Volatility,
Schm-olatility…
Just Earn Dividends.

Key Takeaways

• On balance, BMO Dividend Fund likely to benefit from inflation and rising rates
• Best dividend-payers likely have the pricing power to pass inflation on to consumers
• Corporate earnings have been strong, and investors should consider the managements’ discussion for outlook

1. Volatility has been one of the big stories in equity markets this year. Do you expect that to continue, and what would it mean for dividend strategies?

LZ The short answer is yes—volatility is likely to continue. It’s been about 40 years since we’ve seen inflation and interest rate hikes of this magnitude, and those are key considerations when it comes to equity analysis and valuation. The jury is still out on the root cause of the inflation, however. As long as the market is debating whether it’s transitory in nature or a longer-term concern, the day-to-day gyrations will continue. Currently, the difference between the best performing sector and the worst performing sector on the TSX is 84%. I can’t recall the last time we saw that kind of disparity. It will take some kind of consensus on what the market environment will look like in the medium-to-long term before that volatility will subside.

PH Markets are dealing with a lot of hurdles: slowing growth, central bank tightening, tension between the West and Russia, and ongoing supply chain problems. These are all legitimate issues, and they’re splashing cold water on investors who have had stronger-than-anticipated returns since the market bottomed out in 2020. Both globally and in Canadian markets, one of the big stories of the year has been the relentless surge in commodity pricing. Because of these unusual cross currents, we’re expecting the volatility in financial markets to persist.

2. You’ve written that equity returns tend to be strong when inflation is declining. Are you confident that central banks have gotten in front of inflation? How has it impacted the BMO Dividend Fund's asset allocation?

LZ It’s the million-dollar question—what’s the right formula to tackle inflation? Central banks were behind the curve initially because the economic situation was a little precarious. Rates stayed near zero for an extended period, and as BMO Chief Economist Douglas Porter has said, “it is now staggeringly obvious that policy overcooked the goose in 2021.” To quote Doug again, “the bill has now come due for that excess,” and central banks are aggressively playing catch-up. The risk today is that they might tighten monetary conditions too much and create a policy error that would lead to economic uncertainty. Needless to say, being a central banker right now is no easy task.

PH In terms of asset allocation, we’re always examining the companies in the Fund, having discussions with their management teams, and looking at where the stresses are within their cost structures. The key consideration is pricing power—we like to invest in companies that have enough market power to raise prices to offset inflationary pressures. That’s the benefit of keeping Quality front and centre in our allocation process.

LZ More importantly, we don’t change the way we invest through business cycles. Instead, we look at company fundamentals—like whether they have the ability to compound their earnings and cash flow in the long term. Companies that can do that typically have some sort of strong competitive advantage. Macro-level forces, which are difficult to forecast, don’t change that kind of forward-looking analysis nor should they impact how we invest.

3. Financials represent almost 40% of the BMO Dividend Fund's holdings. Given that rising interest rates are often viewed as a tailwind for banks, what’s your outlook for the Canadian banking sector for the rest of the year?

LZ In theory, interest rate increases are beneficial to Canadian banks because they widen the spread at which the banks can borrow and lend out money – that’s Financials 101. The concern is that central bank action may negatively affect things like consumer spending and loan growth. I don’t think Financials will make or break a portfolio this year the way they did last year, when we were increasing our weight in Canadian banks amid strong tailwinds.

PH Agreed. In fact, some of those tailwinds have since turned into headwinds. But in general, the banks are well-positioned. They have attractive valuations, strong dividend yields, and business models that can withstand monetary and economic pressures. Credit issues have been minimal and loan growth has been quite durable. And we’re starting to see a few of the banks, like TD and BMO, put their excess capital to good use through strategic mergers and acquisitions, which will create longer-term value for shareholders.

4. In our recent discussion with your colleague Brian Belski, he was extremely bullish on North American industry over the next three-to-five years. What are your expectations for the Canadian Industrials sector, which makes up over 12% of the Fund’s holdings?

