Many companies are at a high yield now. Should we take advantage of it? Or leave it alone because these are unknown times?
I have always advocated to not chase yield, and instead, chase dividend growth and the sustainability of growing that dividend. So this becomes the classic evaluation about value trap vs value opportunity, which is nothing new.
For me to consider a company a value trap, I have to believe that there is a permanent long-term deterioration in the future fundamental strength and health of the company. To me, a company becomes a value trap when either it’s on the verge of going out of business, or poised for a long protracted period of collapsing or even disappearing earnings, cash flows, and inevitably dividend cuts or elimination.
The best value opportunity manifests when earnings, cash flows and dividends continue to grow or improve in spite of current price weakness. It is for these reasons that I believe in focusing on fundamentals first and foremost, with the primary objective of evaluating a company’s intrinsic value. Once this is accomplished, and only when it is accomplished, will I even consider bringing price into the analysis. When I am confident that the current stock price is lower than my assessment of intrinsic value, I see opportunity, not a trap.
However, we also must be aware of the conditions we are facing today. Investing during exceptional times like now (in a pandemic, and soon, in my opinion, in a recession), is different than investing during “normal” times, where the rules above would easily apply. Companies might choose to cut or suspend dividends temporarily, but once recovery begins, they will place it back and grow again, provided they manage these challenges accordingly. Hence a diversified portfolio, exposed to many sectors (including recession-proof sectors) is key to maximize a growing stream of income. We also need a few updates to understand their guidance and determine what is the E in P/E, the S in P/S or the OCF in P/OCF. So this is a process that takes time and fundamentals, not price action, should drive our decisions.
During these exceptional times, capital intensive businesses are affected first. I don’t know how to invest in mining / natural resources, but this sector, along with energy, are well known for these vulnerabilities. Speaking for energy, where I do have some exposure, not all industries are the same. A midstream company does not have the same risks than an upstream or downstream company. Cash flow ultimately is king when it comes to financial strength, as well as how management can react and adapt to these challenges. Consumer Discretionary companies are also affected first during a recession.
We won’t know how long it will last, or who will do well and who won’t survive. We can gauge the past to assess how management handled previous challenges, and how the business did in previous extreme conditions (which speaks volume to management competency and business maturity), but it’s no guarantee that they will succeed again. Hence again, a diversified portfolio with exposure to different sectors is key, as well as how a portfolio is constructed is also key – taking valuation into account to maximize margin of safety.
Which brings to my next point of taking advantage of opportunities, and be aware of how that aligns with your risk tolerance to be partnered with these companies. For example, partnering with energy companies involves more risk than partnering with standard utility or consumer staples companies. So if you are willing to be exposed to that risk, take advantage of opportunities when they present themselves. On the energy side, I believe ENB and SU are not going anywhere and will survive this. On the consumer discretionary side, I believe that QSR, MCD and SBUX are not going anywhere and will survive this. Moreover, I firmly believe that they will continue to grow and in 5 or 10 years be at operating levels higher than today. So I would take advantage of lower prices to be exposed to a higher return, given the risks associated with it (otherwise I wouldn’t have partnered with them). So I would dismiss the generic “stay away from that sector” advice and instead evaluate how much exposure you want to have to that sector in your portfolio (based on your risk tolerance and objectives) and take advantage of the opportunities when they appear. I also believe that other names in these sectors that will be severely affected are at a higher risk, so my position on those are to hold – not buying and not selling. I like to measure quality of business on how they handled their operating performance after a recession (and in this case, a pandemic) recovery, not during a crisis.
Same with Canadian banks, they are not going anywhere and I don’t see them cutting dividends either. They are better positioned financially now than they were in 2008, and they endured 2008 well. The government will help them as needed. Some CEOs already stated that they don’t intend to touch dividends. You need to do this evaluation for every sector.
If you step back, investing in equities is all about determining how much you want to allocate to partner with these companies, and have enough large timeframe to let that work for you. Equities are cyclical, and we are not insiders, so the best we can do is to analyze their past (for quality history), present (for current quality and valuation) and future (for estimated quality and valuation) and have enough diversification so that our portfolio, as a whole, can work for us and provide the expected outcome – be it superior capital appreciation, total return or growth of dividends for a reliable stream of income.
Only time will tell how these decisions will pan out. So don’t let the distractions from news and unknowns deter you from taking opportunities. That’s why investing is for the long term. Our job is to allocate capital to the business that we want to partner with, and take advantage of opportunities when they are trading below their true worth – which has always been what we want, buying low.
The following companies are fairly valued and estimated to grow in the long term, and fairly prepared to handle the uncertainties ahead. As earnings season develop, I’ll be monitoring it, but this is my initial list:
Utilities: FTS, ACO.X, CU
Industrials: CP, CNR, WCN
Discretionary: QSR, DOL
Financials: RY, POW, BAM.A, TD, IFC, IAG
Tech: OTEX, CSU, ENGH
Telecom: T, BCE, CCA
On the US side, this is my list:
Tech: ACN, ADP, CSCO, MA, ORCL, MSFT, TXN, V
Financial: AMP, CB
Healthcare: ABBV, ABC, BAX, JNJ, UNH
Discretionary: LOW, HSY, MCD, TGT
Industrials: CTAS, GD, NOC, RTX, SWK
Regardless if there will be a recession soon or not, or which business will survive or not, or cut their dividend or not, investing is about doing our homework to figure out which companies will continue to proper, based on the information available today (operating results from the business, not opinion from the media). If you are not prepared to be 100% convinced of your plan and invested in your normal risk-based equity allocation, Mr. Market is not going to care and will be perfectly content to see countless others move forward while you get left behind. The corona virus crash cannot be an excuse to not do any work, like staying on the sidelines and not identifying the companies you want to own when you decide the time is right.
This is what temperament is about. Having the discipline to stick to the plan during easy and hard times. We are now living through the hard times phase. But the economy is cyclical, recessions come and go, so if you zoom out, this too will pass (and so will the opportunities of lower valuation). Have a defined plan based on informed decisions (not emotional reactions), and stick to it. In the long term, equities on a diversified portfolio will continue to provide a good return considering the low interest rates that we’re living in – and dividends from many stable companies will continue to grow and provide dependable, reliable and steady income, which can be reinvested or spent.
Stay safe and happy investing!!!