MOOSE MARKETS

INVESTING THE CANADIAN WAY

Mike

Most Popular Canadian Stocks at DSR – Top 5

Why look at the 5 most popular Canadian stocks with members of DSR Pro? To get ideas! You have your own process to select stocks, but seeing other investor’s favorites can open the door for new opportunities. It’s a great starting point for your research. I also do it out of curiosity 😉.

I surveyed the DSR database to pull out the 25 most popular Canadian and U.S. stocks, not looking at individual portfolios, but rather the number of times each stock appears across the 2,289 DSR PRO members’ portfolios. This is not based on value; I don’t know how much is invested in each stock.

This week, we have a fairly detailed look at the top 5 Canadian stocks, what I like and don’t like about each one and the roles they can play in a portfolio. We’ll see the remaining 20 in a later article.

 5 U.S. stocks most popular with DSR Pro members

Never let a list like this replace your investment process. Don’t load up on these stocks without the conviction that they fit with your strategy. It’s a good list to start a research project, but that’s just the beginning. There’s more digging required before pulling the trigger…

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TELUS (T.TO / TU)

1st place – 1451 members

Again, this year, Telus is the champ. It’s my favorite telecom. Most of its revenue comes from its wireless business. I like the wireless industry in Canada; there’s still organic growth potential and the development of 5G will enable additional growth vectors. I like how Telus diversified its business through artificial intelligence, healthcare, and agriculture, instead of going after more media business, Telus uses technology to catapult its business, which could be a hit or a miss.

Telus logoWhat’s not to like? DEBT! Telecoms rack-up debt faster than teenagers eat burgers! Right now, the narrative doesn’t fit with the numbers. For 10 years, Telus had a clear plan: get as much cheap debt as possible for investments (CAPEX) to fuel stronger generation of cash flows from operations. Ten years later, it’s time to show that stronger cash flow and smaller CAPEX. It’s improving, but not fast enough. I want to see Telus’s free cash flow cover the dividend payment. Management seems confident though; it raised the dividend again in November.

Telus pleases income-seeking investors with its generous yield, and also attracts growth investors with its technology growth segments. A great balance of growth and “sleep well at night” ingredients. A good fit for both “retirement” and “growth” portfolios. No wonder it’s one of the most popular Canadians stocks.

TD BANK (TD.TO / TD)

2nd place (up from 5th) – 1279 members

The largest Canadian bank in terms of assets, TD operates a classic business model mostly around savings & loans. Everybody likes Canadian banks, right? When you pick among the top 2 largest Canadian banks you can’t go wrong.

I like TD’s US exposure for additional growth (usually, the U.S. economy grows faster than the Canadian) and its 13.5% ownership of Charles Schwab (SCHW). I also appreciate TD’s focus on classic banking activities with some wealth management for good measure. Nothing eccentric. You can count on its solid balance sheet to keep up with its dividend growth policy.

TD Bank logoThere isn’t much to dislike about TD. I rank it third behind Royal Bank and National Bank only because of its larger exposure to the loan market. A more classic bank, TD takes fewer risks in the stock market, but more for mortgages and commercial loans. With high interest rates and possibly a slowing economy, all eyes on its provisions for credit losses. While a great source of growth, TD’s presence in the U.S. can expose it to a more volatile economic environment. When it comes to banks, it’s the wild west in the U.S.

TD is another sleep-well-at-night stock. Interestingly, you’ll get a fair share of growth at the same time!

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FORTIS (FTS.TO / FTS)

3rd place (up from 7th) – 1223 members

A big jump for Fortis, which fully merits a spot in the most popular Canadian stocks. I increased my position in this solid utility after the Algonquin debacle. Fortis is a classic utility offering transmission and distribution of electricity and natural gas to its customers. It’s virtually 100% regulated, leading to stability and predictable cash flow. This sustainable cash flow has resulted four decades of dividend payments!

Fortis logoFortis invested aggressively over the past few years resulting in strong growth from its core business. You can expect revenues to keep growing as expansion continues. I like its goal of increasing its exposure to renewable energy from 2% of its assets in 2019 to 7% in 2035. In its five-year capital investment plan of ~$20B up to 2026, only 33% is financed through debt, while 61% comes from cash from their own operations.

Fortis’s capital-intensive operations make it sensitive to interest rates. Many income-seeking investors left equities to go to bonds and GICs. Also, with most of its assets regulated, it must get regulatory approval for each rate increase to its customers.

