Episode 91: Dividends in a different light—Market Insights Monthly Special Edition

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Kevin Headland:

This podcast is provided as a general source of information and should not be considered personal, legal, accounting, tax, or investment advice. On this episode of Investments Unplugged, we have something new for our listeners. This is the first of a monthly series called Monthly Market Insights.

We'll be welcoming special guests to the show such as our portfolio managers and we'll discuss their specific fund process and why advisors should be using them in their portfolios. In this episode, my co-chief investment strategist Macan Nia, is joined by Chris Hensen from our essential equity team to speak about the Manulife Dividend Income Fund. I hope you enjoy. Listen on, this is Investments unplugged.

Macan Nia:

We're still dealing with a lot of residual impacts of policy that were implemented during COVID. The ultra-loose monetary policy. Second one would be fiscal stimulus. And what has happened is you saw inflation shoot up, you had governments, specifically central banks, increase interest rates at cases we haven't seen in decades to combat inflation. We've seen inflation come down. We've also seen the global economy slow down.

Now as we move forward over the next couple of years, the backdrop that we see is one that yes inflation has come down, but we still believe that inflation is going to be above its long-term historical average. Are we going to go all the way back down to two? No, we're probably going to be in this new normal where inflation is above the historical average.

With higher interest rates, we expect that we're getting towards the end of the economic cycle, so we will see slower growth. And all of this will have implications for asset classes, for investing, whether it's bonds or equities even within equities, dividends, growth stocks, and so on and so forth. My name is Macan Nia. I'm co-Chief Investment strategist at Manulife Investment Management. And thank you for joining us.

At this time, I'd like to introduce Chris Hensen, MD, senior portfolio manager on the essential equity team with nearly three decades of experience navigating the landscape that we find ourselves in. So welcome Chris.

Chris Hensen:

Thank you.

Macan Nia:

Before we get started, the teams won numerous awards over the past couple of decades. Talk to us in terms of your investment philosophy and walk us through the process that has helped the team garner all the success over the years.

Chris Hensen:

Sure, that's a good starting point. The team's investment process is built on business value creation and that is the only true measure of quality in our minds. Quality is displayed in a number of different areas that we focus on. One is low financial risk, low operating risk, and a strong company management. Let's unpack all three. So low financial risk. We're looking for companies that don't have a lot of debt on the balance sheet, that throw off a amount of free cash flow.

Secondly, low operating risks, we're looking for companies that have pricing power, stable and high reoccurring revenue streams and margins which are under pressure due to competitive threats or erosion in the end market. Combine those two together with a strong management team. And the way we would define a strong management team is a management team that's been in place that has executed on their plans consistently, deliver on what they said they're going to do, and in a strong ability as well to redeploy free cash flow back in the business.

So we're looking for that history of success over a longer period of time as opposed to investing with a new management that doesn't really have that success flavor displayed in the company. So marry those three together and this is the lens we use to analyze each company before it actually goes in the portfolio. You had mentioned we've been together for a long time. Our investment process remains unchanged for close to 27 years now, but what changes is the market environment around us.

And you highlighted earlier on we see a different market than what we saw pre COVID. Rates are going to be higher and stickier going forward from here, inflation as well, and that forced essential banks to keep interest rates higher than what we've grown accustomed to for the last 15 years prior to COVID. Again, investment process is going to stay the same in this current environment, investing in those high quality companies, but it's our portfolio that's going to evolve to meet the current investment landscape.

Macan Nia:

So let's talk about the interest rate environment because that's been front and center for investors really post COVID and we've really seen over the past six months how quickly these interest rate expectations can change. Going into November, markets were expecting three cuts. Then overnight Powell spoke, went up to six, markets ripped. But as we've moved into March, those interest rate expectations have come down to three.

So I checked this morning Canada, US three times by the end of the year, so up to 0.75%. That will likely change too, but I think the big narrative behind that is interest rates are likely to stay higher for longer. So historically we've been used to after the Fed pauses, you're back down the cutting rates within eight months. Probably not the case this time. So these companies are going to have to operate in this new higher interest rate environment. So talk to us how that could potentially impact the portfolio.

