Mike, Author at MOOSE MARKETS

Stock Buying Process – Here’s What I Do

Hey there! Not sure which stocks to buy and feeling overwhelmed? Well, let me share my stock buying process with you. It might just help you out. Here’s how I do it, in a nutshell.

1 – Find stocks with strong dividend triangle

Using a stock screener, like the DSR stock screener, I find stocks with a strong dividend triangle. That means I look for companies that show trends of increasing revenue, earnings per share, and dividends. Ideally, I want to see continuous growth in all three areas. This is my initial buy list.

2 – Focus on stocks with strong 5-year dividend growth

I focus on stocks with solid dividend growth over the past 5 years. I’m a fan of dividend growers rather than high yielding companies with stagnant growth. So, I narrow down my list to those companies that have shown the strongest dividend growth over the past half-decade.

3 – Select only sectors I like and understand

I trim down my buy list further so that it only includes stocks in sectors I’m interested in and actually understand. It’s crucial to grasp the economic sector or industry in which you invest. This helps you feel confident out about your investments and lowers stress.

Each sector has its own ups and downs, although not at the same time during an economic cycle. Some are more resilient during a recession; others outperform the lot in bull markets. A market crisis hurts all sectors, but some more than others. We never know which industries will suffer the most though; banks in the 2008 financial crisis, oil & gas businesses in 2015, entertainment, travel, leisure, and retailers in the 2020 pandemic.

That is why I don’t put all my eggs in one basket. So, while I focus on industries I understand, I choose them in several sectors. I never invest more than 20% of my money in one sector; in doing so, I diversify my portfolio and minimize the impact of market drops on specific industries.

4 – Select stocks with strong dividend safety

Next in my buying process, I dig deeper into each company’s financials to make sure they have strong dividend safety. How specifically? I look for companies with not only healthy revenues and earnings, but also strong cash flow generation. Company financial reports and the DSR stock cards give me a good insight into a company’s cash flow from operations and free cash flow metrics.

Only then do I check out the infamous payout and cash payout ratios. But here’s the thing: I don’t rely solely on payout ratios right away. They can be misleading. Sometimes, high payout ratios are justified, for example when they are due to investments for future growth, and the company is still a solid dividend grower.

5 – Study the business model

Now that I’ve done my homework on the financial side, I dive into understanding each company’s business model to know how they make money and how they plan to grow in the future. For example, what do they sell, who do they sell to; is demand for their products cyclical, growing, stagnating; are the products and markets diversified; is the growth through acquisitions, innovation; is it a very competitive industry; and more.

If I can’t explain the business model in simple words a 12-year-old would understand, I don’t fully grasp it. I remove the company from my list and move on to the next one.

6 – Identify potential risks and growth

Now comes the fun part. I identify potential risks and growth prospects for each company. It’s important to be realistic and not get carried away by the positive aspects. I look at growth trends to see if they’re slowing down, review the evolution of company debt over the years, and consider potential downsides like vulnerability to inflation, interest, regulation, patent expiry, and competition. I read up on bear theses to understand why some investors might dislike a company. It’s important to know what I’m getting into and to be prepared for any challenge that may arise.

7 – Look at valuations: immediate buy or add to watchlist

Valuation is another factor I consider, but it’s not the be-all and end-all. I’d rather buy a stock with a strong dividend triangle, great growth prospects, and lots of potential for the next decade, even if it seems overvalued; I’d take Microsoft over AT&T any day. I might keep “overvalued” stocks on my watchlist and wait for the right opportunity. Quality takes priority over short-term undervaluation in my stock buying process.

I use two valuation methods. First, I review the PE ratio and the dividend yield over the last 5 years. This shows how the market values the stock over a sizeable part of an economic cycle; did the PE grow, i.e., the price grows faster than earnings, or was it stable year after year. Reviewing yield pinpoints opportunities when the yield is better than its 5-year average. For stocks yielding 3% or more, I look at the valuation from the dividend discount model (DDM).

8 – Write my investment thesis and click BUY

Finally, I write down my investment thesis for each company, laying out the reasons why I think it’s a great investment along with the potential downsides.

This helps me to stay focused on why I buy a stock and, later on, evaluate if my original reasons for investing still hold true. The market and companies change all the time—remember what Apple’s iPhone did to Blackberry, or how the pandemic-induced shift to remote working affected office space REITs—so it’s crucial to keep an eye on things and reassess regularly.

So, there you have it! That’s my stock buying process in a nutshell. By following these steps, you can make more informed decisions, focus on dividend growth, and build a well-diversified portfolio based on your understanding of different sectors and individual companies. Happy investing!

Buy List Stock – July 2023: CCL Industries (CCL.B.TO)

If you’re looking for a strong Canadian stock in the materials sector to add to your buy list, take a look at CCL Industries. The world’s largest producer of pressure-sensitive and specialty extruded film materials, CCL offers products and solutions to address decorative, packaging and labelling, security, loss prevention, and inventory management needs.

A global presence, CCL employs over 25,000 people in 200 production facilities in 43 countries. Its revenues come from North America (41%), Europe (32%), and Emerging Markets (27%).

CCL Business Model

Operating through four segments, CCL Industries sells its solutions to global corporations, government institutions, small businesses, and consumers.

The CCL segment converts pressure sensitive and specialty extruded film materials for a range of decorative, instructional, functional and security applications.
The Avery segment supplies labels, specialty converted media and software solutions.
The Checkpoint segment develops radio frequency (RF) and radio frequency identification (RFID) based technology systems for loss prevention and inventory management applications, and labeling and tagging solutions, for the retail and apparel industries.
The Innovia segment produces specialty and layered surface engineered films for label, packaging, and security applications.

