What’s up with divvy stocks?

RYAN   By Guest Blogger Ryan Lewenza

It’s been a rough year for dividend-paying stocks, underperforming the broader markets. For example, the iShares Canadian Select Dividend Index ETF is down 14% this year, much worse than the S&P/TSX Index, which is down 5%. Dividend stocks are supposed to be less volatile and hold up better in downturns versus the overall market, so what’s up?

Canadian Dividend Stocks are Under Pressure

Source: Bloomberg, Turner Investments

Let’s first look under the hood of the Canadian dividend index and review the sector composition. Financials make up the largest sector weight at 60%, followed by utilities (11%), communication (10%), consumer discretionary (8%) and the energy sector (5%).

The Big 6 Canadian Banks – RY, TD, BMO, CM, BNS and NA – represent the lion share of the financials sector here in Canada and some of them have had a rough year. The banks with more international exposure like TD, BNS and BMO have taken it on the chin, while big blue and CIBC have held up relatively well.

A key reason behind the share price weakness in the bank stocks are the large losses the banks are writing down on their loan books. Called ‘provisions for loan losses’, they’ve been spiking as a result of the Covid-19 induced global recession. Below I capture this with loan loss provisions surging from roughly $2 billion per quarter in late 2018 to $11 billion in the second quarter of this year.

This happens in every recession as the banks have to estimate what mortgages and loans will go bad. But what invariably happens is the economy turns, they overestimate their loan loss provisions and the banks then end up reversing or ‘releasing’ these loan loss provisions in future quarters. This is exactly what happened a few weeks ago when HSBC Canada announced that it was ‘releasing’ $2 million from its previous loan loss provisions. I believe this may mark the peak in loan losses in this downturn.

Big 6 Bank Loan Losses look to have peaked

Source: Bloomberg, Turner Investments

Looking at the historical data, since 1994 there have been four (including this one) spikes in provisions for loan losses from the banks. These include the tech recession from 2000, the financial crisis recession of 2009, a mini spike in April 2016 related to losses on the banks energy portfolios, and the current one due to Covid-19.

Now the cool thing about this is that the peak in loan losses generally marks the bottom in bank share, prices with large gains following in the first and second year following the peak. As seen below, the median 1 and 2 year return after the peak in loan loss provisions is 20.4% and 43%, respectively.

This is one key reason why I’m advising our clients to stick with their dividend stocks and in fact, that they continue to add to them. I see dividend stocks doing much better next year in large part due to my bullish view of the Canadian banks. Patience will be required as Covid-19 is surging again and the Canadian economy remains under pressure, but this patience should be rewarded with nice gains in 2021.

Banks Do Very Well Following Peaks in Provisions for Loan Losses

Source: Bloomberg, Turner Investments

Another industry I see recovering are the Canadian pipelines, which have been hit hard as a result of weak oil prices. Currently, oil prices are around US$37/bl and I see oil prices recovering to $50-$60/bl next year as we get a vaccine, the global economy recovers from the current recession and we see oil demand pick up.

Below I chart US oil prices with Enbridge and TC Energy and it’s clear that the low oil prices have weighed on their share prices. But as oil prices recover so should the share prices. Additionally, with ENB and TRP yielding 9% and 6.4%, respectively, these beaten dividend stocks look quite attractive, which are large weights in our preferred dividend equity ETF.

Low Oil Prices have Weighed on Canadian Pipelines

Source: Stockcharts, Turner Investments

This year investors have flooded into tech and high growth stocks, while eschewing staid dividend paying stocks, which I believe is creating a good buying opportunity. As Garth keeps reminding readers, pandemics end and when we start to see a rollout of vaccines next year, I believe some of the ‘fast money’ will flow out of the expensive tech sector with beaten up dividend stocks receiving some of those flows. So get ahead this and consider adding to your dividend stocks and ETFs, as better days lie ahead.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.