When Dividend Investing, the Payout Ratio Does Not Tell the Whole Story

For the most part, I am a dividend investor. Oh, I hold some ETFs for diversity but mainly I hold dividend-paying Canadian stocks. I've written about dividend paying stocks in the past. I have always told my readers to pay attention to the Payout Ratio when buying a stock for the dividend. Too high a payout ratio indicates the dividend may not be secure.

I have come to think this "rule" is not a rule at all. Lots of good, secure dividends are paid by company's with payout ratios above 100%. If the payout ratio is the percentage of a company's earnings going to meet its dividend demands, how is it possible to pay out more than 100%? I will try and give you an answer but if you'd like an explanation from a more knowledgeable source try Morningstar. (Click the link.)

Take Enbridge Inc. (ENB). It has a payout ratio of 123.64%. Yet, ENB has consistently paid its dividend, without missing a payment or reducing it, for the past 29 years. What is going on? I turned to Perplexity for an answer.

"Pipeline companies like Enbridge often base their dividend payout ratios on Distributable Cash Flow (DCF) due to the financial characteristics of their operations. Here’s a detailed explanation:

 

Capital Expenditure Demands

1. High Capital Expenditures: Pipeline companies typically face significant capital expenditure (capex) requirements to maintain and expand their infrastructure. These expenditures can include costs for building new pipelines, upgrading existing ones, and ensuring regulatory compliance.
2. Impact on Earnings: High capex leads to substantial depreciation charges, which can reduce reported earnings. Since these accounting entries do not reflect actual cash flow, relying solely on net income can present a misleading picture of a company's financial health.

Cash Flow Characteristics

1. Stable Cash Flow Generation: Pipeline companies benefit from relatively stable cash flows due to long-term contracts and regulated rates, which provide predictable revenue streams regardless of fluctuations in commodity prices.
2. Distributable Cash Flow as a Metric: DCF represents the cash available for distribution to shareholders after accounting for necessary capital expenditures. By focusing on DCF, companies can provide a more accurate reflection of their ability to sustain and grow dividends.

Enbridge's Payout Ratio Strategy

1. Target Payout Ratio: Enbridge has established a target payout ratio of 60% to 70% of DCF. This range allows the company to balance returning cash to shareholders while retaining sufficient funds for ongoing capital projects and operational needs. (I calculated the ENB DCF at 70.4% today by multiplying the annual dividend by 100 and dividing this by the Cash Flow. Using WebBroker, both figures are found under Fundamentals)
2. Financial Stability: By maintaining this payout ratio, Enbridge aims to ensure that its dividend payments do not jeopardize its financial stability, allowing it to continue investing in growth opportunities while rewarding shareholders consistently."

This brings me to company like Telus (T). When I tried to check the Telus earnings, cash flow, and payout ratio, I discovered that all fields were blank. No earnings, no cash flow and therefore no ratios. Yet, Telus pays a 7.33% dividend -- $1.61 annually. Again, I ask, what is going on? This time I used Google Gemini to get the answer:

"Telus (T) is able to pay a dividend while reporting neither cash flow nor earnings thanks to to several factors:

1. Cash Flow Generation: While specific cash flow numbers may not be publicly disclosed, Telus is a mature telecommunications company with a stable cash flow generation. This cash flow can come from various sources, including subscription fees, equipment sales, and network infrastructure investments.

2. Dividend Policy: Telus has a well-established dividend policy, with a focus on maintaining and growing its dividend over time. This commitment to shareholders is a key consideration for the company.

3. Financial Planning: Telus likely has a robust financial planning process that takes into account future cash flow expectations and dividend obligations. This allows them to assess their ability to maintain the dividend even in the absence of immediate earnings or cash flow reports.

4. Debt Management: The company's debt levels and interest expenses play a significant role in its ability to pay dividends. A strong balance sheet and disciplined debt management practices can help ensure sufficient funds for dividend payments.

5. Regulatory Environment: The regulatory environment in Canada, particularly for telecommunications companies, can provide stability and predictability in revenue streams. This can contribute to a consistent cash flow and support dividend payments.

It's important to note that while Telus may not have explicitly reported cash flow or earnings numbers, they likely have internal financial metrics and projections that guide their dividend decisions. "

Lastly, I checked the Telus Dividend Investment page on the company website to see if I could find some published numbers. I discovered that Telus has an expressed goal of making semi-annual dividend increases ranging from 7% to 10% annually through to the end of 2025. The declared payout ratio is 60% to 75% of free cash flow based on prospective basis. But, read the small print: "There can be no assurance that we will maintain a dividend growth program through 2025."

