Franklin Bissett Dividend Strategy Update

Employment has been strong on both sides of the border. Yet, expectations persist that we are heading into a recession. Are you taking a more defensive stance in the dividend portfolios? 

As always, our portfolio composition is driven first and foremost by our bottom-up approach to research and valuation. If we were to characterize the portfolios as defensive versus offensive, our outsized exposure versus the benchmark when it comes to sectors such as Consumer Staples, Communication Services and Utilities, and our underweight positioning in Materials and Industrials would put us firmly in the defensive square at this point. Even in more cyclical sectors our emphasis on high quality durable businesses and strong capital positions and dividends influence our positioning significantly, so where we do have more cyclical exposure, we own companies with the balance sheets to endure a downcycle and in some cases to be able to take advantage of their capital positions to do accretive M&A.

We know quality dividend-paying companies have outperformed the broader Canadian equity market in the long term. We have been in a high inflationary environment, not seen since the 1980s. How do you expect dividend-paying companies to perform in such an environment? Considering also the inflation rate has dropped from the highs of last year but continues to be well above Bank of Canada’s target.

This is where it’s so important to remind holders of our portfolios that despite our emphasis on dividends in these mandates, we are always looking for an attractive total return profile meaning that growth is a key element. Where you have not only a dividend but an underlying business that can deliver growth in free cash flow over time. This supports not only growth in the dividend but growing value attributable to the shareholder. Waste Connections is an example of a recent addition to the portfolio. They are the third largest provider of waste and recycling services in North America. It’s not the highest yielding name in the portfolio, but this company has been able to grow free cash flow in the double digits in an inflationary environment, partially due to its ability to push through price increases across its asset base. We expect the dividend to grow over time, and we think the stock is undervalued.  

A major theme in the market these days has been the energy sector. What are your views on the sector and prospects of the holdings in the sector?

Last year’s significant volatility in energy prices was the result of a return to pre-COVID demand levels colliding with supply concerns centering on direct and indirect impacts from the Russian invasion of Ukraine.  We saw near-term cycle highs for both crude oil and natural gas, which contributed to windfall cashflows for many producers.

In contrast to most past cycles, high prices did not translate into considerable growth in capital spending.  Producers utilized the excess cash flow first for debt repayment, and second as an opportunity to return cash to shareholders through dividends and share buybacks.  As a result, most producers are in much better financial position than they were even prior to COVID, with significant de-levering occurring over the past two years.

Both crude oil and natural gas prices have since come off their highs.  This is especially true for natural gas, where in the summer we saw prices in North America hit highs not since 2008 and have since retreated sharply.  However, not all companies have the same ability or skill to market their gas effectively.  Tourmaline and ARC Resources are two core holdings in the Dividend portfolios.  Both firms market their natural gas under a number of different marketing arrangements at various different pricing hubs.  As one example, although gas prices may be depressed in Alberta, Tourmaline is able to sell some of its natural gas in the premium California market, which fetches considerably higher prices.  When combined with relatively good prices for liquids production, cash flows remain relatively robust, with common dividends well covered.

Lastly, higher interest rates raise the cost of capital for all businesses, but we note that the considerably improved financial position of the producers means higher borrowing rates are not a drag on their profitability.

There are also discussions and plans around the mining of rare metals. Where do you see the opportunity in Canada, when also balancing the team’s ESG approach?

The global buildout of clean energy infrastructure is driving the need for these metals, and there are certainly some long-term prospects for investors given that Canada has some large resources of rare earth metals and there are some Canadian companies with development projects both in Canada and internationally. As far as investable securities, there isn’t anything that we would deem suitable for the dividend mandates given our investment criteria. Our holdings in the Materials sectors are again reflective of our fundamental research and are companies with well-established track records and free cash flow. Agnico Eagle Mines would be our only pure play mining business, and as you mentioned ESG, I would put up Agnico as an example of a Canadian mining company that has demonstrated its commitment to environmental stewardship, social responsibility and strong governance and continues to make meaningful progress.