Chris Hensen:

Yeah, that's a great observation and we concur with the thoughts of yourself and the rest of your strategy team that in an environment of higher rates than we've been accustomed to, there are certain parts of the market, of the economy that are going to be at risk of higher rates. We talk about, let's say real estate, it's been a great asset class, diversification, but in a higher interest rate environment, certain parts of the real estate market have been steamrolled because interest costs have skyrocketed.

So as a result of that change, you need to sort of shift your allocation out of that and look for other opportunities in the marketplace that are going to benefit from a higher interest rate environment. And that's usually not the common belief. They think rates are higher, that's bad for everything, but higher inflation can actually benefit a lot of companies and that sort of goes back to the things we're looking for.

Low operating risk, do you have that pricing power in high inflationary environment, yes or no? Financial risk, you have a lot of leverage on your balance sheet? And the real estate, part of the real estate did and that altered the return profile of that asset class and it's going to be very difficult for them going forward over a period of time.

Macan Nia:

So let's transition from rates to inflation because inflation again is likely going to be stickier. The easy fight was high single digit inflation, you break up interest rates, slows down. And you've seen inflation come back down. Depending on where you're looking in the world, that's that three-ish percent range. So the next fight is going to be difficult, to get it from three to two.

And who knows even whether there'll be successful for doing that because there's a lot of things that are adding to inflation that are outside of the mechanisms of monetary policy. So let's assume inflation's at this 3% range, it's going to be sticky at these levels. How does that impact the portfolio? Because like you mentioned, these businesses that were really funded by low interest rates, the business model may be impacted. So how does that inflation feed through the portfolio?

Chris Hensen:

Yeah. It could be a challenge to certain parts of the marketplace or a certain sort of style exposures. If you're a higher dividend oriented type company, it could pose a lot of risk going forward. And we do it differently the way we construct our portfolio. We want that low operating risk where companies can actually benefit in a higher inflationary environment because they can actually price higher than their cost trends or at the current inflation levels.

Just this most recent quarter we saw some of our companies push through price increases of 15 to 20 percent. This is unheard of. Why? Because they can and they can still drive higher profitability to their bottom line. Secondly, you want to make sure you're not investing companies with a lot of leverage on the balance sheet, low financial risk. Those are the type of companies we focus in on. Those companies with high debt, they might not fail today, but they're on this sort of slow glide path as we go forward.

We don't know if they're going to be in survival mode for the next few years. And we've seen examples of this just over the last year in Canada where some big companies out there had too much debt on the balance sheet, interest costs went up, what do they have to do? They had to start selling assets, they're breaking the company apart, they're slowing down the dividend growth rate. That's survival mode. We want to own companies that are creating business value each and every day. Survival mode is not a good, it's not a good investment philosophy, not a good focus, it's just a waste of time.

You got to focus on those companies that can drive those results. And as a result of the shift we've seen in rates, it's sort of a new group of companies that are going to benefit from this type of environment. And that's our goal, is to capitalize on that. And we've seen that over the latest year, year and a half in terms of our performance, companies growing their revenues well and ahead of their inflationary costs, driving it to the bottom line and that's the setup that's going to be successful in this type of environment.

Macan Nia:

Yeah. And you nailed the aspect of growth. Right? So if you're contributing more of your income cashflow towards interest expense, you're not able to grow organically. And that's a good transition into the next question. There's this focus especially in Canada on the dividend and income story or companies and its under-performance especially over the past couple of years relative to the tech name, so on and so forth. So looking at Canada as a example, so I was doing some research earlier, so the Canadian dividend income category, we know that we've seen flows out of it because of performance.

Chris Hensen:

Yes.

Macan Nia:

And actually your colleague was pointing out earlier how within actually the category we've seen, I wrote it down here, close to 20 funds actually close in the last three years. So kind of a unique situation. I think we've talked to some of that, but what do you attribute that in terms of the category underperforming and then the fund flows out of it?

