Dividend-paying equities were one of the good news stories coming out of the recovery from the 2008 financial crisis. Dividend strategies are key to a resilient portfolio during COVID-19 as well, but they need an evolved approach to be successful now and into the next normal.

Purpose Financial founder and CEO, Som Seif, talks about:

• Three key principles Purpose developed from our own research on dividend stability during COVID-19
• How to look at which businesses will thrive in the new economy
• The on-going importance of diversification and risk management

Read the transcript:

SOM
Hi everyone. This is Som, founder and CEO of Purpose Financial and Purpose Investments.

As we cross past 60 days of facing this healthcare crisis, I continue to have both a positive and a cautious view of where we are. First, the data on the number of cases of the virus are starting to turn in Canada and the U.S., although a little slower than we had hoped. In Canada, the real impact of not properly managing our strategy for long-term care facilities will force us to have to rethink that industry for years to come. We as a nation will have to really look in the mirror and reckon with how we handled the risk to our elderly and most vulnerable.

Second, as a leader in my business, I can tell you that over the past few weeks we’ve been able to start to see paths forward more clearly and to start planning further ahead. 60, 90, 120 days ahead, which frankly is still not great — but much better than not knowing what one week ahead was going to look like.

With that said, I’m cautious because I just don’t feel like we have real understanding of how the economic and social structure will change in the coming months and quarters. Frankly, I’m amazed by the sheer level of unemployment numbers in the U.S. and Canada. The market seems to believe that all of these job losses are temporary and that they people will have their previous good paying jobs back within one to two quarters. But I just don’t believe it.

We’ve never seen job losses at this scale so quickly, and I don’t see businesses hiring as aggressively and, more importantly, jobs being of the same quality as they were pre-COVID-19. This troubles me because you have to believe that either the government will fill the gap left by this under-employed group or that the consumer spending and economic growth in Canada and U.S. will be impacted by this for some time. Either path doesn’t make me feel comfortable.

There’s obviously still a lot to be figured out in the world, from both healthcare and economic standpoints. There is still a lot of confusion in society around what it means when the government signals to start re-opening our economies. It doesn’t mean that COVID-19 is going away, rather it is saying that we have capacity in the hospitals to handle the spread of the virus. We all need to understand that we still need to be careful and we need to keep our focus on the safety of essential workers and finding a vaccine.

As we turn to the markets and investing, we’ve talked a lot over the past few weeks about how much has changed in a short time, and all I know is much more will keep changing. Each of the guests I have spoken with has shared their own version of “we’ve been here before, we’ve recovered, and we’ll recover again.” And that’s important to remember.

The freshest recovery in our memories is from the global financial crisis of 2008-2009. Coming out of the ‘09 recovery, one area that really worked well was dividend-paying equities, which was one of the good news stories and I believe there are some similarities to that situation today.

During ’09, coming out of the financial crisis, investors sought out the relative safety of more mature and defensive businesses that were oversold. There was also extraordinary monetary policy that pushed investors to have to go out the risk curve to satisfy their yield objectives. So dividend stocks looked like the right approach and came into great demand.

This time around, despite the difference in the catalyst, we believe there are similar circumstances playing out in the current market environment. Like before, corporate dividends are priced very attractively versus other income sources, such as government and corporate bonds.

Yet this time around it’s not just about dividend yields — the real risk is around the uncertainty of a company’s willingness or ability to pay its dividend. In fact, I believe any company that had been questioning its payout ratio or dividend policy over the past few years will consider “cleaning this risk up” under cover of a COVID-19 related decision.

For me, dividend investing has always been a core strategy of the way I think. In my first business, Claymore, I created some of the best dividend strategies using dividend growth principles. Back in 2005, most dividend ETFs were just focused on the highest yielding stocks. I had done research to show that if you buy the stocks that have shown a persistence in raising dividends, even though it may mean having a lower yield today, over time you outperform because they generate capital appreciation and underlying business growth. You do better than just a portfolio of high yielding stocks. And those funds, called Dividend Aristocrats strategies, did really well.

When I started Purpose, I went back and said, “we can do better by focusing on not just companies that grew their dividends historically, but also those that had the quality and momentum in profits to grow their dividends in the future.”  We found a lot of value in this and our core dividend funds here at Purpose have really performed spectacularly over the past six years.

However, when the pandemic hit the markets and the economy, I asked the team to go back and look at our dividend strategies and ensure we were analyzing and incorporating a forward-looking principle to our investment process.

The team really put a huge amount of effort into taking a bottom-up look at all the sectors and companies in our investable universe and after analyzing the impact of the changing world on dividend sustainability, here’s what we’ve learned:

It’s important to understand that buybacks do really matter for dividend investors, and so does the ability to generate cash flow to pay out to shareholders. Our early analysis found that 90% of relevant companies had suspended their buyback programs and about 20% of the companies in our universe had a high risk of suspending dividends.

