Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Middlefield Canadian Income. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
In his book ‘The Intelligent Investor’, Benjamin Graham claims that a defensive investor should follow a few rules when investing in equities. In the copy of the book I own, which was updated in 1971, one of these was to only invest in companies that had a dividend track record dating back to 1950.
Diktats like these can seem silly given the dynamism that markets exhibit. However, you get the sense that Graham may have been on to something if you compare the returns of the S&P 500 with the S&P 500 Dividend Aristocrats Index, which is comprised of US-listed firms that have paid a rising dividend for at least 25 consecutive years.
From the end of 1992 through to the end of 2022, the dividend index delivered annualised total returns of 17.33% in dollar terms. The S&P 500 returned an equivalent return of 14.8% over the same period.
Significantly, the Aristocrats index does not contain any of the FAANG stocks and at the end of February its weighting to information technology was 4.2% - the third smallest by sector. In contrast, the same sector has the largest weighting in the S&P 500, with 27.3% at the end of February.
This may all sound counterintuitive given so much of the US market’s performance over the past decade has been driven by those technology companies. What it arguably reflects is the quality of reliable dividend payers, who must generate consistent positive, excess cashflows so that they can make those payments to shareholders.
That is something which has also been demonstrated over the past 18 months. Even with inflation and interest rate hikes, companies in the Aristocrats index delivered positive total returns from the start of Q4 2021 through to 20/03/2023, at the same time as the S&P 500 declined. Similarly the much maligned FTSE 100 has hit a record high.
Less discussed has been Canada. Perhaps because the North American news flow is so dominated by its southerly neighbour, investors may not be aware of the strong dividend culture that the country’s stock market has.
But as with the other indices mentioned above, the S&P/TSX Composite Index has delivered positive total returns over the past 18 months. Like the UK, that has partly been fuelled by sizeable weightings to commodities and financials, both of which may be better able to handle the economic problems we’re facing today.
These are some of the opportunities that Middlefield Canadian Income (MCT) tries to tap into. The trust aims to pay consistent dividends to shareholders by investing in Canadian companies. The trust yields 4.6% as at 20/03/2023 and has a portfolio concentrated in energy, financials and real estate.
Manager Dean Orrico is careful about avoiding value traps and so firms in the portfolio must have strong balance sheets and sustainable cash flows. Firms that use debt financing to cover their dividends, for example, would immediately raise red flags with the team.
Having said that, there are plenty of signs that Canadian companies today offer good value, not value traps. If you factor out technology, which tends to inflate US valuations, Canadian firms are still trading at two or three multiples lower than their US peers on a price-to-earnings basis.
Financials, which MCT has a 20% weight to, are arguably a good example of the opportunities these lower valuations present for income investors. Canadian firms have proven to be extremely robust in the past, with the major banks not cutting dividends in the financial crisis or during the pandemic.
Another area Dean believes is particularly interesting is real estate, a sector that Middlefield specialises in and to which MCT is substantially overweight relative to its benchmark. Listed housing funds in Canada have seen their discounts widen substantially due to interest rate hikes. In some instances shares were trading at 50% of net asset value (NAV).
Although sell offs have been understandable given rate hikes, Canada’s housing shortage and immigration policies are combining to push rents up. Close to 2m people are likely to move to Canada from 2021 to 2025. This is a massive increase considering the country’s population today is only 38m and will represent a huge challenge to a country already estimated by the Canada Mortgage and Housing Corporation to need at least 5m new housing units by 2030.
Perhaps unsurprisingly then, Dean added to MCT’s existing holdings in several REITs when they were trading at those wide discounts. He also substantially upped his stake in MCT itself, purchasing 70,000 shares in October alone.
Despite these potential tailwinds, the trust is trading at a discount of 7.75% as at 20/03/2023. However, given that many of the REITs in the portfolio are themselves trading on a discount, the ‘lookthrough’ discount is wider than that topline figure.
Income investors may find this an interesting moment at which to look at the trust as a result. Large sell offs have already taken place over the past 12 months, with the existing discount potentially providing some cushion against further volatility. At the same time, the managers adding to existing positions and buying substantial amounts of shares in the trust itself demonstrate that they believe valuations are attractive.
None of this is a guarantee of returns but for investors who believe Graham’s views are as relevant today as they were in 1971, MCT’s focus on dividends and the lower valuations on offer, both in the Canadian market and via the trust’s discount, may be appealing.
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