Chris Hensen:

Yeah, the world has changed for traditional dividend income oriented type mandates. Let's clear observation, the Canadian economy, the Canadian stock market, highly leveraged interest rates. You have a huge housing market, big mortgage portfolios that are out there, rates go higher. That's not a good thing. Secondly, 40% of the TSX is made up of companies that are sectors that are highly sensitive to interest rates. And interest rates are going the wrong way, going against them. You've got telecoms, you've got pipelines, banking, utilities and REITs.

These businesses will be directly impacted by this environment of stickier inflation. And that's such a big part of the market. So if you're a dividend only mandate and you're investing in these areas, that doesn't set you up for a period of robust performance going forward. Probably a good chunk of those businesses are going to be in survival mode as we move forward. So you need to rotate out of those areas and look for other areas in the marketplace that have that pricing power, that low operating risk, the low financial leverage combined with the strong management teams.

Macan Nia:

That's a really important statistic. I'm going to repeat that. 40% of the TSX is interest rate sensitive.

Chris Hensen:

Correct.

Macan Nia:

When you factor in basically the big ones, the financials, any of basically the pipeline, so on and so forth. So we've been having this discussion when it comes to duration, when it comes to bonds. You're like, "What are we talking about bonds for? This is an equity pedal," but we've been hearing from questions from advisors, "Okay, what's the duration of the fund? What's the duration?"

And duration is so much more unique than that, that it's more complicated. I'm going to flip it to your side where now we're getting tons of questions on, "What's the dividend yield? What's the dividend yield? What's the dividend yield?" Then there are many setbacks from an investor perspective, from just looking at investments from a dividend yield perspective. What are the risks to that in terms of saying, "Okay, the dividend yield is 7%, sounds great, I want to invest in it."

Chris Hensen:

Yeah. You just can't look at that one number. There can be a lot of risks underneath that. And then we find that in Canada specifically, if you focus just on yield, you're going to fall into something called the yield trap, almost like a value trap where you're choosing the highest dividends today.

Macan Nia:

Explain a value trap first because I feel like some people don't understand it.

Chris Hensen:

Yeah. So a value trap would be like you're looking at a stock that trades at a very low valuation, it's cheap, therefore it's attractive, but there could be underlying risks around it where-

Macan Nia:

It's cheap for a reason.

Chris Hensen:

Yeah, cheap for a reason. The earnings could implode. There's a lot of leverage on the balance sheet. So as you roll out a few years, the return profile might shift significantly against you even though you paid a low valuation. And then if you look at the sort of the yield trap, you buy something with a high yield well, underlying that you could have a business that doesn't have any pricing power, is in secular decline or has a tremendous amount of leverage in the balance sheet.

Rates go up, what happens? They're forced to sell assets break up, or in worst cases, they cut the dividend by close to 50% or whatever and the stock goes down a lot. So you want to avoid the yield trap. And we're finding that in the dividend space, a lot of funds go down that road buying the high yield and so much that we'll never sacrifice future capital to chase yields.

So we're so focused on that, that [inaudible 00:13:09] actually moved us out of the Canadian dividend income category in 2018 because our yield was too low. We didn't want to stay in the category and move the yield higher because we thought we were going to take on a tremendous amount of risk. And that was a great move for us to sort of shift out of the category. We weren't going to sort of succumb to sort of just buy high yield. That's going to be great to sort of meet what the category wants.

Macan Nia:

Given there's two major geopolitical events occurring in the world right now, we have a US election coming up, how does a team look at risk management through the lens of geopolitics or politics?

Chris Hensen:

Yeah, that's a good question. And you highlighted been in the industry a long time. I remember day one there was a lot of things to worry about. Today, there's a lot of things to worry about, yesterday there was, and tomorrow there's going to be a bunch of things to worry about. For us, risk is inherent in the underlying business. That's really where the risk is, whether it comes from high financial risk or in a net management team or operating risk where the business is not really well set up for high levels of profitability going forward.

So for us, what we want to do is control the business risk exposure in all our mandates. And that's something we laid out when we founding of the team in the 1990s, that we'll have a portfolio of a number of different business risks and then a lot of those business risks are uncorrelated to one another. And we feel that's the best way to manage risk as opposed to looking at the sector weights and whether you plus or minus or whatever, because some of these sectors can actually really be impacted by one risk.

