A Time to Rejoice


By Russil Lea, CFA

IN THIS ISSUE:

Do stocks ever go ‘on sale’? The answer is yes, but investors usually grimace because it means prices are dropping. Yet with proper due diligence and a good understanding of “cash flow investing” it becomes an opportunity to buy and take advantage of market fluctuations. In this edition of Tactics, Portfolio Management team member, Russil Lea, breaks down the concept of dividend growth and turns your frown upside down.
 

 

If you plan to eat hamburgers throughout your life and are not a cattle producer, would you like beef prices to be higher or lower? If you are going to buy a car (which will probably happen across the border), but are not an auto manufacturer, should you prefer higher or lower prices? These are two questions that Warren Buffet posed to his investors in his 1997 letter to shareholders. But what was his point and how is this relevant to the world of investing?

Before we tackle this question, let’s review how we do things at Nicola Wealth Management. Our investment philosophy revolves around looking for assets that generate cash flow. Why? Simple: if your assets generate a reliable and steady income, then much of the risk is reduced. 

For example, suppose you own an apartment in downtown Vancouver which you rent out. The sale price of the apartment will go up and down over time depending on the supply/demand of apartments in the downtown Vancouver market. However, as long as you can rent out the apartment and have it generate cash flow – and as long as you have a sufficiently long time horizon to persevere down periods – then the price fluctuations are not important, because the asset is generating a return for you via the monthly cash inflows. “Cash Flow is King”. This philosophy can be applied to other assets such as high dividend paying stocks and income trusts. A key element of our investment strategy is rigorous adherence to the cash flow approach.

Essentially, we’re buying income for our clients at a reasonable price.

“Rejoice when prices decline.” Mr. Buffett, I couldn’t have said it any better myself. When prices decline for your dividend paying stocks/income trusts, you should take this as an opportunity to buy dividends/ income “on sale”.

Let’s go back to our opening questions and see his response. If you plan on eating hamburgers throughout your life and are not a cattle producer, you should be happy when prices for beef are low. Lower beef prices allow you to buy more burgers for the same amount of dollars spent. Rejoice when prices decline.

Many investors, however, don’t see it this way. In fact, they are elated when stock prices rise. This reaction makes sense only if you are going to be a net seller of equities in the near future. If an investor is saving a lot of money and plans to buy stocks every year for the next 10 years, then the reaction makes no sense at all. If you are going to be buyers of equities, you should prefer sinking prices, because undoubtedly the more cheaply you make your buys, the more profitable your savings program will be.

Not All Cash Flows Are Created Equal

Now you might be thinking, “Hey, this sounds easy. Just buy and hold high dividend paying securities and buy more if the price goes down.” Likewise, you might be thinking about a recent article from the Globe and Mail or Financial Post that had a list of high dividend paying stocks. Why not just create a portfolio out of lists like that? How could there possibly be any pitfalls to taking an approach like that?

First off, not all cash flows are created equal. I don’t like dividend yield screens, because they don’t take into account the quality of the distributions. A common perception is that high dividend yield is the most important measure. But consider this: a yield that is considerably higher than other stocks in the same industry might not indicate a good dividend, but rather a depressed price (dividend yield = annual dividends per share/ price per share). As a result, when looking at the quality of the distributions, you should probably be asking: “why is the dividend yield so high?”

Investing in a company with a high dividend yield as a result of good business is a much safer bet than investing in a company that has a high dividend yield because of a suffering price. A declining share price may signal a dividend cut or even an elimination of the dividend altogether.

Take the case of Cinram International Income Fund – an example of a worst case scenario for yield investors: a 100% distribution cut.

Cinram International: The Death of a Distribution

Background:
Cinram is the world’s largest provider of pre-recorded optical discs (DVDs, CDs and VHS cassettes) and related logistics services for leading motion picture studios, music labels, publishers and computer software companies.

In May of 2006, the company converted from Cinram International Inc. into Cinram International Income Fund. By the end of 2006, the fund paid a whopping $3.25 per unit annually (approximately $190-million), which translates to a yield of 14% (better than the average business trust). With the prospects of growth in high definition DVD (hands up, how many people do you know who have bought a plasma or LCD TV within the past 2 years?), and exclusive long-term agreements to manufacture for major customers like Warner Home, New Line Home, and Twentieth Century Fox Home Entertainment, the company seemed ready for a good year in 2007. And even if they didn’t have a great year, who cares? Unit holders were making 14% – much better than the 3.99% yield on 5-year Government of Canada bonds!