Fortis remains a utility; don’t expect astronomical growth. It’s definitely a defensive stock you can count on no matter what the economy’s like. It will keep paying a decent yield with a mid-single digit dividend growth rate.

ENBRIDGE (ENB.TO / ENB)

4th place (down from 2nd) – 1184 members

Income-seeking investors want to keep Enbridge and its 7%+ yield. I get that, but I got rid of my shares this year. ENB isn’t a bad company, but it lacks growth vectors, which doesn’t fit with my dividend growth strategy.

Like a toll road, Enbridge collects money day and night from oil & gas companies that use its “roads”, i.e., “pipelines”. We need oil & gas; Enbridge provides an impressive network of pipelines covering North America. Pipelines usually enjoy long-term contracts, sheltering them from short-term commodity price movements. ENB is diversifying through acquisitions in the natural gas business. It makes sense to lower exposure to crude oil. With 28 consecutive years with a dividend increase, you can rely on Enbridge to honor its shareholders’ investment.

Enbridge logoWhat’s not to like? Legal battles and debt! Building, maintaining, and replacing pipelines has become a toxic topic. Politicians and regulators are cautious about projects related to oil & gas transportation; they have environmental impacts and are increasingly unpopular with the public. So, more legal battles and fees, and increased likelihood that projects go sideways. This explains why Enbridge offers such a generous yield.

I like the move into the natural gas business, but not piling on more debt to do so. At one point, Enbridge has to pay down its debts. I’ll keep an eye on ENB’s dividend growth. It has slowed down to 3% per year after a generous run including double-digit increases. Does it make sense for management to increase it every year?

Truly the definition of a deluxe bond, Enbridge provides reliable income, but don’t expect much capital growth. Continue to monitor this one quarterly.

BCE (BCE.TO / BCE)

5th place (down from 4th) – 1175 member

Bell is a classic telecom company that combines wireline, wireless, and media. Most of its revenue comes from wireless and wireline business and 13-14% from Media. BCE’s yield is its most appealing feature. With interest rates on the rise, BCE still beats most GIC’s with a 7%+ yield. That generous payout comes with steady increases since 2009. Will it continue forever? That’s another story.

As BCE has limited competition and high barriers to entry. With its range of products, BCE can easily increase revenues generated from different customers. 5G should be a tailwind for years to come. BCE enjoys a relatively stable business generating predictable cash flows.

BCE logoHowever, it could become another AT&T (T). T pleased investors for years until things fell apart and ended up another high yielder nightmare for investors. With high interest rates, BCE’s debt burden could hinder its ability to increase dividends. Always monitor the dividend growth and start worrying if the trend slows down. Finally, if 5G doesn’t generate the expected cash flow, I wonder where BCE will find its growth.

This stock is a deluxe bond crafted for income-seeking investors. As long as the company shows increasing cash flow from operations and reduces its CAPEX to generate sufficient cash flow to cover the dividend, you’re in good hands.

Buy List stock for November 2023: TD Bank (TD.TO / TD)

A stock that remains on my buy list for November is Toronto-Dominion Bank (TD.TO/TD). I look at TD as a core holding, because it meets all my investment requirements and it’s a stock that I would hold for a long time, while reviewing it quarterly for good measure. Here’ why.

TD Bank logoTD has a very lean structure that plays a significant role in its expansion. It also has a solid dividend growth history, and management recently rewarded shareholders with several dividend increases. Plus, it has a significant presence in the US compared to other Canadian banks.

TD.TO Business Model

Toronto-Dominion Bank operates as a bank in North America. TD’s segments include Canadian Personal and Commercial Banking; U.S. Retail; Wealth Management and Insurance; and Wholesale Banking.

  • Canadian Personal and Commercial Banking offers a full range of financial products and services to approximately 15 million customers in Canada.
  • S. Retail offers a range of financial products and services under the brand TD Bank, America’s Most Convenient Bank. It also TD Auto Finance U.S., TD Wealth (U.S.) business.
  • Wealth Management and Insurance provides wealth solutions and insurance protection to approximately six million customers in Canada.
  • Wholesale Banking operates under the brand name TD Securities and offers a range of capital markets and corporate and investment banking services to corporate, government, and institutional clients.

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TD Investment Thesis

Branch of TD bank at night with lit signOver the years, TD has increased its retail focus, driven by lower-risk businesses with stable, consistent earnings. The bank enjoys the largest or second largest market share for most key products in the Canadian retail segment. TD keeps things clean and simple as the bulk of its income comes from personal and commercial banking. It has sizeable exposure in major cities like Toronto, Vancouver, Edmonton, and Calgary, combined with a strong presence in the US.