Like and I talked about, we talked earlier on, 40% of the TSX is exposed to higher rates. If you're investing specifically in that part of the market, there's a lot of risk to take on. So for us, you want to make sure you're diversified by business risk. And that helps to deal with geopolitical issues, macro issues or micro issues that the return profile of the fund, and we've seen it over a longer term, gives you a better risk return profile out over a longer period of time.

Macan Nia:

And from a big picture perspective, I think when it comes to geopolitics, we've done the work where we looked at all these major geopolitical events going back to the 40s. And when you average the peak to trough basically sell off, it averages around 5%. So it's immaterial for that medium to long-term investor. And typically you recover that within, I think it's six weeks.

So it's often short term in nature. Very rarely does it align to the time horizon of many of the investors. Many, many years ago I sat beside your team and back then it was a new concept in terms of active management. And now I feel like you're talking about investing in dividends differently. How is the team looking at, very similar to the active share discussion that the team-

Chris Hensen:

Yes.

Macan Nia:

... was having more than 10 years ago, the difference in investing in dividends today?

Chris Hensen:

Well, we've always talked about our process being consistent out over a longer period of time, but what changes is the market environment, whether at a sector, industry or company level. And what we've seen over the last few years, the form in which companies return capital shareholders has shifted from dividends only to a mix of buybacks as well. So we focus on both of those and we call it shareholder yield. For us, it's a measure of what a company can earn and sustainably return irrespective of the form, whether it's dividends or buybacks or all buyback or all dividend.

And we calculate that for each company that we own in the portfolio. And then the studies conclude in the work we've done that high shareholder yield stocks tend to outperform over the longer term versus the broad market and definitely outperform pure high dividend yielding stocks. So for us, having that focus of both dividends and buybacks, it opens up our opportunity set to investing in a broad range of companies versus just focusing on high yielding securities or dividend oriented securities.

Macan Nia:

And you mentioned it was the work that your team did, but it's also work that Morningstar did themselves.

Chris Hensen:

That's correct.

Macan Nia:

Where they highlighted total shareholder year, where you not only factor in the dividend but share buybacks. And that's a better gauge of expectations moving forward. Can you give an example of a company that would've been missed using a traditional dividend screen?

Chris Hensen:

There's a large cap Canadian technology company that is in the IT services industry. It was founded 40 years ago. The chairman is still involved with the business. They provide mission-critical digital work to governments and corporations around the world. But what's interesting is sort of go back to our investment philosophy. Debt is extremely low. The debt to cap is one of the lowest in corporate Canada and it's the lowest it's been in the last 10 years.

Operational risk, fairly well diversified customer base, long-term contracts, they have pricing power because it's mission-critical. And then underlying that is a very strong management team. Now let's look at the financials of the company. They don't pay a dividend. So if you're a dividend focused investor, you completely would've missed it. But what they do do is they pay out 60% of the earnings in the form of shareholder buybacks.

Macan Nia:

Wow.

Chris Hensen:

So to put it into context, over the last 10 years, they bought back $8 billion worth of stock. You'd be like, "Okay, well, what does that mean?" It's close to 30% of the stock they bought back in the last 10 years.

Macan Nia:

Say that again.

Chris Hensen:

So they bought back $8 billion worth of stock in 10 years. What does that mean in terms of your shareholder? They've decreased the share count by 30%.

Macan Nia:

Wow.

Chris Hensen:

So if I owned one share of stock 10 years ago, my earnings power, my ownership of the business just increased by 30% because they've shrunk the share account. Even though they've done that, that $8 billion, it's a big number, there's still a billion of dollars of cash on the balance sheet. You would've missed out if you were just focusing on dividends.

And here's a stock that's compounded by 15% over the last decade. So for us, we were indifferent whether they're going to pay it out in dividend or they're going to do a buyback. Again, focusing on shareholder yield, what type of cash can the company generate? What are they doing with it? If they're buying back a ton of stock, we're okay with that. If they want to pay it on dividend, we're fine with that too. But the underlying metrics of the company fit our profile in terms of management, operating risk and low leverage.

