A corporate dividend should be a sign of a healthy company that has strong revenues and earnings. This article is in response to client questions about some well-known companies in Canada that should probably not be paying dividends due to tepid growth prospects and very high levels of debt. It is consistent with the major goal of this blog to communicate investment strategy.
A dividend is a corporate liability but it is voluntary (unlike a bond payment which must be paid). Dividends may be increased, reduced, or eliminated by a company at any time. There is a group of well-known large companies in Canada that have especially benefited from the lower trend in interest rates over the past three decades. These companies were able to grow their businesses with cheaper and cheaper financing and they accumulated very large amounts of debt. The low cost of capital allowed them to pay out dividends despite high debt levels and the low level of interest rates attracted investors to buy the common and preferred shares. The crisis of 2008 and the move to even lower interest rates provided these equities with an even larger headwind that resulted in very high valuations. Investors were rewarded with high stock prices and people were conditioned that these investments should be a core part of any Canadian equity income portfolio in any economic environment.
The problem with these companies is that they did not take advantage of the low interest rate environment to reduce debt levels. They actually increased debt substantially under the guise of expansion into the U.S. market over the past couple of years. Now that the trend in interest rates may be changing, the stock prices have been declining and the debts are still at record levels. The combination of rising financing costs on the corporate debts and declining stock prices may result in a “snap” and breakdown of equity prices.
What to Avoid
- Avoid companies that have large debt levels relative to their market capitalizations. Anything approaching 1:1 may be a potential problem. These situations may be quite easily identified and discussed.
- Be especially weary of companies that have promised divided growth and have very high debt levels. These are two liabilities for the company that are competing for capital; one of them is voluntary and the other is not
A “Hypothetical” Example
- A company has an equity market capitalization of approximately $70 Billion
- The debt level is approximately $70 Billion
- The dividend yield is currently over 6.00%
- Dividend growth has been promised in the future
- The company has negative cash flow
- The stock is down over 35% in the past few years and many market participants consider it to offer good value
The potential problem with the above scenario is that the debt level is rising as a percentage of the market capitalization. If rates do “normalize” in the coming years, the additional cost to service the debt may be in the billions of dollars per year. The higher financing costs will probably result in downgrades to the corporate bond ratings and the potential for dividend reductions or elimination. If the dividend is reduced or eliminated, investors may liquidate resulting in even more pressure on the equity. This would be a very difficult set of circumstances which may result in the company attempting to raise large amounts of equity at lower stock prices. This is all in the context of the company promising substantial dividend growth in the coming years. In a situation like this, a dividend actually appears to be a negative attribute.
We are especially concerned with the long-term outlook for companies that are in the Utility and Pipeline sectors where debt levels are very high. The goal (with maybe one exception) is to avoid these sectors and to focus on situations that offer more positive risk/reward. Other interest rate sectors such as telecom may face a challenge from higher interest rates but the balance sheets are better and growth prospects appear to be more positive.
To review, laddered GICs should be considered as a substantial part of the fixed income side of the portfolio. Investment grade bonds with individual maturity dates of less than 5 years are OK but currently the yields on GICs are competitive with a lower risk profile. Preferred shares should be avoided due to esoteric structures, lack of liquidity, and the absence of firm maturity dates.
Investors looking for dividend income may look in areas of the market that have the combination of earnings growth, pricing power (the ability to pass on inflation), and better balance sheets. There are very large capitalized U.S. companies that have raised their dividend every year for decades. The combination of strong balance sheets, reasonable earnings growth, and diversification outside of Canada is attractive and may protect portfolios against the potential for secular inflation and Canadian dollar weakness over the longer term. There are attractive valuations in the current market.
In summary, avoid low growth, high debt common shares as a replacement for low risk guarantees. We are happy to discuss and review specific situations if readers have questions.
This publication is solely the work of Jon Batchelor for the private information of his clients. Although the author is a Manulife Securities Advisor, he is not a financial analyst at Manulife Securities Incorporated and Manulife Securities Insurance Inc. This is not an official publication of Manulife Securities. The views, opinions and recommendations are those of the author alone and they may not necessarily be those of Manulife Securities. This publication is not an offer to sell or a solicitation of an offer to buy any securities. This publication is not meant to provide legal, accounting or account advice. As each situation is different, you should seek advice based on your specific circumstances. Please call to arrange for an appointment. The information contained herein was obtained from sources believed to be reliable; however, no representation or warranty, express or implied, is made by the writer, Manulife Securities or any other person as to its accuracy, completeness or correctness.