How to Find the Dividend 'Sweet Spot'

06/05/2013 10:15 am EST

Focus: DIVIDEND

John Heinzl

Reporter and Columnist, GlobeInvestor.com

Horizon ETF seeks appealing stocks using a three-pronged strategy that has performed well so far, writes John Heinzl, reporter and columnist for The Globe and Mail.

Srikanth Iyer uses a GPS system to navigate the world of dividend stocks. No, it's not an electronic gizmo in his car.

"The three main components that we look for in a dividend stock are what we call GPS-growth, payout, and sustainability of dividends," explains the manager of the Horizons Active Canadian Dividend ETF (Toronto: HAL).

Unlike exchange traded funds that passively track an index, HAL employs an active stock-picking methodology that relies heavily on a computer-based screening system, with a human being-Mr. Iyer-getting the final say on what stocks make the grade. As a result, the fund's management expense ratio (MER) of 0.99% is significantly higher than that of other Canadian dividend ETFs.

Is Active Management Worth It?
According to Horizons, in return for the higher MER, investors get better diversification, less risk, and the potential for better returns than other dividend ETFs.

Iyer, head of systematic strategies at Guardian Capital (the subadvisor on the fund), has only been running HAL since August 2012, but the results so far have been favorable. HAL has posted a total return of about 12.8%, including reinvested dividends, according to Bloomberg.

Those results beat the S&P/TSX composite index's return of 10.4% over the same period, and is similar to the returns of other Canadian dividend ETFs. On a year-to-date basis, HAL's return of about 9% leads the Canadian dividend ETF pack, and handily tops the TSX's gain of 3.9%.

Investors shouldn't judge an ETF based on such a short time period. What's more, because of HAL's higher MER, the portfolio will have to generate consistently better returns than competing ETFs or the fund's performance, after fees, will lag its peers. That said, it's worth digging into Iyer's GPS methodology, because there are some key lessons here on stock selection and diversification.

G is for Growth
"Dividend growth is extremely critical as a component that we look at," he says.

In addition to examining one-, three- and five-year dividend growth rates, his model also screens for the precursors of dividend growth-namely, a history of growing earnings, rising cash flow, and low variability in earnings.

"We're looking at all the shareholder-friendly components that are needed to support a growing dividend," he says.

Perfect Payout Ratio
Turning to P-payout-he favors payout ratios that aren't too high or too low. If a company is paying out too much of its earnings as dividends, there's little cash left to reinvest in the business. If the payout ratio is too low, investors won't get much cash in their pockets.

He likes payout ratios that are at least average for the industry, but no higher than one standard deviation above the average. "That is the sweet spot where you're combining dividend yield with dividend growth and stock buybacks, versus just chasing yield," he says.

According to Horizons, HAL itself has an estimated annualized yield of about 3.6%.

Sustainability Is Key
Finally, there's S for sustainability. To identify companies whose dividends are safe, the model examines financial ratios that relate to balance sheet strength and the ability to service debt. The goal here is to pick companies that won't have to cut their dividends in order to make debt payments or preserve their credit ratings.

The stock-selection process doesn't end with GPS, however. The model also considers factors such as yield, profit margins, valuation, and investor sentiment. Using proprietary third-party software that examines thousands of news stories a day, "we're able to map...how positive or negative the sentiment is on any stock in the world," he says.

It's not clear whether HAL's active strategy will beat passive dividend ETFs over the long haul, and-this bears repeating-the higher MER that comes with active management creates a performance hurdle. What's more, the ETF is thinly traded, which may result in wider bid-ask spreads that can increase an investor's costs.

However, it's interesting to note that HAL's holdings differ in certain respects from some other dividend ETFs. For example, its total exposure to Canadian banks is less than 10%, compared with more than 30% for the iShares Dow Jones Canadian Dividend (Toronto: XDV), Canada's largest dividend ETF.

And HAL has roughly a 12% weighting in real estate investment trusts, whereas many dividend ETFs have little or no REIT exposure. As such, HAL can potentially provide diversification benefits to investors looking to build a dividend-oriented ETF portfolio.

Read more from The Globe and Mail here...

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