Investment Thesis

An international leader with a well-diversified business that is based in Canada is a rare find. With its 2013 major acquisition of business units from Avery, the world’s largest label producer, the company set the tone for several years of growth. Bolstered by its earlier success, CCL also bought Checkpoint and Innovia, and it keeps making more acquisitions.

CCL is still able to generate organic growth (roughly 4-5%) on top of its growth through acquisitions. You can rest assured that management’s interests are aligned with yours since the Lang family still owns 95% of CCL’s A shares with voting rights. We appreciate CCL’s capital allocation that includes a mix of dividend, share buybacks, acquisitions, and CAPEX. With its attractive PE ratio, CCL can generate more growth through acquisitions.

CCL’s Last Quarter and Recent Activities

CCL reported a strong first quarter in 2023; revenue up 9% and EPS up 12%, with organic growth of 1.4%, acquisition-related growth of 3% and a 4.2% positive impact from foreign currency translation. Sometimes, doing business across the world works out! By segment, CCL sales were up 7.5%, Avery was up 44%, Checkpoint was up 3.6%, and Innovia was down 14%. In constant currency, the company saw high single-digit growth for revenue and earnings. It is looking good for the rest of the year!

In less than 30 days, in June and July 2023, CCL made three small acquisitions:

It bought Pouch Partners for $44M in an all-cash deal. Pouch Partners supplies highly specialized, gravure printed & laminated, flexible film materials for pouch forming, including recyclable solutions, with sales of $104M in 2022.
It announced the acquisition of Oomph Made for $7.1M. CCL said Oomph had sales of C$6.7M in 2022. This adds to Avery’s growing portfolio of access control, badging and credentials technologies, products, and brands focused on the retail, hospitality, live events, and conferencing markets.
It bought privately held Creaprint S.L., a specialist producer of In Mould Labelling (IML) with sales of $17M in 2022, for a debt and cash-free purchase consideration of $38.1M. This acquisition brings IML technology and expertise to global CCL Label operations.

Want other stock ideas for your watch list? Download our Dividend Rock Stars list!

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Potential Risks for CCL.B.TO

We often see rising stars such as CCL yielding a high return over a short period. In 2014, the stock traded at approximately $15, steadily rising to $62 in 2017, peaking at $72 in 2021, and now around the $66 mark. CCL is a leader in many sectors, but double-digit growth will be hard to achieve going forward.

The possibility of a recession is affecting investor interest for this stock. CCL used leverage for its acquisitions many times in the past few years. Further acquisitions to support growth might be riskier as many expect a global economic slowdown. CCL also faces inflation headwinds as the cost of raw materials continues to rise.

CCL.B.TO Dividend Growth Perspective

CCL shows a nearly perfect dividend triangle over the past 5 years, with strong revenue and dividend growth. However, earnings are beginning to slow down.

CCL’s business model is built on repeat orders generating consistent cash flows. With their low payout ratios, investors can expect dividend growth for many years. After a smaller increase in 2020, CCL roared back with yearly dividend increases of 17%, 14%, and 10.4% from 2021 to 2023. It will be interesting to see how CCL will grow its payouts going forward with EPS not growing as fast. With a payout ratio of 25% and a cash payout ratio of 35%, there is nothing to worry about.

Final Thoughts on CCL.B.TO

I look at CCL.B.TO as an educated guess; it’s almost perfect but I expect price fluctuations and I know the risks. As it operates in the cyclical materials sector, CCL faces potential headwinds from a looming recession and increased raw material prices. That being said, the dividend is safe, and the company can sustain dividend growth for several years.

If you are looking for a company focused on growth by acquisition, and you can live with fluctuations in this uncertain economic environment, CCL might be for you. Or you can keep CCL on your watch list while you wait to see how the economy evolves over the next months and quarters.

Never Again! How to Avoid Loser Stocks in your Portfolio

I’m sorry to say there is no foolproof method to avoid loser stocks in your portfolio. It’s impossible to not make occasional mistakes as investors. If you can’t bear the thought of losing 30%, 40%, 50% of your investment in a stock, you should probably not invest in equities.

However, you can minimize the risks. In fact, you can reduce the number of times it happens, and you can also reduce the impact of those rotten apples in your portfolio. This starts by acknowledging our mistakes.

Recognizing our mistakes

I’ve made mistakes in my investment journey. For example, with Algonquin (AQN):

I let the company narrative take too much importance in my analysis and ignored the financial numbers. Who doesn’t like a good story, right? Always rely on company fundamentals and metrics; they either back the narrative or reveal it as fiction.
Wearing pinked-colored glasses, I hoped for the best outcome and minimized the impact of the worst-case scenario.
I put too much faith in company management, thinking it would keep paying the dividend. Obviously, the dividend wasn’t a priority for AQN’s management team.

Other common investing mistakes are:

Being seduced by a high yield: investors often concentrate too much on the generous dividend yield in their decision to buy or keep a stock. Appealing as a high yield might be, it is often a warning sign.
Underestimating the potential downside of a company. No company is invincible. Being aware of the risks is a good defense; knowing about a company’s dependency on the housing market will alert you to watch its results when interest rates rise. Just as risk awareness helps to spot a problem stock, it can also prevent bad buying decisions.

Another mistake that adds to the pain of having a loser stock is investing heavily in a single stock, thus granting it too much weight in your portfolio, without considering the effect a dropping stock price will have on your portfolio.

An ounce of prevention: portfolio review to detect loser stocks

Always review of all your holdings quarterly so that you can detect when you have overweight sectors or stocks, verify that growth is still in the cards by consulting the dividend triangle, identify red flags, and investigate them properly.

