Over the last twenty years, investors have witnessed a steady decline in the interest rate on investment grade bonds, GICs and term deposits. Now, interest rates on most fixed income (ie. bonds, GICs, etc.) are at record low levels and in many instances, produce negative “real” rates of return after taking into account inflation and taxes. This means that an investor’s purchasing power is shrinking year by year often resulting in a reduction in their standard of living. The challenge facing investors is further exacerbated by the fact that the equity markets have been very volatile in recent years.
So where do investors turn for a steady source of income with reasonable growth and inflation protection?
We believe a key element of the solution to this problem is Dividend Growth investing. A sound, proven approach to investing that has been used predominately in the management of estates and trusts for many years.
…managing the portfolio’s Beta risk is a key differentiator in our Disciplined Dividend Growth investment process.
At its core, this approach is based on the premise of investing in companies with a history of paying a sustainable dividend. Dividends provide a regular source of income to the investor that can be used to support their lifestyle or be reinvested. The share price of dividend paying companies tend to fair better in periods of market turbulance because of their steady income. Also, Canadian source dividend income is taxed at a lower rate than most investor’s other income.
Simply investing in companies that pay the highest dividend isn’t the answer. There are many factors that must be considered including:
- Dividend Growth – Current yield is important but a history of dividend increases is more important. Various studies have shown that dividend growth equities have outperformed the combined group of dividend paying equities and the broader TSX and S&P 500 indexes over the last decade.
- Earnings and Cashflow Growth – Growth in earnings/profits and cashflow help to ensure that a company can continue to increase their dividend rate in the future.
- Payout Ratio – This measures how much of a company’s profits are being payed out in dividends. Paying out too much suggests they aren’t investing for the future and the current dividend rate may not be sustainable.
- Managing Risk – Risk in a portfolio needs to be managed at several levels: asset mix; sector exposure (eg. Energy, Financials, Materials, etc); and at the individual security level.
- North American Focus – Often investors concentrate their investing in Canadian equities. We think this creates significant unrecognized risk since the Canadian market consists predominately of Energy, Financial and Materials’ companies. In other words, sector concentration risk which translates into higher portfolio risk. Instead, we invest in the best opportunities that trade in the North American markets which provides more balanced exposure to sectors such as Technology, Health Care and Consumer Staples. This is a significant distinction from how many mutual funds are managed.
- Portfolio “Beta” Management – We believe that this is a key means of managing risk that is often overlooked. Beta is a measure of how a equity’s price will change relative to an index. For example, BCE has a Beta of approximately 0.4 versus the TSX which means that a 1% change in the TSX should, on average, translate into a 0.4% change in the price of BCE (thus BCE is a low Beta equity). While understanding the Beta of an equity is important what is more important is understanding the blended Beta of the constructed portfolio. We focus our attention on managing Beta in our portfolio construction and understanding how our solutions will respond to changing market circumstances.
We call this investment process, Disciplined Dividend Growth and we believe that it is a significant differentiator in the marketplace.
We aren’t suggesting that equities are the entire answer to the challenge facing investors. Our Dividend Growth solutions still need to be blended with other asset classes such as fixed income and real estate to craft the right asset mix for an investor. Even with low interest rates, bonds and preferred shares also protect the portfolio during periods of higher equity volatility. We also complement our equity and fixed income investments with the selective use of the covered call option strategy to further enhance returns.
So, Why is it “Disciplined Dividend Growth” Investing?
Discipline refers to the rigorous quantitative and qualitative methodologies used in the identification and selection of companies that have: better than average relative valuations; a track record of dividend growth and a sustainable payout level; and balance sheet strength. The companies selected in our process are then combined in the construction of Bellwether portfolios to ensure overall risk is effectively managed.
Growth because we emphasize profit and dividend growth, which we invest in at reasonable valuations. Our definition of Dividend Growth investing focuses on the long term profitability of a company and applies extensive testing to ensure profits and dividends will continue to grow into the future. It is a conservative approach to measuring the current value of future profitability.