Did you notice that the free cash flow is based on "prospective basis". This is a key point. It indicates  the company is looking forward and making an estimate of its future cash flow. Actual free cash flow is a more accurate measure of a company's ability to pay its dividends.

 

TD Cowen is maintaining its BUY rating. Morningstar has Telus on both its Canadian Core Pick List and its Canadian Income Pick List. Plus, Morningstar rates Telus as a five star stock; it is severely undervalued in the eyes of the Morningstar analysts.

Is the Telus dividend secure? It appears to be at the moment but . . .

 

For more information on Dividend Investing go here: https://www.td.com/ca/en/investing/direct-investing/articles/dividend-stocks 

Quebecor (QBR.B) may be a buy

I picked up a little Quebecor (QBR.B) some months ago. It immediately climbed into the black and never looked back until now. Late last week, my QBR.B holdings dropped into the red. By Friday close my Quebecor shares were back in the black but the Quebec-based telecom had my attention.

In an ideal world, I would own a bit more Quebecor than I do. My telecom investments are not as diversified as I would like. For instance, I have more Telus than I am comfortable owning. The excess shares will be sold when the Telus share price recovers. I look forward to the sale. I may invest for dividends but everyone benefits from pocketing some capital gains now and then.

My ideal portfolio has about 350 additional Quebecor shares. At $29.11 I can afford the purchase. The price is good but it could be better. The Morningstar Analyst Report rates QBR.B a four star stock. This means Morningstar believes appreciation beyond a fair risk-ad-
justed return is likely.

And speaking of Morningstar, the respected investment authority believes one should consider holding Quebecor as a core holding in a portfolio based on Canadian stocks. It isn't among the first tier "consider buying recommendations" but it is still listed as a stock worth holding.

The dividend yield of 4.12% is not great but it is adequate. With a payout ratio of 45.14% the dividend should be solid with very little chance of being cut in the near future. The quick ratio of 0.6X also adds to one's confidence in the company.

So, what is holding me back? QBR.B recorded a low of $23.845 in the past year. I worry that QBR.B could drop if the market were to continue to weaken. Am I being greedy? Maybe. (Oh, just to be clear, this post refers to QBR,B. Note the B. It is important.)

Algonquin Power Utilities Corp may have found a bottom

 

For investors in Algonquin Power Utilities Corp the last few months have been difficult. The stock is some fifty percent off its recent highs. The question being asked is this: "Is it time to sell? Is it time to save what is left and move on?"

This is a tough call. Investors had confidence in AQN and that confidence was misplaced. If we have confidence in AQN today, is that confidence again misplaced? My gut feeling is no, it's not. AQN will not drop a further fifty percent from its present price. The days of massive losses are over. AQN stock may go down but it will do so in lock-step with a falling market. AQN will not lead the retreat.

Look at the screen grab posted at the top of this post. Note that four absolutely superb stocks were all down at the open this morning. AQN balked. AQN was actually up almost a full percent. I don't find this apparent strength surprising. AQN is testing a bottom. I feel confident continuing to hold AQN.

AQN slashed its dividend. The pain of that cut is reflected in the present stock price. I don't see another big cut in the near future. And so the correct question is: "If I sell my AQN, where can I invest the money and get the same or better dividend income. What investment is offering better potential for a decent capital gain?" I have no quick, easy answer and so I continue holding AQN.

In the mid-afternoon, I checked the gain/loss of AQN again. Wow! It was up more than two percent while everything else remained down. AQN is clearly testing a possible bottom.

Making your annual mandatory RIF withdrawal

My wife and I are retired. We get by thanks in large part to the dividends earned by equities in our RIFs. Because of this, we are very protective of our equities. The more equities we have, the more dividends we have and the more cash we have to spend. We try to never sell any equities. We are buy and hold investors.

We meet the mandatory withdrawal requirements of our RIFs not by withdrawing cash but transferring equities. This is called making an in-kind withdrawal.

TD WebBroker posts your mandatory withdrawal amount. Simply click the tab labelled "RRIF Payments". Although there is no withholding tax, tax must be paid in the year following the withdrawal.

To make a withdrawal in-kind, to transfer equities from your RIF to either a TFSA (tax free savings account) or a non-registered account, you must call TD WebBroker and speak with a representative authorized to buy, sell and transfer equities.

Let's say you own a thousand shares of Enbridge (ENB) in your RIF. You ask the representative to transfer enough ENB shares to match your mandatory withdrawal amount as closely as possible. They check the market, find the stock is selling for $50 at the moment and divide your posted mandatory withdrawal ($13,779.06) by the price of the stock. The representative transfers 275 shares worth $13,750. There is no commission charged as no stock is bought or sold. The remaining balance of $29.06 is transferred as cash from the RIF to the TFSA.