During your quarterly review:

Identify your core holdings, educated guesses, and falling knives
Make sure your core holdings represent most of your portfolio; rebalance if needed.
If you see a dividend yield above 5%, consider it a red flag and investigate that stock further; does it still fit your investment thesis? Does the company have growth vectors? Are the revenue and EPS growing consistently? Is the dividend growing, has its growth slowed down?
Be more demanding about the stocks you keep, for example, look for stronger dividend triangle, a low payout ratio, companies meeting expectations and not lowering their outlook.
Do not hesitate to sell a loser stock, even if it hurts.
Resist the appeal of exciting, sexy, growth stories. Go for boring, yet consistent and recession-resilient investment narratives.

Have a replacement list ready

When a $10,000 investment is now worth $6,500, I try to get the $10K figure out of my head and focus on how I can most efficiently invest what is left.

Make a list of stocks you’d like to have but don’t have money to invest in yet. Choose companies that have good growth potential and a strong dividend triangle in different sectors. Not sure where to start? Download our Dividend Rock Stars list!

DOWNLOAD THE LIST HERE

Comparing two stocks

Equipped with my replacement list, I look for a decent replacement in the same industry as the loser stock I’m considering selling. Then, I compare both stocks, analyzing six factors:

The business models

Review the business models to understand how each company can make money and to find similarities and differences between them.

The dividend triangle

The dividend triangle is an overview of a company’s metrics and the trend of its revenue, EPS, and dividends. Two companies in similar environments would have similar growth metrics.

Dividend safety & growth potential

How of the dividend going to evolve? Double-digit or mid-single digit growth? Low growth, no growth, or cut? Dividend safety and growth potential is assessed by analysing the dividend triangle, the company’s payout ratios, and potential risks.

Growth vectors

Growth vectors point to how a company should grow in the coming years. Reviewing a company’s business model and studying revenue and earnings trends can give you a good idea. Two companies in the same industry can show similar growth vectors.

Potential risks

Review the risks the companies face; are they particularly vulnerable to interest rates, commodity prices, increased regulation? Do they carry a high debt load? Are they in an expanding market? Companies in the same industries might face similar risks.

Valuation

To compare two companies, assess the value of each one’s stock value. Valuation methods include the P/E ratio trend over several years and the Dividend Discount Model (DDM).

Dividend Stocks Rock (DSR) members can find all of the information needed on the stock cards and compare two of them side-by-side. Other sources of information are the investor relations section of each company’s website, and stock reports by third-party financial analysts.

Why I Sold Enbridge and TC Energy

Back in February 2023, as part of my quarterly review of the DSR portfolios and my personal portfolio, I sold all shares of Enbridge (ENB) and TC Energy (TRP).

Many wonder why on earth I would do such a thing. After all, they are much beloved pipeline stocks with impressive dividend profiles; generous yields, 28 years of consecutive dividend increases for Enbridge, TC Energy not far behind with 23 years, and both are part of the 15 Canadian stocks with the longest dividend growth streaks.

Are they unsafe investments? Are their dividends at risk? Should you sell them too? The answers are 1) no, 2) no, and 3) you have to decide for yourself by doing your due diligence; review these companies quarterly to see if they are still a good fit for your investment thesis. Just because I sold them does not mean you should too.

Are Enbridge & TC Energy still safe investments?

Both companies will continue supplying an essential service and they will keep generating substantial cash flow. Like railroads, they are not going anywhere. The world needs energy and pipelines are the ones providing it. They enjoy robust contracts with their customers that, usually, are shielded against inflation and include a minimum fee that ensures the customers pay even if the pipeline is not used.

Are ENB & TRP dividends safe?

Despite their triple-digit dividend payout ratio, show in the graph below, ENB and TRP dividends are safe for now.

Let me explain. At the time of writing, the dividend payout ratio for ENB is over 200% and close to 200% for TRP, which says that they are paying more than, or close to, twice what they earn as dividends. Not good, right? Well, that’s not the complete picture here.

The payout ratio is based on earnings, and the calculation of earnings includes non-cash items such as depreciation and impairments. Non-cash items do not affect the amount of cash a company has to pay dividends.
Capital expenditures (CAPEX) are also included when calculating the earnings and payout ratio. Pipelines are capital-intensive businesses. CAPEX fund infrastructure projects, including investments that the company expects will be profitable and generate new revenue in the future.

To get a clearer picture of ENB and TRP’s ability to pay their dividends, we looked at the Distributable Cash per Share (DCF), which does not include non-cash items or CAPEX. The payout ratio, when calculated using the DCF rather than earnings, is well below 100% for both ENB and TRP. So yes, both pipelines can afford to pay their dividends based on the cash they generate. That doesn’t mean everything is perfect and rosy in pipeline land.

Reasons for selling Pipelines

While both ENB and TRP have done relatively well in our different DSR portfolios and I believe their dividend is safe for now, the dividend growth has slowed down and I don’t see much potential for capital appreciation going forward.

Slowing dividend growth for both ENB.TO and TRP.TO

ENB was increasing its dividend by 10% yearly before slowing down to 3% per year starting in 2021. TRP had 7% to 8% dividend increases until it lowered the targeted rate to 3% to 5% increases, although the last two increases were closer to 3%.

What is slowing down the dividend growth? Quite simply, it is getting more difficult for Enbridge and TC Energy to make money; inflation is pushing their costs up, and higher interest rates are making their debt more expensive.

It costs of lot money to maintain and expand pipeline infrastructure, so both ENB and TRP rely on borrowing. The rise in interest rates, started in 2022, has already increased ENB and TRP’s interest expenses. With both the U.S. Federal Reserve and the Central Bank of Canada clearly not expecting interest rates to go down in 2023, it will only get worse for ENB and TRP as they pay back their older debt, at the lower pre-2022 rates, and add new debt at the higher rates.

