Manager Insight

High payout ratios serve as a warning flag.
By Michael Ryval | 09/03/17

Understanding a company's fundamental attributes such as return on equity, free cash flow and earnings growth are key elements of the value-style process at Vancouver-based Leith Wheeler Investment Counsel Ltd. But in choosing dividend-paying stocks, while aiming for a total-return approach, the managers also need to understand how the business might develop over the next five years.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"Forecasting is fraught with issues. But we spend a lot of time talking to management, look closely at the assets and talk to people associated with the business," says Patrick Reddy, Canadian equity analyst and portfolio manager of Leith Wheeler Canadian Dividend. The $90-million fund has a 4-star Morningstar Rating for its risk-adjusted past returns in the Canadian Dividend and Income Equity category.

"We want to understand where the business is going over the next three to five years," says Reddy. "Since it's hard to forecast, we have our best-case scenario -- and our worst case. If something does go wrong, we ask ourselves, what's our margin of safety?"

Many factors could exceed expectations, on both sides of the equation. That's why Reddy, who is part of a team that includes Bill Dye, head of Canadian equities, and Canadian equity analysts David Jiles, Richard Liley and Nick Szucs, needs to understand how a company will grow its earnings and what that will mean for dividend growth, a key factor in fund performance.

"All our stocks pay a dividend. And, ideally, we want them to grow that dividend over time," says Reddy, an 18-year industry veteran who graduated from Simon Fraser University in 1999 with a bachelor of business administration degree and joined Leith Wheeler in 2006. "So we need to understand the variability of the business model. The higher the variability, the more you need to stress the downside. A lot of this shows up in the management's track record and its ability to generate profits. We also want to make sure that management has skin in the game and that they are aligned with our clients."

Rather than merely focus on the absolute level of a company's dividend, Reddy aims for total return. "Businesses that deliver the best returns are those that are able to not only grow their dividend but also grow earnings over time. If you are unable to grow earnings over time, you will probably be challenged in growing the dividend."

Companies can find ways to boost a dividend, by raising the payout ratio, for instance. But that is a warning flag in Reddy's eyes, since a high payout ratio indicates it will be more difficult to raise the dividend over time and may even call into question its sustainability. "Companies that have high payout ratios tend to underperform."

The universe of stocks that Reddy surveys has about 200 names, yet only about 30 merit inclusion in the fund. Although the fund's running yield is 3.1%, about one-third of the names pay less than 2%. One example is  Canadian National Railway Co. (CNR), which has a 1.6% dividend yield. But over the last five years, earnings have grown by 14% annually, while dividends have had 18% annual growth.

"It has a very strong balance sheet. Debt to earnings before interest taxes depreciation and amortization is 1.5 times. And it has an A-plus credit rating," says Reddy, noting that CN has a payout ratio of 31%. "You have a business which is essentially an oligopoly. If you just want to screen for the highest-yielding stocks, CN would not go to the top of the list. But I don't agree with that approach. If you simply screen according to the highest yielders, there could be issues with those stocks, whether it's high leverage or not being able to grow earnings."

Reddy believes the CN's management has a good track record of earnings growth. Looking ahead, he expects that the railway can grow earnings by more than 10% annually for the next five years. "The dividend can grow by a similar amount."

In a similar vein,  Open Text Corp. (OTEX) has a 1.4% dividend yield, but has risen about 25% in the past 12 months. The $11-billion software company, which specializes in enterprise information-management systems, has grown its earnings by 25% compounded annually over the last decade. Not only does the management team own a lot of stock, notes Reddy, the business generates a lot of excess capital.

"They can use that to grow the dividend, or reinvest back in the business. Given that the ROE is 20% and return on invested capital is 13%, they may be able to find firms with similar returns. They have a good track record of acquiring assets," says Reddy, noting that the company recently spent US$1.6 billion to acquire Dell EMC's Enterprise Content Division, including Documentum.

In the financial-services sector, Reddy regards  Bank of Nova Scotia (BNS) as a favourite holding. "Its dividend yield is 3.9% and the payout ratio is 44%. We see earnings and dividends growing in the mid-to-high single digits," he says, adding that the valuation is 12 times forward earnings. "And we see positive momentum behind its earnings."

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