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Cyclical Dividends Are Tempting
07/09/2012 10:30 am EST
When economic growth returns, these dividend stocks can be solid long-term growers, writes Rob Carrick, reporter and columnist for The Globe and Mail.
Cyclical dividend stocks are like the snacks and soft drink aisle in the grocery store. Sure, you might toss the odd item into your cart, but you know there’s healthier eating elsewhere.
Companies in sectors like energy, materials, and industrials are subject to the ups and downs of the economy, and that adds an element of risk to their dividends. Whereas a utility or telecom company can usually be relied on to maintain or grow dividends, an oil producer or heavy equipment dealer might have to reduce or even eliminate cash payouts in tough times.
We’ve seen some tough times in the global economy lately, and there could be more to come. But when growth returns, cyclical dividend stocks will offer a little more nutrition than usual in comparison to the traditional dividend stocks.
Let’s be clear about something upfront—cyclical stocks can be solid long-term dividend growers. Craig McGee, senior consultant at Morningstar CPMS, produced some data for this column on the Top 40 dividend growers in the energy, industrials, and materials sectors since 2000. There are plenty of companies that have delivered double-digit average annual dividend growth over the past 12 years.
To give us some insights into what it’s like to own cyclical dividend stocks at times of financial stress, CPMS also included dividend-growth data for the period since the financial crisis first broke in 2007. Some companies have had to reduce dividends over this five-year period, although it’s important to note that they still, in some cases, have good long-term dividend-growth records.
Take Russel Metals (Toronto: RUS), a processor and distributor of steel industrial components that paid 45 cents a quarter in dividends back in 2007. The dividend was slashed to 25 cents in 2009 and has worked its way back up to 35 cents. Overall, CPMS says the 12-year dividend growth rate is 20.5% on a compound annualized basis.
Through most of the past few years, a tame, defensive brand of dividend stock has ruled. Telus (Toronto: T), a telecom giant, has doubled in price over the past three years on a cumulative basis. Saputo (Toronto: SAP), a dairy foods company in the consumer staples sector, has risen 80%. The electrical utility Fortis (Toronto: FTS) has risen 28%.
There are limits on how much higher these stocks can go. If the economy heats up and interest rates rise, the 3.7% dividend yield from Fortis would look less attractive. And while both Saputo and Telus have done very well, investors seeking companies that will benefit from a stronger economy will look elsewhere.
Maybe they’ll look to some of the well-known industrial stocks that made the list compiled by CPMS. One possibility is SNC-Lavalin (Toronto: SNC), the global engineering company that is being investigated by the RCMP on allegations of wrongdoing and has seen its share price fall by roughly one-third in the past 12 months.
Dividend enthusiasts may know SNC as one of Canada’s dividend growth stars, with a 12-year average annual dividend growth rate of 22.1%, according to CPMS.
In the materials sector, Cameco (CCJ) is an example of a dividend-growth stock with potential for share-price gains. Cameco shares are down 18% in the past three years on a cumulative basis, but they’ve jumped 23% this year. (Full disclosure: I’m a Cameco shareholder.)
Cameco is an example of a cyclical stock with dividend sustainability though all kinds of conditions. The 12-year annualized dividend growth rate is 14.4%, which is nearly the same as the five-year rate of 14.9%. That said, the company has not raised its dividend this year, and is overdue for a hike.
A recent pop in oil prices suggests there’s some potential for dividend growers in the energy sector like Suncor Energy (SU), which has actually stepped up its dividend growth rate during the difficult past five years. Where energy stocks have cut distribution in the past five years, one of the factors may have been conversion from an income trust into a dividend-paying corporation.
The presence of several gold stocks on the list is a testament to the sharp rise in gold prices in the past several years. Rising gold prices would suggest potential for more dividends, while a big decline in gold prices would raise questions about the sustainability of the current payout.
Notice the presence on CPMS’s list of a few traditional dividend stocks that don’t really fit the cyclical profile—TransCanada (Toronto: TRP) and Enbridge (ENB), both of which are classified as energy stocks. Both are also among the best performing blue-chip stocks on the TSX in the past 12 months, but rising interest would present a challenge for them.
The average yield for stocks on the list of cyclical dividend growers is 4.1%, but that’s skewed by the exceptionally high yields of companies such as Pengrowth Energy (Toronto: PGF) and Superior Plus (Toronto: SPB).
Fact is, cyclical dividend-growth stocks tend to have lower yields than more traditional dividend-growth stocks. For that reason, cyclical dividend growers are best suited to investors who are less focused on straight dividend income than they are on generating a strong total return based on both dividends and share price gains.
You wouldn’t want to feed a portfolio nothing but dividend-paying cyclical stocks, but they’re far from junk food. You’ll see this play out when the economy snaps back.