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Ryan Modesto, CFA, is Managing Partner at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.
Investors haven't seen a year like 2015 in some time. It has also been a while since we have seen oil in the $30 (U.S.) range and the Canadian dollar so low. With the past few years having been so good, recent market performance can be a harsh reminder that things won't work out all of the time when investing. Tough times can also provide a great opportunity to reflect on what went wrong and how we can learn from it. We wanted to cover a few lessons that investors have hopefully learned in 2015.
Dividends are not 'safe'
We often get questions asking whether a certain dividend for a company is 'safe'. We almost always answer 'NO'. By nature of what a dividend is, it is very hard to consider them safe. There is no obligation to pay them on a go-forward basis and they can be cut at the board's discretion. Sometimes this can be due to bad prospects like we are seeing in the oil sector but other times it can be done just out of conservatism or to allow for other actions such as a strategic acquisition. We have seen cuts occurring across the energy sector for the 'right reasons' but have also seen many cuts from companies that had very strong balance sheets such as Wi-Lan (WIN) and McCoy Global (MCB). Kinder Morgan is an example of a company that operates in a stable industry and many would have viewed as a 'safe' dividend payer only to see the dividend cut very recently. Instead of calling dividends safe, which can lead to a false sense of security, we would far prefer to view dividends in terms of sustainability. Can the dividend be maintained at current levels? What needs to be done if not? Investors have been reminded that calling a dividend safe can be misleading and when tough times come around, these are often one of the first areas management and the board of directors look at in order to ensure operations continue.
The first cut is never the last
This point is similar to the first but from a different frame of reference. Many view a dividend cut as an opportune time to get a stock on the cheap. But very often, when there is one dividend cut there will be another. Cuts are usually done when a company is facing tough times. So right off the bat, the prospects for investing are likely not that great as the company is likely facing slower demand or some sort of major shift in the industry that is making them less profitable. These are scary times for a company but the changes/shift can often go underestimated. On top of this, management usually wants to maintain some sort of semblance of a dividend for shareholders, which leads to a cut that is less than is probably appropriate. Both of these factors help contribute to the issue that the first dividend cut is rarely the last. Even if it is the last cut, an investor is still left owning a company facing a changing or more difficult environment. We think 2015 has shown investors to think twice before trying to catch a falling knife after dividend cuts, because there could be more cuts on the horizon. Recently, Westshore Terminals (WTE) has been a great example of this with a 24% cut initially on October 28, 2015 and then another on December 9, 2015, a further 35% cut. Teck Resources has also followed a similar path, although not quite as quickly with a big cut in April, 2015 and a further one in November, leaving a minimal dividend compared to a year ago. Finally, Encana recently slashed its dividend by 79% and had cut the dividend previously back in November 2013, showing that the risk of further dividend decreases can linger on, years after the first cut. While it can be painful, we would far prefer to have the Band-Aid pulled off quickly so the whole question around the dividend can be put behind the company and markets can move on.
Preferred shares are not fixed income
There seems to be a lot of confusion surrounding preferred shares, as many investors do not fully understand how these securities work. The past year has made investors learn the hard way, unfortunately. While the above heading sounds obvious, many investors do not realize that preferred shares do not guarantee the safety of your principal. There is no promise to repay the initial amount invested and they can trade at depressed prices indefinitely. There is also little assurance that preferred shares will be redeemed by the issuer, ever. These are all common assumptions we have seen investors make and many have been surprised by the long and sustained ~30% decline in the asset class. We actually think these securities can offer the worst of both worlds but if you are seeking an outsized, tax efficient income, these securities can make great sense. It is important to remember, however, that these are quite different from fixed income.
The Canadian dollar actually is a petro-currency
This is a tough lesson to swallow, but it is hard to dispute at this point. A look at a chart matching the Canadian dollar and oil show that where oil goes, so goes the dollar. A few years back there was a well-covered story on individuals calling the dollar a petro-currency and others disputing it. This was when oil was strong and relatively stable. Yes, in these kinds of periods, small fluctuations in oil are unlikely to be reflected in any material way in the exchange rate. However, when there are large fundamental shifts in these markets, it appears quite clear that the Canadian dollar will follow.
There may be better alternatives than indexing
Canadian investors have now been made fully aware of the risks involved with benchmarking to the TSX. The composite is heavily weighted toward energy and commodity markets, with other industries such as financials being influenced by these sectors as well. Investors that did not follow TSX benchmark weights have likely fared much better over the past year than those that were devout or closet indexers. This is not an argument against passive investing as much as it is an argument against not looking under the hood of the indexes, benchmarks or funds that one holds. Just because an index is heavily allocated toward certain industries does not mean that a portfolio is required to do so as well. Owning or tracking an index does not ensure diversification nor does it ensure prudent portfolio structure.
There were numerous land mines strewn across the Canadian markets in 2015. Some of them avoidable but many were unavoidable. While it has been a tough year and the outlook for Canada is not the most promising sounding, it is important to remember that a year should just be a blip in most investors' time frames. Not every year will be a positive one but if we can learn and improve on lessons from the bad years, it might just make the good years even better and ensure long-term success.
Readers can follow @5iresearchdotca on twitter to get timely updates on dividend initiations, increases and cuts in Canadian markets.
Please perform your own due diligence before making investment decisions.
In order to remain truly conflict-free, the writer and employees of 5i Research cannot take a position in individual Canadian equities.
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