Inflation and increasing interest rates are hurting ENB and TRP. This will go on for a while, limiting their ability to increase their dividends. While their yields are generous, as a dividend investor, I look for robust dividend growth.

ENB & TRP shares price won’t go anywhere

In the current landscape, I do not see a lot of room for capital appreciation for ENB and TRP.

They lack growth vectors. New pipelines are difficult to build; they are subject to substantial regulations and are expensive to build. There are often delays in construction, for a variety of reasons including supply shortages, labor shortages, and regulatory complexities, which translate into higher costs, even more so now that inflation has kicked in.

ENB and TRP will also have to deal with Canadian carbon emissions taxes that are expected to increase to $170 a ton by 2030 from $40 today. Enbridge is already on board to reduce its emissions to offset this increase but doing so requires considerable capital investments.

These obstacles to growth are only made worse by the higher interest rates that make borrowing more expensive.

In closing: Why I sold Enbridge and TC Energy

Besides enjoying a generous dividend, I don’t see how ENB and TRP will make me richer over the coming years. Since my strategy is focused on total returns by selecting dividend growers, they do not meet my investing strategy. Both pipelines will either end up as deluxe bonds or dividend traps.

Having said that, I think it’s fair to say both END and TRP will continue to pay their dues for a while. There is a case for holding on to them for stability and income; however, it is essential to follow them with great attention quarterly. If you see more references in their quarterly reports to higher cost of debt, high debt ratio, impairments and charge due to delays and inflation, you’ll know that the dividend safety is under pressure.

Dividend ETFs, Are They Worth it?

How about dividend ETFs? I’ve been asked this question often during webinars. ETFs are useful due to their offering the investor immediate diversification along with minimal fees. To be honest, it’s the perfect solution for anyone who doesn’t want to put the time and energy into managing their portfolio and selecting their stocks.

However, in most cases, this also means you are likely to be leaving money on the table. Dividend ETFs could be too diversified. Having over 100 dividend stocks may hurt total return. I found out that investing in a small number of stocks brings better results.

I haven’t yet found a dividend ETF that shows only companies that I would like to invest in. If I look at the top holdings for XDV.TO for example, its largest holding is CIBC (CM.TO). While Canadian banks are great, CIBC ranks #5 in my Canadian Banks Ranking. The other thing I dislike is that they count all 6 banks in their top 10, which may lead one to believe they haven’t heard of the concept of diversification.

source: BlackRock iShares Canadian Select Dividend Index ETF

To get back to the question: are dividend-paying ETFs worth it? If you don’t have the time, knowledge or interest to manage your portfolio, ETFs could be a good strategy. Selecting individual stocks will help you reach your goals faster and stay closer to your investing values.

However, that doesn’t mean ETFs can’t coexist with individual stocks in your portfolio.

What Could be Really Worth it?

I can see several reasons why an investor would consider ETF investing. Here are a few good examples.

Benchmark

Since the beginning of DSR, we have been using VIG and XDV.TO as our benchmarks. The point of using benchmarking is to assess our strategy vs. an existing alternative solution. Why would I spend time managing my portfolio if I could quickly buy an ETF and make the same money? It only makes sense if I can do better than existing investing solutions.

The problem with benchmarking is we often become too focused on short term results. One must know that looking at any performance records under three years is pure noise. It starts to be meaningful after five years and is very meaningful once you have gone through a full economic cycle.

Start investing

Many asked me how I started my RESP, the account used in Canada to pay for childrens’ college tuitions. I started this account a long time ago with just a couple of hundred dollars. It was not enough to build a portfolio and the monthly systematic investment plan would add a lot of complexity if I had to pick a different stock each time. Therefore, for the first few years, I invested all that money in ETFs until I built a value above $10,000. I then switched this portfolio to the DSR investing methodology focusing on dividend growers.

As a first step in the investment world, ETFs will provide you professional support (ETFs are built and managed by experienced industry professionals), instant diversification (invest in 50-100 securities with a single trade), and peace of mind (no need to manage the ETFs composition). Therefore, it’s the perfect vehicle to use to start a new portfolio. I’m currently showing this same strategy to my two teenagers (and soon to my 10yr old son).

Diversification

While I wouldn’t use ETFs to replace any of my individual stocks, you might improve your portfolio diversification by using them for other asset classes. You can invest in fixed income products such as bonds and preferred shares (we have over 80 bond ETFs and 18 preferred share ETFs in our screener). You could also invest in commodities, emerging markets, or cryptocurrencies through ETFs.

Searching by theme using the search box of our screener, you can rapidly find viable options to add to your portfolio. This additional diversification may help to reduce volatility (bonds / preferred shares), protect your portfolio against inflation (commodities) or hopefully improve the upside potential. Those assets won’t necessarily generate dividends, but they can bring something else to your portfolio.

Exposure to a sector without the work

It could also be a good strategy if you want to gain exposure to a specific industry that you don’t fully grasp. I’ve expressed my interest for the technology sector in the past. Some investors may be intimidated by new technologies and wouldn’t be comfortable analysing growth opportunities in this sector. Some others might have a hard time understanding big pharma’s pipeline development and patents while others might be lost trying to understand how life insurance companies work. Many times, Canadian investors have told me they were good at selecting Canadian stocks but would rather use ETFs to gain exposure to the U.S. markets.

If you aren’t comfortable with investing in a specific sector or market, you can use ETFs. You would benefit from an ETFs best quality (diversified, cheap and professionally managed).

Build a core portfolio

Finally, ETFs could be a good tool to build a core portfolio and then add some spice with individual stocks. Think of investing as cooking a good meal. You can use ETFs as your “core soup” while you make necessary adjustments with different spices by using individual stocks. A 50% ETF and 50% stock portfolio might bring you the peace of mind you may be looking for while you keep control of a good part of your money.