With about a third of its business coming from the U.S., TD is the most “American” bank you’ll find in Canada. If you are looking for an investment in a straightforward bank, TD should be your pick as increasing retail focus, large market share in Canadian banking, and U.S. expansion are key growth enablers for TD Bank. The 13% stake in Charles Schwab (SCHW) is another interesting growth vector.

TD.TO Last Quarter and Recent Activities

In August, TD reported a disappointing quarter with net income down 2% and EPS down 5%, but it could have been worse. TD’s results were affected by amortization charges, acquisition & integration costs, the termination fee of the acquisition of First Horizon, and strategy costs to reduce the interest rate impact on their balance sheet.

Graphs showing evolution of TD Bank's revenue and EPS over 5 years

We do like a proactive bank that takes steps now instead of doing what US regional banks did a few months ago, which was nothing! Canadian Personal and Commercial Banking net income was down 1%, mainly due to higher provisions for credit losses (PCLs). US retail was down 9%, hurt by higher PCLs and termination fees on the acquisition. Wealth Management & Insurance was down 12% while Wholesale was flat. TD also announced a 5% share buyback program.

There weren’t any news about TD in October, so we are patiently waiting for the end of November to look at their earnings!

Potential Risks for TD Bank

The housing market has been a concern since 2012. However, TD seems to be managing its loan book wisely and the Canadian economy has been remarkably resilient as well. A higher insured mortgage level in the prairies seems adequate while TD continues to ride the ever-growing downtown Toronto housing market tailwind. As interest rates rise, TD’s loan book will profitably generate stronger income. However, this also comes with increased risk of defaults and slow volume growth.

TD must identify other growth vectors because consumers can’t borrow continuously, even more so with higher interest rates slowing down the economy. It is important to follow the bank’s provision for credit losses, which have risen in the latest quarters. So far, everything is under control, but a recession still looms. In early 2023, TD paid $1.6B in a settlement related to a Ponzi scheme (Stanford Litigation Settlement). While this is treated as a one-time event, it still affected their quarterly earnings report.

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TD.TO Dividend Growth Perspective

TD is a Canadian dividend aristocrat (which allows them a “pause” in their dividend increase streak). TD shareholders were lucky enough to enjoy a dividend increase in early 2020 (+6.8%), right before regulators forced a break in dividend growth. In 2021, the bank rewarded investors with a 12.7% dividend increase. It returned with a more regular increase in 2022 (+7.8%). Going forward, you can expect a mid-single-digit dividend increase as payout ratios are quite low and TD is well capitalized.

For more about dividend aristocrats and the paused dividend growth for Canadian banks, listen to my podcast.

Graph showing steadily increasing dividend payments for TD Bank over years, except when regulators forced pause during pandemic
Steady dividend growth except when regulators imposed a pause

Final Thoughts on this Buy List Stock

Its legal settlement early this year and the general economic landscape may have seemingly taken some of lustre away from TD, but it has a lot on offer for dividend-growth investors. A lean structure conducive to expansion; growth potential through its focus on Canadian retail banking, its US exposure, and its stake in Charles Schwab (SCHW); and dividend growth.

We have TD in the DSR retirement and 500K portfolio models, for both Canada and the US. A stock to consider if you’re looking for holdings in the financial sector.

Market-Beating High Yield Canadian Stocks

High yield Canadian stocks that beat the market? Yes, here are some examples. After writing so much about the virtues of low-yield, high-growth stocks, it’s time to talk a bit about high-yield stocks. To be fair, they’re not all bad investments. Some provide a fairly sustainable source of high income for investors, and some even manage to beat the market!

High yield Canadian stocks that keep giving

I searched for high yield companies that also matched the overall stock market performance of late. On October 7, the iShares S&P/TSX 60 ETF (XIU.TO) 5-year total return (capital + dividends) was about 52% and the SPDR S&P 500 ETF Trust (SPY) was about 74%. So, I search for all companies generating a total 5-year return of at least 50% and a yield of at least 6%; this returned 101 stocks.

Here are three of the Canadian stocks that provided high yields while matching or outperforming the market for total return over the last 5 years. Caution: there’s no guarantee that they will keep performing that well in the future, especially with a long-predicted recession looming. As always, do your due diligence when considering any investment.

Want a portfolio that provides enough income in retirement? Download our Dividend Income for Life Guide!