The last 15 months have been tough for highly valued/potential companies. You have avoided these in recent years, even those with some level of dividend. Are you finding opportunities now that their valuations dropped substantially?

Valuations have certainly retreated for some of these stocks.  And we do continue to watch them.  Our focus is on companies with full-cycle profitability that are able to pay a stable, growing dividend.  Companies with that ability generate positive free cash flow.  Some of the “high-flyers” during the period of near-zero interest rates are still not profitable, and don’t generate free cash flow.  So according to our valuation approach, many of the stocks we would place in that “potential” stock bucket are still not attractive, as often we see our valuation estimates for these names degrade in lockstep with market prices.

Companies that require frequent injections of external financing may have to adjust their business models, if equity is not available at a competitive cost of capital.  And, obviously, the cost of debt is higher now than it has been.  Self-financing businesses have a resiliency in this environment that we appreciate.  These tend to be the types of businesses that pay dividends.

However, we are finding that some stocks with good fundamentals have been caught up in the downdraft, and we continue to compile a “wish list” should an opportunity arise to acquire them at attractive valuations.

Your dividend strategies are underweight Financials. Neutral on Banks but underweight Insurance Companies and Capital Markets. How do you anticipate the higher interest rates to impact these sub-sectors and their dividends? And how about what’s going on right now with some regional banks in the U.S. and more recently Credit Suisse?

In addressing the second part of your question, I would want to note our holdings in the Financials sector in the U.S. equity component of the portfolios, which are both longstanding holdings and these are JPMorgan Chase and Wells Fargo. Obviously, the recent failures of two regional banks in the U.S. over the past week have led to heightened volatility in debt and equity markets and essentially driven discount rates higher across equities in the U.S. financial sector. Regionals have been the most impacted, but the larger institutions including those held in the portfolios are also under pressure. Although it may be rational for the valuations of the large diversified banks to compress to some degree given the implications of this situation are likely tighter regulation and potentially a higher cost burden industry wide over time among other things, the risk to federally regulated banks such as JPMorgan are not of the same nature as they are for smaller or less diversified or less capitalized banks. Incidentally, we have not made any changes to our positions in these holdings. The situation south of the border also illuminates the benefits to the Canadian banking clients of our more heavily regulated system, with strict liquidity and capital requirements.

With regards to the main question on higher interest rates, as for banks, higher interest rates are generally good for profitability as a less-responsive deposit base is used to lend at higher rates, benefitting profitability. In the current environment however, short-term rates have increased so much more than long-term rates that deposits have become more responsive than normal as depositors demand a higher return. In the insurance business, it's about the interplay between higher interest rates, allowing for higher returns to be earned on their long-term assets that are duration matched against long-term liabilities, versus the pricing of policies which can be more or less competitive depending on the assumed return on their assets. For capital markets, higher interest rates and quantitative tightening by central banks has led to a decrease in liquidity in financial markets, and general availability of capital, leading to declines in capital formation which is generally bad for capital markets-oriented businesses.

Both the Canadian Dividend and Dividend Income strategies outperformed their respective benchmarks and passive strategies in the last year. They also continue to deliver less volatility in the current market than the broader market and peers in general. What are you most excited about moving forward?

2022 marked a year where finally the long-term decline in interest rates began to reverse, and money was no longer free.  That remains the case today.  The pace of interest rate increases has slowed, and there is more economic uncertainty.  But even once the central banks stop raising rates, we feel that the market and the economy will need time before we see the cumulative effects, given the lag exhibited by monetary policy. 

We believe the portfolios are well positioned for this environment.  As Ryan said earlier, we are positioned defensively as we believe that is still prudent. Our companies are well capitalized, with leverage ratios that are reasonable for their industry.  And in the case of commodity cyclicals, leverage ratios are comfortably below historical averages.  So we feel good where we are.

But we are ready to pivot from defense to offense when the time is right. 

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