Macan Nia:

The essential equity team manages all different types of mandates across the world, different balance, pure equity, but we're talking about dividend income. So talk to us how dividend income is positioned for success in 2024.

Chris Hensen:

We highlighted earlier on that we believe we're in an environment of higher interest rates and higher inflation that we've grown accustomed to over the last 15 years. So what do you need to own? You need to own businesses that have consistent pricing power where they can push through those price increases and not lose customers and drive it through to the bottom line. There's other sort of themes that are going on.

One is de-globalization and larger governments, larger governments being record deficit spending. Where is the de-globalization, couple that with higher government spending, where is that money going? Right? It's going into healthcare, it's going into infrastructure, it's going into consumer. So we focused our portfolio to reward companies with that pricing power that benefit with some of these trends.

And even if the economy remains stronger than expected, and that's what's probably been going on for the last 12 months here, our companies are still going to participate in that growth versus sort of traditional high dividend yielding stocks. Every day, they're going to face that headwind of higher rates.

And typically these businesses when we've done our work, they don't have that pricing power ability. They don't have that ability to reinvest back in the market because why? They're trying to solve for their debt situation right now. So they're in survival mode. Again, we want to focus on the companies that each and every day they're driving that business value creation as opposed to being in the survival mode.

Macan Nia:

So when an advisor is adding this to a client's portfolio, what should they be expecting? Or for those clients, there's many that already own dividend income, what should they expect moving forward?

Chris Hensen:

Yeah. When you align ourselves with us, whether it's dividend income or any of our other mandates, you want to think of three things, people, performance and the partnership. So there's 10 investment professionals based in Toronto, diversity, background, thought. We've been working together for over 27 years now. Continuity in management. The team's seen a lot. I've lived through the Dot-com boom and bust, the income trust boom and bust.

We managed through that. The global financial crisis and then this amazing period of lower rates and stability of inflation and let's call it the pre COVID world. And now we're in this post COVID world. So we've managed through a lot of these environments and we've seen the changes. But again, you have to know is that the process hasn't changed throughout that. It's the companies that change or sectors that change, the opportunity sets open up or some opportunity sets actually close.

Secondly, performance. Our goal is to outperform over a longer period of time and the performance is driven by our process. And if you look at our longer term numbers, we provide superior risk adjuster returns versus the benchmark and it's gone on for decades now. And then finally, partnership and our compensation is based on long-term returns. A big part of my compensation gets invested in our funds. We have to hold it there for three years.

So I get the same statements the advisors do and the clients do. When things are performing well, I can see it in my statement every day. And then when our performance is out of sync, I see the same performance. So we're all in this together in a big way. So for us, we want to just compound wealth out over a longer period of time. And we've shown it over that period of time, starting from whatever it was, a dollar in assets to where we are today and a number of different mandates. So the proof is in the performance over the longer term.

Macan Nia:

And all three of those are important. I think the partnership is very important as well, because that's not common across a lot of the managers across the industry in terms of the interest aligned. And I think that's important when you're making those decisions not only for our clients but for yourselves. So that's a good area to stop. Chris, your favorite part. We always like to do this. It's called our lightning round. And the whole purpose of this is try to humanize Chris from just a portfolio manager to a human. So you have two young kids.

Chris Hensen:

Yes.

Macan Nia:

Ages?

Chris Hensen:

Ethan's going to be four, in another few weeks, and Kyle had just turned one.

Macan Nia:

So you're a busy household.

Chris Hensen:

I'm very busy, yes.

Macan Nia:

So these answers, I kind of feel like I already know what the answer is going to be. Okay. Last Netflix binge?

Chris Hensen:

It was Blippi with my son. Fortunately I don't have time to do Netflix binging.

Macan Nia:

Not even with your wife?

Chris Hensen:

No. The kids go to bed and I'm so tired I end up just going to sleep right after that, so.

Macan Nia:

What time do you go to bed?

Chris Hensen:

10 o'clock.

Macan Nia:

That's hilarious.

Chris Hensen:

10:30.