How to Select Your ETFS

As is the case with any investment products, ETFs may track the same asset or follow the same investing strategy, but they are not created equal. There are a few things you must consider before making your decisions.

Financial metrics

In the DSR ETF screener, you will find a good list of metrics to analyze ETFs. The year to date, 1yr, 3yr and 5yr returns will tell you much about the performance of the ETF. It is then easier to know what to expect from this product and make comparisons.

The expense ratio is also very important since you can then pick the cheapest (and hopefully best performing) ETF for a specific sector. If you can’t decide between two similar ETFs, pick the one with the cheapest fees. It is likely the one that will have the best chance of performing well in the future.

Volume and assets under management (AUM) will tell you more about the liquidity and the size of the ETF. It’s important to invest in assets that are liquid. You also want to avoid the latest flavor of the month.

The historical spread will also give you an idea on the ETF’s volatility (the wider the spread, the higher volatility). This could have a big impact on price fluctuations during a market crisis. We saw how some preferred shares and bond ETFs plummeted in March of 2020.

The discount/premium to NAV (net asset value) will tell you if you are paying more than what the ETF is worth or if you are getting a bargain. In general, you want this number to be as close to zero as possible in order to buy at the right price.

ETF analysis

While you can easily make your selection based on basic metrics, but if you want exposure to commodities, or bonds, you must perform a few additional checks if you want an ETF that includes equities.

Once you have selected a pack of ETF that might work with your portfolio, you still have some work to do. The ETF analysis must include the comprehension of the investment strategy. You can usually find this information from the ETF manufacturer (the financial firm managing and selling the ETF). Here’s an example from VIG:

“The investment seeks to track the performance of the S&P U.S. Dividend Growers Index that measures the investment return of common stocks of companies that have a record of increasing dividends over time. The adviser employs an indexing investment approach designed to track the performance of the index, which consists of common stocks of companies that have a record of increasing dividends over time. The adviser attempts to replicate the target index by investing all, or substantially all, of its assets in the stocks that make up the index, holding each stock in approximately the same proportion as its weighting in the index.”

Some are obviously more complicated or opaque than others. Here’s ZWB.TO, a covered call ETF:

“BMO Covered Call Canadian Banks ETF seeks to provide exposure to the performance of a portfolio of Canadian banks to generate income and to provide long-term capital appreciation while mitigating downside risk through the use of covered call options.”

You know they will use covered call options. Unfortunately, you won’t know much about how their option writing process works with this information. If you are curious, you can also read more in the ETF prospectus also found on the company’s ETF website.

The second step is to check the ETF’s top holdings. It will quickly determine if this ETF could fit in my portfolio or not. By looking at the top 10 holdings, you will see what drives this investment. If you cringe on one or two company names, you might want to skip this one and select an alternative ETF.

The third step will require you to look at the ETF sector allocation. At DSR, we are currently able to give you the ETF sector if it’s a single sector ETF, but we can’t ventilate several sectors. To do that, you must go to the ETF’s website and look at the graph provided by the financial firm. Looking at how the ETF is invested throughout various sectors will allow you to better predict the impact on your portfolio’s volatility and upside/downside potential. This extra step requires more calculations, but it is crucial for you to include your ETFs allocation in your portfolio.

Finally, I wouldn’t over complicate things when it comes down to ETF investing. ETFs have been created to be efficient and simple to understand. Once you have selected the asset exposure you desire, look at a few financial metrics. Then, confirm your choice by looking at what’s inside the hood. Don’t attempt to track each ETF movement and change in allocation. You may spend as much time as you would have if you selected individual stocks. The power of ETF investing resides in the simplification of your strategy. Therefore, adding a dozen ETFs doesn’t necessarily improves your portfolio quality or simplicity.

Warning: Canadian Dividend ETFs’ Dividends Aren’t Stable

You read right: dividend ETFs don’t pay a stable dividend. It creates lots of confusion and frustration among investors! Let’s take a look at how the iShares Canadian Select Dividend ETF (XDV.TO) rewarded its investors.

Dividend ETFs will receive dividends from the company they invest in. They may also reward investors with additional distributions generated by capital gains or other profits generated by the liquidity or other investment vehicles inside the ETFs.

As you can see in the previous graph, the dividend eventually goes up. Unfortunately, it will not be steady from quarter to quarter.

Final Thought

I am not considering investing in ETFs any time soon. However, I consider this product to be a great tool for investors. The fact that you can quickly diversify your portfolio at a ridiculously low price makes ETFs an investors friend. It’s the perfect fit if you want to invest in a sector but don’t want to do the extra research attached to stock picking.

If you are happy with individual stocks like I am, please do not feel the need to add ETFs to your portfolio. If your strategy is working already, there is no need to fix something that is not broken.

Smith Manoeuvre – A Tax Deductible Mortgage Strategy

The Smith Manoeuvre is a Canadian strategy that is designed to structure your mortgage so that it is tax deductible.

Since the Real Estate market has gone up in value significantly over the past few years, I’ve decided to use some of that equity sleeping in my house to invest in the stock market.

For Canadians, this means I’m doing the Smith Maneuver (transforming the interest paid on my mortgage into a tax-deductible expense). For all other investors, this article will talk about leverage in general. Should you borrow to invest? What’s the possible outcome? What are the risks? How to start investing with borrowed money? These are the subjects we will discuss today!

Why do a Smith Manoeuvre?

First things first, the Smith Manoeuvre includes leverage. This means borrowing money to invest. This is not for everyone (more on that later), please do your due diligence and make sure you have the right risk profile before using leverage.

All right, now that we have the disclaimer out of the way, here’s some background information from yours truly. In 2003, I completed my bachelor’s degree with a double major (finance & marketing). I started a job at National bank in the credit department for partnerships with Power Corporation. My goal was to help financial advisors build credit applications for their clients who wished to use leverage to provide capital for investments. In other words, I was the architect behind millions of dollars of investment loans.

