The Case for Small Firms with Big Yields

02/06/2012 4:45 pm EST

Focus: STOCKS

Rob Carrick

Columnist, The Globe and Mail

Some little-known Canadian dividend stocks offer high yields and better opportunity for capital gains, but there are risks, writes Rob Carrick, reporter and columnist for The Globe and Mail.

The most often-repeated piece of investing advice of the past couple of years has to be "buy blue-chip dividend stocks." Hey, I’ve raised this idea a few dozen times myself.

But now it’s time to take stock, so to speak. Dividend payers have in many cases soared in price, and while they still offer a good flow of dividend income, they’re not the bargain they once were.

Non-blue-chip dividend stocks are a different story. In many cases, they offer high yields, the opportunity for capital gains…and, oh yes, higher risk.

Many of these companies represent the evolution of income trusts, which for the most part no longer exist in their old structure as a business passing along virtually all of its earnings to shareholders each month. They’re now corporations paying dividends that in many cases generate yields far in excess of what the blue chips offer.

"When most people think dividend stocks, they think of banks, pipelines, utilities, telecoms," said Leslie Lundquist, manager of the Bissett Canadian High Dividend Fund. "We have a small component in those types of names, but what we have more of are smaller companies that in many cases used to be income trusts. We’re finding better value in some of those."

Here’s a quick highlights package from the blue chip dividend world:

  • Enbridge (Toronto: ENB), up 30% in the 12 months to mid-week
  • Tim Hortons (Toronto: THI), up 19%
  • Telus (Toronto: T) and BCE (Toronto: BCE), up 14% and 12%, respectively
  • TransCanada (Toronto: TRP), up 13%

Meantime, the S&P/TSX 60 index of big companies (included non dividend payers) was off 9%.

Rising share prices mean falling dividend yields. So, while BCE, an outlier, yields 5% or so, most other top dividend performers are between 1% and 4%.

That’s not bad when compared with a 1.8% yield on a ten-year Government of Canada bond, especially on an after-tax basis in a non-registered account. But some of the former trusts in Lundquist’s portfolio beat that by far. Examples:

  • Morneau Shepell (Toronto: MSI): Canada’s largest domestically owned pension and benefits outsourcing firm offers a dividend yield just above 7%. Lundquist said Morneau’s share price has been depressed by concerns about debt levels, but this is a company that tends to keep its customers through economic ups and downs. "We think that dividend yield is very sustainable, and we think there’s still upside in the price."
  • Medical Facilities (Toronto: DR): This company runs private surgical hospitals in the United States, which raises concerns ranging from health-care reform to legal liability. "But, really, this has been a remarkably stable business and has made all its distribution payments," she said. Investor trepidation about this stock is evident in the 9.3% yield.
  • Zargon Oil & Gas (Toronto: ZAR): Zargon reported disappointing results in 2011, as a result of cost control issues and flooding on a property, Lundquist said. Add a dividend cut to the picture, and you get a share price that was down more than 50% at its worst last year. "In speaking with management there, we’re confident they’ve identified what went wrong, and recent results have given us some encouragement." Zargon’s yield is about 8%.

Investing in smaller companies that lack the franchises of big blue chips means more risk of losing money and having your dividend cut or suspended. Lundquist said these companies can be more tied to economic cycles, and they lack much of a following with investors.

"But at the same time," she added, "we think they offer a good risk-return tradeoff." In fact, she said that mixing blue chips and smaller dividend payers has in the case of her fund produced less risk than the S&P/TSX composite index.

One measure of a fund’s tendency to bounce around in price is called beta. The S&P/TSX composite index has a beta of 1, while Bissett Canadian High Dividend comes in at a comparatively low 0.8. Last year, the fund lost 1%, while the composite index fell 8.7% with dividends factored in.

The value of owning big blue chip dividend stocks was clear last year, when they massively outperformed the overall market. These stocks are foundational investments, but some of them are no bargain at the moment. You have alternatives.

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