One somewhat odd item to note about Cinram was that they did their financial reporting in US$ since most of their expenses were in US$, but they paid their distributions in CDN$.

What Happened?
Well what can we say about the strength of the Canadian dollar? It’s hard to believe that the exchange rate was only 0.8591 at the end of 2006. The 20% surge in the loonie so far in 2007 is unprecedented. For a company that reports and has most of their revenues and expenses in currencies that are depreciating vs. the Canadian dollar, this is bad news – it makes the distributions more expensive. Consider that the Fund had an annual payout rate of $190-million (CDN$) per year. Using the beginning of the year conversion rate of 0.8591, that translates to a mere $163-million in US dollar terms. But using the current conversion rate of 1.0342, the fund would have to pay out $196-million US$ in order to fund a year’s worth of Canadian dollar distributions. Cinram was partially hedged, but the rapid move in the currency really impacted the fund. According to their 2006 annual report, they were paid out 92% of their distributable income so Cinram really needed sales to pick up in 2007 to offset the currency move.

It Was the Best of Times
The thrill of Victory…

So, What Happened Next?
Operations did not pick up to offset the currency move. Replication of the high-definition formats (HD-DVD and Blu-Ray) were solid, but below expectations. It’s possible that the inability of the industry to pick one high definition format is slowing sales – people don’t want to get caught with the “Betamax” of the high-def format wars, so they may be waiting for a winner to emerge before buying a new DVD player.

Then They Did What?
Cinram’s management made some questionable moves. They squandered their cash and increased their net debt position on business acquisitions at inopportune times. They also bought back 400,000 shares in October further depleting their cash despite the fund being close to breaking debt covenants. As a result, in early November with the release of their Q3 numbers, Cinram announced distribution cuts in two stages: a 40% reduction in the monthly distributions for November and December and a full suspension of all distributions after December 2007.

It Was the Worst of Times
The agony of defeat…

The objective of this analysis is not to point and laugh at Cinram unit holders, because the rapid ascent of the CDN$ and the quick decline in business operations took many people by surprise. The bottom line is that not all distributions are created equal and concentrating only on the attractive yields rather than the quality or sustainability of those yields can be hazardous. Analysis of the fundamentals of the company’s underlying business wouldn’t hurt either. In Cinram’s case, if the investor was looking solely at the size of the dividend yield, they would have been buying Cinram all the way down to the bottom (see chart below for the “attractive” month end yield calculations). After the last dividend payment is paid this December, owners of Cinram units would be stuck with a no yield “deep value” income trust rather than the high yielding product they thought that they were buying. As this case study demonstrates, “worst case scenarios” can happen.


Dividend Growth: The Real Signal

In general, companies can return wealth back to the shareholder by buying back shares, paying a one-time special dividend, or increasing their regular dividends. While the first two options are all well and good, companies that have an excellent history of raising their dividends are the ones sending out an important signal: that the company is experiencing real earnings growth and is confident that it will continue to grow in the future. While there is no long-term commitment to “share buy backs” and “one-time special dividends”, an increase in a company’s regular dividend is a commitment. No company wants to cut their dividends for fear of an investor backlash. Consequently, a company only raises their dividends if they are confident they can pay it in future years.

While some investors look at dividend-paying companies as boring, low-return investment opportunities, one should not underestimate the combination of consistent dividend growth with an increasing stock price. Dividend growth drives the compounding principle for individual stocks in a way that is certain and predictable. Also, it has been proven that historically, dividend growers outperform dividend payers and the market. 

We understand that in dealing with dividends, not all of them are created equal. We provide our clients with the due diligence that differentiates between a solid stock that offers a good dividend, and a failing company that is paying out a dividend it can’t afford. So, while you may not necessarily rejoice the next time the market takes a dip, maybe you’ll smile the next time you bite into a hamburger, as you think fondly of the Buffett analogy and take comfort in the dips that give us the opportunity to execute our long-term investment plan. 

Bon appétit!