I also used the Smith Manoeuvre for several years back then with great success. I saw the best and the worst of this strategy throughout those five years. I’ve seen investors build enormous wealth and others have burned down tens of thousands of dollars on a margin call. I can’t stress this enough; leverage can bring the best out of the stock market and can also destroy your wealth. Please use this strategy with caution.

Wealth generation

Why did I decide to use such a “dangerous” strategy? Because I have time, knowledge and an incredibly high-risk tolerance on my side. The math behind leverage is quite simple. If you can borrow money at a 3-4% interest rate and then invest it at a 6-7% return, you can create wealth out of thin air.

With conservative numbers and $333.33 per month ($4,000 / 12), you can create more than half a million dollars in 30 years.

Imagine borrowing $100K at 4% for the next 30 years. The cost out of pocket would be $4,000 per year, or $120,000 for the entire duration of this loan. Keep in mind that the $4,000 doesn’t move (unless your interest rate changes). This means that $4,000 in 20-30 years from now isn’t that much if you factor inflation.

Now if you take that $100K loan and you invest it at a 6.5% average annual return, 30 years later your investment would have grown to $661K. You could then pay off your loan and end-up with more than half a million dollars. Over 30 years, you turned $120K into $561K (more than 4.5 times your investment). With leverage, the advantage is that you turned a 6.5% return into 9.1% (you must achieve a 9.1% investment return on a yearly investment of $4,000 to reach $566K in 30 years.

Using a 6.5% expected return is quite conservative (see the chart of the S&P 500 and the TSX on the following page). I could potentially talk about 8.5% return and how you could transform the same $120K in interest payment into more than $1M net of debt.

But that’s daydreaming and you must also consider taxes applicable to this strategy. Now that you understand the wealth generation ability, let’s talk a little bit more about the dangers inherent in this strategy.

The danger of leverage – This is not for everyone

While I used conservative numbers (a 100% equity position should generate an annualized return of 6.5% over a 30-year period), this is still a positive scenario. If you borrow $100K today and your investment goes down by 30%, you then have $70K invested and you are still paying interest on a debt of $100K. You could also get sick or need additional money for many reasons. These perspectives are enough to make a lot of investors sick. At best, leverage should be a complement, not a “all-in” strategy. It could turn even worse if you have a margin call.

If you use your investment as collateral, there is a good chance that the bank will set a minimum value for your portfolio to maintain the loan. When your portfolio goes down too low too fast, the bank will “call you” and ask you to put more money in the portfolio. If you don’t have liquid assets, the bank would simply sell your investments and use the proceeds to cover the loan (or a part of it).

Because I want to slowly build my leveraged portfolio and I don’t want to get squeezed by a margin call, I’ve decided to use my house as collateral for my leverage strategy. Here comes the Smith Manoeuvre!

What’s the Smith Manoeuvre?

The Smith Manoeuvre is a Canadian strategy that is designed to structure your mortgage so that it is tax deductible. A financial planner named Fraser Smith introduced this concept where you borrow money against the equity in your home, invest it in income-producing entities (dividend paying stocks), and use the tax return to further pay down the mortgage. It’s not that impressive for our fellow Americans since their mortgage interest is already tax deductible. But it’s a big thing for Canadians since we don’t have this advantage!

To set this strategy up, you need a home equity line of credit (a source of revolving credit). Then, each month, you pay off a part of your mortgage (imagine $500 in capital). Right after you pay off that capital on your debt, you use the home equity line of credit (HELOC) and borrow that same $500 and invest it.

Month	Mortgage	HELOC	Interest paid	Investment Account	Net Wealth Creation
0 (start)	-$200,000	$0	$0	$0	0
1	-$199,500	-$500	$1.66	$502.70	$1.04
12	-$194,000	-$6,000	$130.04	$6,215.50	$85.46
360	-$20,000	$180,000	$108,300	$556,084	$267,784

Following this chart, I could transform $180K of debt into a tax-deductible mortgage by simply using $500 a month for my leverage strategy. You could go a lot faster by increasing the amounts. Obviously, if you boost the amount invested or increase the percentage of expected return, the strategy looks even more attractive.

The largest advantage of leverage (on top of the tax deductibility) is the power of compounding interest. While the interest you pay monthly doesn’t compound, the amount invested is compounding. Throughout time, a small difference of 2.5% (4% interest vs 6.5% investment return) creates thousands of dollars even if you start small.

All about long-term

The point here isn’t to make you dream about riches, but rather to show you how even a conservative leverage strategy could create incremental wealth. The plan I’m about to discuss applies to the start of my Smith Manoeuvre (with $500 a month) but could be applied to a larger leverage amount either using a monthly investment or a lump sum payment.

Keep in mind that the basic rules of leverage will apply on a $500 or a $500,000 loan. The way you build your portfolio and how you should approach this strategy remains the same. Numbers are just growing with zeroes, but they react the same to the power of compounding interest.

In the next two parts of this article, I’ll share with you my plan and the portfolio model I wish to build in the coming years. I will show you how to use DSR tools to build your own leverage strategy.

The Smith Manoeuvre Plan

The purpose of this exercise isn’t to make you follow my plan and invest the same way. I want to provide you with a guideline as I am building this wealth creation strategy. As I successfully built my pension portfolio using exclusively Dividend Stocks Rock tools, I’m doing the same thing for the Smith Manoeuvre portfolio. Numbers and details could change depending on your financial situation, your age, and your risk tolerance. Again, do your own due diligence.

