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Dividend fund steers clear of Canadian bank stocks

Portfolio manager Stephen Groff explains that he doesnít hate banks Ė he just worries about their future profitability. So, what does he like?


Date: October 6, 2017

Stephen Groff, a portfolio manager with Cambridge Global Asset Management, a unit of CI Investments Inc., doesnít own Canadian banks in his domestic dividend mutual fund.

Itís an unusual call given that banks are index heavyweights, but it hasnít hurt his Cambridge Canadian Dividend Fund. It won a Lipper Fund Award in 2016 for generating strong returns over three years with lower risk than its peers.

He also runs U.S. and global dividend funds without paying attention to benchmark indexes, and will raise cash levels to as high as 30 per cent if he canít find attractive stocks. We asked Mr. Groff why he sees risk in Canadian banks, why he shuns most resource plays and why he likes the stock of an insurer and a beer giant for the long haul.

How do you search for dividend-paying stocks?

We aim for the best total return in terms of capital appreciation and dividends. We want to own high-quality businesses at a reasonable price versus simply getting a good yield. That way you reduce the risk of losing money in a company with major problems that may not be fixable. And just because a company has historically paid a high yield doesnít mean it wonít cut its dividend. You saw that with former energy trusts. We donít just look for dividend growth, either, because some companies will raise dividends even when their businesses face pressures from technology, cyclicality or excessive leverage. Our Canadian portfolio owns mega-caps like Alimentation Couche-Tard, a convenience-store operator, as well as smaller companies like Cara Operations and Cargojet. We will also raise our cash positions if, for instance, we feel securities are fully valued.

What do you have against owning Canadian banks?

Itís not that we hate banks. They are an oligopoly, and historically have generated very good shareholder returns and return on equity. But we see risks in drivers of bank profitability Ė whether in overall loan growth, rising consumer debt or elevated housing prices. If things get challenging and housing prices fall, a lot of consumers could face financial trouble. The amount of capital that banks need to hold would rise to absorb loan losses, and that can hurt profits. But Canadian banks also need to re-engineer their business model as technology shifts to banking online from branches. We are not predicting Armageddon, but we think there are more headwinds than tailwinds. At the right time down the road, we likely will own banks.

How wary are you about energy and resource dividend payers?

Itís generally not a good place to find yield. Oil and gas exploration and production companies tend to be cyclical and capital intensive. Energy prices have been volatile. Because the well-production-decline rates of many companies are high, significant money needs to be invested just to keep production flat. There are exceptions, like Canadian Natural Resources, which we own. We like its management team because it aims to get the highest value for every dollar spent. And it has lower decline rates, which allows the company to generate more cash flow. Royalty companies are also attractive, partly because they donít have capital expenditures. We also hold PrairieSky Royalty in the energy sector, and Franco-Nevada in gold mining. You just need to make sure management doesnít overpay to acquire royalty streams.

Rising interest rates can hurt dividend stocks because they mean higher borrowing costs and competition from less risky bonds. How are you prepared?

Many higher-yielding stocks face greater headwinds because their businesses reinvest less in their business. Firms with smaller payouts reinvest more to grow their business. We tend to own a higher number of the latter, which should hold up better if rates climb. Real estate investment trusts [REITs] will also face pressure if rates rise sharply. We do own REITs, such as U.S.-based STORE Capital, but are highly selective. Generally, we want to own good, durable businesses with economic moats that will prosper irrespective of the interest-rate environment.

Name a favourite Canadian dividend stock for the long term.

Intact Financial is Canadaís largest casualty and property insurer, so it has an advantage because of its size. Because the company has more data and analytics on customers, it can underwrite smarter and price risk better than its competitors. Intact tends to generate higher returns on equity than its peers. And its management tries to stay ahead of the curve; for instance, it insures drivers who use their cars for ride-sharing. Intact is also growing by acquisition. Its recent purchase of OneBeacon Insurance will allow it to expand into the U.S. market. Fires, floods or higher injury claims are always risks, but what matters is that the insurer is compensated by pricing that into its policies.

How about a U.S. dividend stock?

Anheuser-Busch InBev is the worldís largest brewing company, and it has strong brands such as Budweiser, Stella Artois and Corona. It uses the cost-cutting model of 3G Capital, one of its shareholders, so itís very efficient and lean. Debt rose with last yearís purchase of SABMiller, but the company has been able to borrow at advantageous rates and still generates a healthy amount of cash flow. Growth will come from a rising middle class in Asia and South America. And Anheuser-Busch continues to make acquisitions, including the odd craft brewer. It owns Goose Island, which was just a small Chicago brewery, and that brand now has been rolled out all over the United States. That is the kind of thing we like.

This interview has been edited and condensed.

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