As we head into the Labour Day weekend, it looks like this was finally Canada’s quarter in terms of equity performance. At the time of writing, the TSX was up around 6.3% compared to a 5.7% gain on the Dow and a 2.5% lift for the S&P500. Some of this can be attributed to our benchmark index not having some of the issues that American stocks have faced in recent weeks, from a hefty drawdown in large-cap tech to the unwinding of the yen carry trade. Yet, there is another factor that is potentially driving a large contingent of the Canadian market and that is a renewed hunger for dividends.

Last week, our portfolio strategy group put out a report that was highlighted in the Globe and Mail. They estimated that there was at least $200 billion in capital looking for higher-yielding stocks as interest rates on GICs and high interest savings accounts (HISAs) begin to fall alongside rate cuts by the Bank of Canada. The report differentiated the experience of Canadian investors with their American counterparts on the basis that there is a relative lack of alternative higher yielding instruments. These would include things like high-yield bonds and even municipal bonds, where the interest earned is usually free from federal tax and state tax (where the bond was issued in that particular state).

In early 2023, many investors were coming off the jolt from the previous year when both bonds and stocks suffered major losses and were in search for options. GICs and HISAs fit the bill for those that wanted to move away from traditional blended portfolio solutions. The flows into these vehicles came at the expense of bonds (unfortunately, where investors crystallized losses instead of waiting for the rate cycle to turn) and dividend-paying stocks. This might partly explain the underperformance of this segment of the equity market, relative to the broader TSX. As the above chart shows, the S&P/TSX composite index has gained 20% since the beginning of 2023, compared to only an 8% rise in the S&P/TSX high dividend index. When we think of dividend stocks in Canada, we typically focus on financials, utilities, pipelines, REITs and telecoms.

As the chart above shows, all three major sub-groups have not only underperformed the overall TSX composite since the start of 2023, but are essentially flat over this period, if not down sharply as in the case of telecoms. This summer, however, these groups have started to recover some ground and as our portfolio group suggests, some of this has come from flows out of low-risk interest-bearing vehicles.

Next week, we anticipate that the Bank of Canada will deliver a third straight quarter-point cut in its overnight rate target. This call is reinforced by the fact that while Canadian real GDP growth came in at 2.1% (annualized) in the second quarter, the economy was flat in June. Furthermore, the implicit GDP price deflator rose by only 1.1% in the quarter, supporting the view that the Bank will reach its 2% CPI inflation target by the end of the year. If we do see a cut next week, then the rates on short-term GICs and HISAs will likely fall as well. Today, a 1yr GIC for a double-A rated issuer is in the 4.2% neighbourhood and HISA rates are around 4.05%. A quarter-point move by the Bank should cause both of these to dip below 4% and I would suggest that the “sticker shock” of seeing a 3 handle on these instruments will intensify the search for yield.

Let’s return to that TSX high dividend index we showed in the first graph. There are 75 members in this index, with dividend yields (calculated by taking the total annual dividend distribution and dividing it by the current stock price) ranging from 2.7% to 14.7%. There are only ten companies with yields below 4%. Not all of these companies can be considered large-cap. The average market cap of all 75 stocks is just over $21 billion and only 19 of them are in excess of this amount. Company size is an important consideration when looking at the dividend yields offered in comparing with low-risk short-term interest rate vehicles since this is going to be one factor in supporting the sustainability of dividend distributions going forward.

Sometimes, a correction in the valuation of a company does not lead to either a cut or elimination of a dividend, but this could happen if the company’s underlying fundamentals have deteriorated to the point where there is pressure on its ability to distribute earnings to shareholders. Or it might simply stop growing its dividend. If the share price has fallen sharply, it’s possible to see dividend yields jump to double digits, which might entice investors to buy in and get a juicy income stream. The problem is that some of these situations end up being what we call dividend traps and there are more than a few examples of this over the years. Think TransAlta.

I made this point on my BNN Bloomberg interview yesterday (click here for highlights), as a number of viewers called or emailed in asking about whether certain dividend-paying companies should be looked at as opportunities given their recent price declines. Let's use Emera Inc. and Superior Plus as examples. As we saw in the previous chart, utilities underperformed the TSX this year and that group includes Emera, but that stock’s dividend yield is now roughly 5.7%. The company’s market cap is just north of $14 billion, and it hasn’t lowered its dividend since September 2010. Superior’s stock price has fallen to the extent that its market cap is now just under $1.9 billion, and its yield is now 9.5%. It’s dividend was last cut in October 2011.

The difference between the two payouts can be viewed as the added yield premium that investors are demanding for the relative probability of the dividend being maintained or “safe”. For those that are coming from the low-risk section of the fixed income market, that premium may not be enough to compensate for the added risk. Instead, we can focus solely on larger-cap names. If we look at the dividend yields for those companies in the High Dividend Index that have market caps higher than $21 billion, then we end up with an average dividend yield of 5.2%. A year ago, this may not have been that attractive, but in a sub-4% low-risk world, it might just be enough to move even more funds into these types of names.

On behalf of the Pyle Wealth Advisory team, have a wonderful Labour Day weekend.

Andrew Pyle