Opening a margin account allows options

First things first, which type of account should you use to invest using leverage? Since I’m a bit crazy, I’ll be opening a non-registered margin account. To make your leverage strategy successful, having a non-registered (meaning a taxable account) is mandatory. One of the perks of leveraging is to be able to use the interest you paid on your loan against the investment income you generated. Therefore, using the 4% interest rate and the 6.5% expected returns numbers, the first 4% return of the portfolio is “tax free”.

Margin account

Opening a margin account instead of a regular non-registered account is to give me additional flexibility. My goal isn’t to use margin on top of borrowing money. That’s what we could call a “double-dip”. However, if the market drops drastically, I’d like to have additional liquidity ready to be deployed. Imagine if my pension plan was in a margin account during March of 2020. I could have easily borrowed $50K and boosted my positions into amazing companies like Canadian Banks, Telcos, Utilities and Tech stocks.

My margin account also allows me to trade options. Since the goal of this portfolio is to generate investment income, I would also leave the door open to writing covered calls in the future. This would obviously not happen right away, but I would rather be set with the most flexible investment account upfront. Then, I don’t have to worry about any other paperwork.

Setting a budget

Once I decided to open a margin account allowing option trading, it was time to determine how much money I wanted to borrow each month (or a lumpsum amount if you have lots of equity sleeping in your house). Keep in mind that leveraging should be a complement to your wealth generation plan. Your financial plan should not rely solely on leverage.

The reality of a business owner is that there are always a thousand things going on in my financial life. Therefore, I don’t want to go “all-in” with my Smith Manoeuvre for now. For this reason, I thought of starting with $500 per month. This enables me to keep my financial flexibility (and continue to support my children as they go to college!). I will revisit this amount separately each year.

If you intend to use a larger amount for your leverage strategy, I’d suggest you consider two things. First, the amount of interest that must be paid monthly on that loan. It’s fun to imagine the compounding interest on a $250,000 investment over the next 20 years, but this requires cash flow in the meantime. At $250K, we are talking about a very nice car payment $833.33/month at 4%. To make sure the leverage strategy works, the most important thing is to have time. Therefore, you must ask yourself if you can afford a “BMW payment” for the next 20 years or so.

Investment rules

As you know already, I like to keep things simple. There is no need to have a complex investing strategy because you have borrowed money to invest. However, there are a few more rules to observe for this specific approach.

#1 Follow the DividendStocksRock methodology

When you borrow to invest, you want to reach a balance between generating an interesting total return and making sure you don’t put your portfolio at risk. Taking “bets” would end-up badly in a leveraged portfolio while focusing on dividend growers will achieve this balance. The DSR methodology to pick stocks will apply perfectly to this strategy (but I’ll add rule #4 in my stock selection process).

#2 Invest for the long term (minimum 20 years)

I’m currently 40 and I plan to use this strategy for the next 30-40 years. Since it’s a compliment to my wealth generation plan, I will be able to keep my leverage strategy above 70. The idea with leverage is to use compounding interest to your advantage. You can only do that over a long period of time.

#3 Invest 100% in Canadian stocks

I’m not your tax guy, but if you are Canadian and you want to play around taxes, it would be a good thing to invest in Canadian stocks to benefit from the preferential Canadian dividend tax treatment. Only Canadian corporations will pay eligible dividends. Therefore, I’ll keep my love for U.S. dividend growers in my tax-sheltered pension (LIRA) and retirement (RRSP) accounts exclusively.

#4 Generate a minimum yield of 5.5%

Right now, my HELOC interest rate is set at 5.4%. Therefore, my portfolio must generate at least 5.5% in dividend income. Again, I’m not your tax guy, but if you are Canadian and you wish to deduct the interest you pay against your investment income, it can’t be used against capital gains (e.g., it must be interest or dividend income). Then again, it doesn’t mean that all stocks in your portfolio will offer a 5% yield and above, but the total generated by the portfolio must be in that range.

Smith Manoeuvre Execution – Portfolio Model

To select the companies “worthy” of my leveraged portfolio, I will get inspiration from the Canadian Retirement portfolio and the 100% Canadian portfolio models. I’m looking at stocks offering a decent yield (minimum of 3%) but with some growth opportunities as well. I used the DSR stock screener, the watch list (PRO feature) and the portfolio builder (PRO feature) to build my portfolio model. If you can’t use the DSR stock screener, you can look at the Dividend Rock Stars List here.

Stock selection using DSR stock screener

The first step in finding interesting stocks is to go to the Canadian Retirement portfolio and the 100% Canadian portfolio models’ pages and select companies with a minimum rating of 3 for both the DSR PRO rating and the Dividend Safety Score. I also added a minimum dividend yield of 4% as I want to make sure I can use the full 5%+ interest rate that will be charged on my loan by the end of the year. Right now, I’m at 5.4% on a variable rate. That helped me to select a few stocks, but it wasn’t enough to build a complete portfolio. I wanted to double-check across our entire stock library.

Then I used the same filter with the stock screener. I don’t want to start too narrow. This simple set of filters gave me a list of 75 companies. To build a diversified portfolio, I’d like to have about 20 stocks. The plan is to buy one position each month over the course of almost two years. Having to investigate 75 stocks upfront seems a bit overwhelming.

So, here’s my trick: I kept the filters in place and looked at each sector one by one. After all, there is no point in looking into 10 stocks in the same sector. If this happens, I can always add more minimum metrics or select stocks with a rating of 4 for the PRO rating or the Dividend Safety Score.

I then selected my favorite 3-4 companies per sector to see how many companies I could rack up. Between both techniques, I got to a short list of 22 stocks that might make a good fit for my portfolio.

Deep dive with the watch list

Before I started my research with the stock screener, I emptied my watch list. The watch list enables you to see only the stocks you have selected in the screener. This is great to create a group of companies you like and want to follow going forward.