And, of course, the longer this crisis goes on, the worse it gets.

The team implemented a number of key changes to focus on sustainability of dividend and we rebalanced the portfolio a few weeks back.

Given all of this, what should an investor’s strategic approach be to dividends today?

Here are a few principle ideas:  First, I think it’s important to understand we are entering a new business cycle, and to think about what industries and businesses will be strong or weak going forward, not just looking historically.

Second, in the past it’s been relatively easy to select a company based on its dividend yield, but today I strongly believe that yield alone won’t be successful because of the changing tides of underlying businesses. We need to have a more focused strategy around understanding the quality of a business’s capital structure, its profits, and its trends in revenues and profitability.

Finally, I’ve always believed that diversification matters. Not only in ensuring you don’t have too much single stock risk when relying on dividend income, but also ensuring you have proper industry diversification.

On the first point around assessing the new business cycle, it’s important to try and gauge the depth of the real economic impact of both this pandemic (and its reach to undermining the stability of certain industries that we have gotten used to looking at for dividends in the past) and also the meaningful trends that will emerge or accelerate because of changes in growth rates of different businesses. For example, old economy businesses may be threatened even further due to digitization accelerating faster than ever seen before and we need to be aware of this when selecting a stock for its ability to pay sustainable income to us today and far into the future.

A great example of the challenge of economic impact is within the oil patch, where North American crude oil benchmarks have seen steep declines on an unprecedented basis. Energy stocks globally have historically been a strong source of dividend investing, but the risk in energy stocks is very high. We’ve just seen companies like Royal Dutch Shell cut its dividend for the first time since World War II.

On the industry and business trends that will come out of this environment, many businesses in the travel industry or entertainment industry, which were rocky even heading into this current crisis, have only seen acceleration away from their business models.

Even if they can maintain dividends in the short term, they present significant risks to being able to pay over the long-term as profitability may be challenged or decline severely. Companies like Carnival, Las Vegas Sands, any travel and tourism related business have slashed their dividends, but we also see basically the entire consumer discretionary sector as being impaired from a dividend perspective, with certain exceptions like McDonalds and Yum Brands.

Even looking at the traditionally defensive consumer staples sector, we’re questioning whether blue chips like Kraft Heinz and Sysco Foods will be in a position to sustain distributions.

It’s clear that, with the extreme impact COVID-19 has had on the global economy, dividend safety is a critical consideration. I read a Goldman Sachs report recently saying they expect aggregate dividends to decline by 23% in 2020 after a decade of consistent increases.

With some sectors and businesses affected more than others, I believe security selection is more critical than ever with dividend investing. Buying a stock because it has an attractive dividend yield is not a sure bet to generate long term dividend income.

Today, we need to be incorporating several other factors, such as earnings and profitability quality, the volatility of a stock and its price momentum.

Many of the results in our analysis are intuitive and there are a few standouts:

● In energy, dividend investors should avoid exploration and production companies, but midstream companies are probably OK.

● Consumer staples that sell necessities have a higher chance of dividend sustainability going forward.

● Banks in Canada look more attractive for dividend stability given strong dividend coverage ratios. Outside of Canada, dividends could be at greater risk. Despite dividends being stable, banks may frustrate investors from a growth perspective.

The last thing that we see as really critical today for any dividend focused investor is risk management, which is something we’ve always placed a great deal of emphasis on here at Purpose through diversification at the single stock and industry level.

First, ensuring you have a diversified portfolio of names that provide you strong income is important. You don’t want any single company’s cut in dividends to impact your income and portfolio.

Second, and just as important, is the need to ensure proper diversification by industry.

In our core Canadian dividend fund, the pursuit of greater sector-level diversification means using U.S. names where the Canadian economy is underdeveloped or has limited exposure. In all fairness, this has served us well at times, but it’s also meant that sometimes we’ve lagged behind others.

For a Canadian investor, it’s important to understand that buying multiple banks, telcos and utilities isn’t diversification. It’s critical to have technology companies, healthcare companies, consumer staples and discretionary names and often we have to find these names in U.S. to get real quality companies.

Our world is different this time and having strategies in place requires change. In particular, side-stepping high yielding businesses that look attractive based exclusively on their backward-looking fundamentals and dividend growth is more important than ever.

I believe dividend stocks are still the bedrock of a sound portfolio and will lead in a recovery, but it’s important to recognize that the investment processes that thrived from 2009 to 2019 aren’t enough to avoid the fallout now.

A great opportunity exists, but it requires a more holistic approach than just screening for high dividend yield or buying a passive index of the highest yielding companies to take advantage of it.

Happy hunting and remember the world we are entering will look different for some time than the world we just left.  So be prepared.