LZ It depends on the individual business. Industrials, like Financials, is a fairly diverse sector. Infrastructure-type companies like CN and CP Rail and Waste Connections Canada offer some inflationary protection through their pricing power and strong market positions. But keep in mind that these are cyclical businesses. They can weather a slowdown, but if there’s a policy error and we enter a recession, their revenues will naturally get hit—even if they may ultimately come out ahead when the market rebounds.

PH We tend not to look top-down and make broad sector calls, because individual companies can be impacted by all sorts of variables. WSP is another firm I’d mention. We love differentiated, self-funded, capital-light businesses—and this is one that has accelerated through COVID and is robust and growing. Of course, if the economy spirals downward, there will be pressure on these names. But if they’re unduly punished by the market, we'll be interested in them because we’re confident that their business models can sustain over time.

5. In your first quarter commentary, you noted that the Fund’s underweight positions in Energy and Materials have contributed to its underperformance year-to-date. What do you anticipate for these sectors?

LZ Historically, companies in these sectors have struggled not just to grow dividends, but even to maintain them. Though their recent performance has been impressive, it’s largely been driven by rising energy and commodity prices, and we’re not sure anything has changed from previous cycles to make their business models more sustainable. While there are exceptions, many of these companies are unable to differentiate themselves because they are literally commoditized, with prices being set by the global market. The bottom line is that it’s unclear how much control they actually have over their success and long-term growth. Eventually, prices will come back down, as they always do.

PH For the most part, the same executive teams have been managing these companies for the last decade, and we’ll see if they’ve truly gotten religion in terms of capital allocation. We’re still a bit skeptical. Recent dividend growth numbers look attractive, to be sure, but it’s because many dividends had been eliminated or dramatically reduced over the previous three-to-five years. Overall, the Energy sector carries one of the highest odds of a dividend cut. We’re more interested in energy transition companies like Northland and Algonquin, which are part of a multi-decade decarbonization growth trend that’s still in the early innings. We also like energy transmission and transportation companies like Enbridge. They’re a low-risk way to get the same exposure because, unlike many of the energy producers, they do have sustainable competitive advantages rooted in their infrastructure.

6. Earnings season has just passed. Are there any trends or key takeaways that stood out to you? And how does the near-term look in terms of dividend growth?

LZ This was the first full quarter to include central bank movements and the Russian invasion of Ukraine, so our focus is less on the strength or weakness of the earnings and more on management’s comments on how they’re dealing with those issues. After all, earnings numbers reflect a fleeting moment in time and may not tell you much about a company’s long-term prospects for success. Management commentaries, on the other hand, may offer insights into developments that change our fundamental assumptions about a company. Anything that could affect longer-term growth would be considered a red flag.

PH On the topic of dividend growth, it’s been one of the standout stories not only this year, but over the past few years. Much-feared dividend cuts haven’t really come to fruition, and in Q1 of 2022, we saw a return to strong dividend growth trends. In our management meetings, two common points of discussion are – what does a company’s capital allocation strategy look like? And, more importantly, what is their plan for capital return to shareholders via dividends or buybacks?

7. Lutz and Philip, one last question for you. We like to end by asking for book recommendations that have shaped the way you think. What would you suggest for our Advisor audience?

LZ I really enjoyed Lights Out: Pride, Delusion, and the Fall of General Electric by Thomas Gryta. It tells the story of what went wrong at GE. I grew up in the 1980s and ’90s, when Jack Welch was considered one of the top CEOs of his time, but the author makes the case that his management style and track record deserve critical reexamination. They look very different in retrospect. The book is fascinating in the way it drives home the importance of governance to a business, because there was a lack of it at GE.

PH A recent standout for me is The Psychology of Money: Timeless Lessons on Wealth, Greed, and Happiness by Morgan Housel. We know that markets are driven by emotions to a large degree, especially in the short run. Housel is a highly decorated fund manager himself, and his book walks through some of the most common investor pitfalls, which are then brought to life with some interesting anecdotal stories.