I selected each stock that looks interesting by clicking on the star button on the left side of the stock screener. Those selections are then automatically reported to the watch list.

Why would I bother to add all those stocks to a watch list? For two reasons:

#1 I will invest in new companies each month for a long time. I want to keep a close eye on my prospects.

#2 I can then look at my favorite stocks and download the excel spreadsheet with all data

While I love our stock screener, when you look at 30 financial metrics, it’s not that easy to see them and sort them as you want. Excel is a better software to use to make an additional triage among the list of your potential stocks. Then, I can read each stock card and start building my portfolio! Will I go ahead and buy the 22 stocks? Let’s build a fake portfolio to see what it looks like, shall we?

Sector allocation verification with the portfolio builder

The last thing to do before pressing the buy button is to check to see if the portfolio makes sense. I won’t have to make ~20 buy decisions today, but it helps to have an idea of where I’m going with my purchases. Therefore, I’ve built a fake portfolio using the portfolio builder. Good news: in a few months, you’ll be able to select which portfolio you want in your consolidated reports. You will select which portfolio(s) you want and generate as many reports as you wish!

Here’s the list of all the potential stocks after the review:

Symbol	Name	Sector	Pro Rating	Dvd Safety	Dvd Yield Fwd
AP.UN.TO	Allied Properties REIT	Real Estate	4	3	6.74%
AQN.TO	Algonquin Power & Utilities	Utilities	4	4	6.81%
ARE.TO	Aecon Group	Industrials	4	3	7.72%
AW.UN.TO	A and W Revenue Royalties Income Fund	Consumer Discretionary	4	3	5.63%
BEP.UN.TO	Brookfield Renewable	Utilities	4	4	4.34%
BEPC.TO	Brookfield Renewable	Utilities	4	4	4.14%
BIP.UN.TO	Brookfield Infrastructure	Utilities	4	4	4.04%
BMO.TO	bmo	Financials	4	4	4.35%
BNS.TO	ScotiaBank	Financials	4	4	6.22%
CM.TO	CIBC	Financials	4	4	5.31%
CNQ.TO	Canadian Natural Resources	Energy	4	4	4.12%
CRT.UN.TO	CT REIT	Real Estate	4	3	5.44%
EIF.TO	Exchange Income	Industrials	4	3	5.47%
EMA.TO	Emera Inc	Utilities	4	3	5.63%
ENB.TO	Enbridge Inc	Energy	4	3	6.39%
FTS.TO	Fortis Inc	Utilities	4	4	4.30%
GRT.UN.TO	Granite REIT	Real Estate	4	4	4.13%
GWO.TO	Great-West Lifeco	Financials	4	4	6.48%
KMP.UN.TO	Killam Apartment REIT	Real Estate	4	3	4.28%
NET.UN.V	Canadian Net REIT	Real Estate	4	4	5.50%
PKI.TO	Parkland Corp	Energy	4	3	5.12%
POW.TO	Power Corp.	Financials	4	4	5.98%
SYZ.TO	Sylogist	Information Technology	4	3	8.74%
T.TO	Telus	Communication Services	4	4	4.92%
TD.TO	TD Bank	Financials	5	4	4.03%
TPZ.TO	Topaz Energy	Energy	4	4	5.13%
TRP.TO	TC Energy	Energy	4	3	5.99%

I’m not saying this will be my final portfolio. However, it’s a great start and it gives me a very strong buying list to look at. Each month, I’ll go deeper in a specific stock and adjust along the way. Remember, investing is like hiking, you don’t get to the summit or get a great view during the first 100 meters.

Why Using Leverage? Should You Do It At Any Age?

I’d like to end this article on a very important topic; at what age leverage becomes irrelevant? I’ve highlighted the point of risk tolerance several times. If you can’t sleep when your portfolio is down 10%+ or because interest rates are rising, leverage isn’t for you. Not now, not at any age. Period.

As a banker, we used a few rules to qualify investors for an investment loan (on top of having a very high-risk tolerance). I’ve modified them a little:

Smith Manoeuvre Rules

#1 Don’t borrow too much. I believe the rule back then was to not borrow more than 50% of your liquid net worth (liquid = investments, no houses or rental property)

#2 Make sure you can afford to make the loan payment. The investment and growth parts are fun, but if you can’t pay the loan from your regular income, don’t go there. You don’t want to squeeze your budget with another loan.

#3 Invest for 20 years or go home. The rule was more to do it at least for 10 years, but it seems a bit short to my taste. The idea is to go through a full economic cycle (recession + expansion). If you can let your investments ride through several economic cycles, you will realize the full power of compounding interest. In other words, it comes down to: Don’t borrow what you cannot afford and let your investment run for a long time.

If you can withstand fluctuations (and you keep your eyes on the long-term horizon), using leverage before 50 is a very smart move. I’ve used leverage several times in the past and it paid off nicely. Using leverage for 20-40 years seems like a no brainer. But is it the case when you are 50 or even 65?

Should you use leverage at 50? Over 65?

Assuming your life expectancy is somewhere between 85 and 95, if you start a leverage operation at 50, this means you have a good 35 to 45 years to make it bloom. This should be enough to generate wealth for the next generation (and hopefully for your grandchildren too!). Therefore, it would make sense (assuming, again, that you have a high-risk tolerance).

Finally, The “last chance” to do a leverage operation is probably when you get close to 65-70. I really focus on that 20-year period to make sure the investment grows and blooms. I don’t think it would be useful to start leverage in your 70’s as it would likely bring on more stress than anything else. Again, some people want to generate additional wealth for generations to come and this strategy provides a vehicle for that incremental growth.

I hope this article has given you some food for thought. I’ll be covering my Smith Manoeuvre in my portfolio newsletter update going forward. You’ll be able to follow my progress.