Macan Nia:

Okay, so maybe I got to change these questions as I go along now. Okay. I was going to say last book read, but you're probably not reading. We read so much in our day-to-day lives, right?

Chris Hensen:

Yeah. Well, right now we're going through repeatedly the 5-Minute Spider-Man stories. So the good thing is I'm actually learning about all the different characters and the Avengers related to Spider-Man, because I really didn't really grow up with the Avengers. So Iron Man and all that is all sort of new to me. And every night I read that to my son. He picks up which 5-Minute Spider-Man he wants to read through and we go through it and after five minutes he's out like a light. So it's-

Macan Nia:

And so are you.

Chris Hensen:

And so am I, exactly.

Macan Nia:

Let's go with this, favorite meal?

Chris Hensen:

I'm going to surprise you and I have to say jerk chicken.

Macan Nia:

It doesn't surprise me because I know you, but explain why it would, well, don't explain why it would surprise people. We might get ourselves in trouble, but explain why you like jerk chicken.

Chris Hensen:

Well, my mother was born and raised in the West Indies, so I've got introduced to that type culture food at an earlier age, and it's always been my go-to favorite.

Macan Nia:

So half Dutch, half...

Chris Hensen:

Half Guyanese.

Macan Nia:

Half Guyanese. Should we throw a last one in there?

Chris Hensen:

Yeah.

Macan Nia:

Favorite place to visit?

Chris Hensen:

From a high level, anywhere with a beach, but I have to say vacation... I, myself and my wife went on was the North Shore in Hawaii. We are right on pipeline where all the surfers are and all that. So I was dreaming that I could surf, but I just stayed on the shore and just watch it unravel.

Macan Nia:

And we're happy for, that's good risk management.

Chris Hensen:

Yeah. I know.

Macan Nia:

[inaudible 00:25:25]

Chris Hensen:

It is. It is. There's no upside to that move.

Macan Nia:

Well, Chris, I want to thank you for your time. I know how extremely busy you are.

Chris Hensen:

Thank you.

Macan Nia:

For taking the time. We've known each other since I've started here on Manulife for 15 plus years ago. And I always have respected the team in terms of the consistency in their process, sticking to the principles, not deviating when there's these flavors of the month that pop up. I remember many, many years ago the marijuana stocks, I remember sitting beside the team and you guys were doing all the valuation.

So on behalf of myself as a unit holder, but also the client, thank you for a lot of the work that you've done. I think to close, we're in a new environment and the new environment is one where again, we're still dealing with the residual effects of COVID policies. And that's likely to lead a new environment where we have above average inflation than what we've historically experienced, which is going to lead to and has led to above average interest rates.

So in this type of environment, the companies that are going to strive and we've seen this in the most recent earnings, is the ones that have pricing power, that can pass along those high costs to the end client. What does that mean? They sell something that client wants. So if it's gone up in price, they need it, they will pay that premium. And number two is the financial leverage. Very similar to many of us that know someone on a variable rate mortgage, when interest rates go up, you have less opportunity to invest that.

For those that have more debt on their personal balance sheets or from a corporation perspective, they will face challenges. So again, having companies in your portfolio that aren't interest rate sensitive, that aren't levered to really, that have high financial leverage. And we believe that the Manulife dividend income managed by Chris and the broader team is positioned well to operate in this new interest rate inflationary environment, to continue to add alpha, beta, whatever you want to call it, to your client's portfolio.

So you can be rest assured that when they go to sleep at night, the price will always change on a month to month basis. What we're focused on is the actual underlying fundamentals. And we want to consistently see that despite if the market goes ups and down, that those dividends, those earnings, the cashflow are consistently increasing. And I think the team has done a wonderful job of doing that over the years. I want to thank everyone for joining us. Everyone's very busy, but thank you again.

Kevin Headland:

This podcast is provided as a general source of information. It should not be considered personal, legal, accounting, tax or investment advice or construed as an endorsement or recommendation of any entity or security discussed. Investors should seek the advice of professionals prior to implementing any changes to their investment. Certain statements in this podcast are forward-looking that are predictive in nature, depend upon or refer to future events or conditions.

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