U.S. interest rate hike in nearly a decade.

Yield-focused funds and rate-sensitive sectors have materially underperformed the Canadian stock market index since the start of this year – a sampling of the weakness to come, said Mike Newton, director of wealth management and a portfolio manager at ScotiaMcLeod.

“There’s going to be a big reckoning,” he said. “People who think that their dividend ETF is just going up every quarter, they’re going to be in for a rude awakening.”

Whether that means reducing exposure to dividend payers, or shifting focus from high yield to total return or to dividend growth stocks, now might be a good time for Canadian yield hunters to rethink their approach to income-bearing stocks.

Dividend investing has been a lucrative exercise in Canada since the financial crisis.

With the bond market offering miserly yields, equities paying decent dividend yields took on greater profile. Investors were driven to rely on the stock market for income in the absence of attractive fixed-income alternatives.

In late 2008, in response to the worst financial calamity since the Great Depression, the U.S. Federal Reserve slashed its federal funds rate, which just 15 months earlier sat at a now unfathomable 5.25 per cent.

The Fed cut the upper bound of its trend-setting rate to an unprecedented 0.25 per cent, which rippled through markets as long-term bond yields also withered. Since the beginning of 2009, for example, Canadian five-year benchmark bond yields have averaged 1.8 per cent and an uninspiring 1.4 per cent since the start of 2014.

Those sectors traditionally generous with dividends – utilities, telecoms and real estate investment trusts – drew outsized investor interest as a result.

Since the S&P/TSX composite index bottomed out in March 2009, those three sectors have all outperformed the broader market, with annual total returns ranging from 15 per cent to 22 per cent, compared to 13 per cent for the composite.

As a result of their popularity, those stocks are now looking expensive. “That’s the problem,” Mr. Newton said. “Every single ETF in the country is chasing the same names.”

So with the Fed signalling its intention to raise rates from near-zero by the end of the year, investors have begun to rotate out of higher-yield sectors. While the Bank of Canada, on the other hand, seems as likely to cut rates again as hike them, Canadian yields tend to track the U.S. bond market more so than the domestic economy.

As a result, Canadian stocks with no dividends are now beating those that pay, on average. Since the start of the year, several Canadian dividend ETFs, including BMO Canada Dividends ETF, iShares S&P TSX Canadian Dividend Aristocrats Index, and Vanguard FTSE Canadian High Dividend Yield Index ETF are all in negative territory, while the TSX composite is up by 3.79 per cent on a total return basis.

That’s due to continue, with Canadian dividend champions likely to be traded down to an extent comparable to the so-called “taper tantrum” of 2013, when several of those types of stocks dropped by 10 to 12 per cent, Mr. Newton said.

“They’ll react negatively, but history has shown that six to 12 months later, they produce positive returns, after the initial shock is over. It’s not enough to get bounced out of really high quality names,” he said, citing his preference for lower-yielding stocks like Brookfield Asset Management Inc. and Canadian National Railway Co.

Ryan Lewenza, strategist with Raymond James, said he is also not swayed from his belief that high-quality dividend paying stocks need to be the “cornerstone of an investor portfolio.”

Rather than high-yield names, he said he prefers shares of companies likely to increase dividends, which are less volatile and more reasonably valued. He named Agrium Inc., Suncor Energy Inc. and Linamar Corp. as fitting the description.

Other money managers are taking more evasive action.

Bob Sewell, president of Bellwether Investment Management, who runs a concentrated portfolio that is now about 70 per cent weighted in U.S. stocks, said investors need to be selective about the Canadian market.

“You’ve got to go through and think what dividend growth companies are likely to perform well. What is their earnings growth and is the current price supportive of that,” he said, naming Ag Growth International Inc. and Linamar Corp. as promising dividend growth stocks.

Meanwhile, Patrick Horan, principal and portfolio manager at Agilith Capital, said he largely unloaded holdings of Canadian dividend payers last year.

“Some dividend stocks are trading at all-time high valuations,” he said. “If there’s one main theme we have in our book, it’s that we are short stocks that have exposure to rising interest rates and we’re long stocks that have exposure to cyclical earnings.”


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