If you are transferring stock and cash to a TFSA, you must ensure you have adequate headroom to accept the transfer. TFSA headroom is the sum of three amounts:

• deposit headroom remaining unused from last year
• the total dollar amount withdrawn from the TFSA last year. Funds withdrawn from a TFSA cannot be replaced in the year the funds were withdrawn. One must wait until the following calendar year to be able to replace the funds.
  
• the annual TFSA dollar limit. This has been increased to $6500 for 2023.

If the sum of these amounts is not large enough to accept the total transfer, the remaining balance can be moved to a non-registered account.

One nice perk provided by this approach is that the dividend income from the stock held in one's TFSA is tax free. Today, ENB is paying a dividend of $3.548 CAD annually or 6.52% based on Friday's closing stock price. The 275 shares transferred in the example would pay $975.70 annually and no tax to pay!

The annual withdrawal amount is based on your age and a percentage of the value of your RRIF -- a percentage that increases with each passing year. There tables detailing the percentage that must be withdrawn annually from both LIFs and RIFs. 

Here is a link to the table posted by the University of British Columbia. Note, as the UBC post makes clear, the maximum withdrawal amount in BC for a LIF may be higher than the maximum quoted in the tables. It can be equal to the investment return earned by your LIF in the previous calendar year. Mawer also discusses this in a post: 2022 LIF withdrawals: What you need to know.

Unlike LIFs, there is no maximum withdrawal limit for RIFs but one is wise to think carefully before withdrawing too generously.

With TD Direct Investing clients must contact WebBroker to make an in-kind withdrawal or transfer. If making a cash withdrawal, simply click the green "Make withdrawal" button. I always have a minimum withholding tax of 30% applied. Sometimes, I even have 35% withheld. I find this is necessary as no tax is withheld from the in-kind withdrawal. I do not want to learn I had too little tax withheld and now must pony up cash to cover an unexpected tax bill.

When making an RIFwithdrawal, always have all relevant information available:

• RIF account number
• amount of mandatory withdrawal
• name and symbol of stock to be transferred
• TFSA account number
• TFSA contribution headroom available (Check this carefully. Do not over-contribute.)
• Non-registered account number
• I do all the math in advance. This is important. The bank reps are busy. Mistakes happen.

The nice thing about the market being down at the moment is that we can move more stock to our TFSA and then it sits producing a tax free stream of dividend income and, if we are lucky, eventually a nice capital gain as well.

Risk free comes at a price

If you want a risk free investment, buy a GIC. You may only make 3.5% on a four year term but at maturity all your investment will be returned. Oh, it may have lost buying power if inflation runs at more than 3.5% but you will get all your money back. Guaranteed.

 

If 3.5% is not enough yield, why not take on a little risk and put 2% of your portfolio in IGM stock. IGM is off its recent high by 21.2%. It is selling for $40.71. A price that puts it in bear territory. Buying today, you will enjoy a dividend income of 5.53% for the next four years. That much is pretty much guaranteed. IGM is not overly generous with its dividend. Its payout ratio is quite reasonable. The dividend should be secure.

Morningstar lists IGM on both its Canada Core Pick List and its Canada Income Pick List. Only eight stocks receive this buy recommendation in the recent monthly report. At the moment, Morningstar gives IGM four stars. This means Morningstar believes IGM will most likely reward investors with capital gain.

During the March 2020 bear market, IGM dropped in price to about $21. Clearly, the IGM price can fall a lot more. A paper loss is possible. On the bright side, it climbed out of the depths of the 2020 bear market in little more than a year. If you can afford to hold, its price should recover. (IGM was selling for $43.20 at market close Mar. 7th, 2023.)

My take

I ended up buying some REITs wrapped up in the ETF RIT. I the units were $17.95 with a yield of 4.5%. These units partially replaced the units of XRE that I sold at the beginning of the recent correction. I sold the XRE high and I bought the RIT at a much lower entry price point.

One thing you never get with a GIC is a profit surprise and with a yield of only 3.5% you are hardly being paid to be patient or otherwise.

Make a note to yourself and revisit this advice in four years. See if I was right when I pronounced RIT or even IGM a better investment than a GIC. With a GIC you have almost locked in a guaranteed loss. With RIT or IGM, but especially RIT, I like to think I am risking making a tidy capital gain and banking a generous dividend. That is a risk with which I can live.