Capital Power (CPX.TO) 6.03%, +89.62%

Not long ago, Capital Power was a darling as its stock price defied gravity while other utilities were doing down. While the market has some reservations about utilities due to their sensitivity to interest rates, CPX continues to show a relatively strong dividend triangle. Management increased the dividend from $0.58/share to $0.615/share. A 6% increase in the middle of an “interest rate crisis” is bold and shows strong confidence.

3 line graphs showing Capital Power (CPX.TO)'s revenue, EPS and dividend payment over 10 years.

CPX is dependent on Alberta’s economy, where it generates 56% of its electricity and 62% of its revenues. That is a concern. It means its share price tends to move up and down with the oil market. As a capital-intensive business, CPX must invest heavily and continually to generate cash flow. The market might not like additional debt to fund projects in the coming years. With interest rates rising, this debt could become a burden and obtaining liquidity from capital markets might get more difficult. Finally, weather variations can affect results as seen recently when a warm winter reduced AFFO.

Considering its wind energy projects and the robust economy in Alberta, CPX expects to increase its dividend by 6% through to 2025, welcomed news for income seeking investors. Through its successful transformation into a more diversified utility company, CPX is earning its place among robust Canadian utilities such as Fortis, Emera, and the Brookfield family.

Enbridge (ENB.TO), 7.90% yield, +50.20%

I smiled at the 50% total return for Enbridge as I remembered buying it in 2017 and selling at the beginning of 2023 with a good profit. ENB is a good example of a deluxe bond that could eventually evolve into a dividend trap!

With inflation and higher interest expenses, Enbridge faces higher operating costs. This could seriously jeopardize growth because ENB can’t find any growth vectors without getting into more debt. In September 2023 ENB announced it was taking on more debt and issuing shares to acquire a gas transmission business for $19B CAD. I like the predictable cash flow it’ll bring, but I’m concerned about the ever-increasing debt level.

Total long-term debt stands at around $80B, up from $67B in 2017; it’s time to see some debt repayments. ENB’s interest expenses are continuing to increase, and it won’t end any time soon. Since building and maintaining pipelines requires significant amounts of capital, ENB may find itself in a position where cash is short.

Enbridge operates high-quality assets, with almost impenetrable barriers to entry. There’s no doubt the business model is solid. The problem is the rising debt level. ENB won’t be able to rely on its pipelines forever; many projects were revised or paused by regulators over the past few years. TRP’s latest Keystone pipeline spills remind us of the environmental risks of this industry.

Line graphs showing Enbridge's revenue, EPS, and dividend payments over 10 years

ENB has paid dividends for 65 years, with 28 consecutive years with a dividend increase. Further dividend growth is expected at around 3%. Management aims to distribute 65% of its distributable cash flow, keeping enough for CAPEX. Consult their latest quarterly presentation for their payout ratio calculation.

See how Mike’s dividend growth investment strategy can secure your retirement. Download our Dividend Income for Life Guide!

Labrador Iron Ore Royalty Corp (LIF.TO) 8.89% yield, +101.4%

LIF receives a 7% gross overriding royalty on iron ore products sold by Iron Ore Company of Canada, a producer and exporter of iron ore pellets and high-grade concentrate. The mine enjoys a high-quality source of products with sufficient inventory to support future expansion. IOC is well-positioned strategically due to the high quality of the iron ore and its ability to produce higher margin pellets.

LIF’s business model depends on factors that are barely in its control; commodity prices, unions, and demand that can affect production of the underlying business. Since we only have data from 2010, we have yet to see how LIF will navigate a recession. However, we can see the effect of an iron spot price decline, and how quickly it happens, as it did in 2022.

4 line graphs showing Labrador Iron Ore Royalty Corps stock price, revenue, EPS and dividend over 10 years

The company must keep a large cash reserve for additional CAPEX. After all, the royalty-based business is only good if you have high-quality assets. The narrative has been quite enticing as LIF surfed on the highest iron prices in its history, and demand seemed stable. Things took a turn, and both the stock price and dividend dropped.

LIF pays a variable dividend: base payment of $0.25/share quarterly + special dividend based on royalties received. You can’t expect a stable dividend, but a yield usually in the high single-digit to double-digit! The generous yield is inflated by the royalty payments.

When iron ore trades at a high price, LIF seems the most generous stock in town. The opposite is also true. Demand for iron ore will come and go, affecting its price, and, therefore, your dividends. It’s not a bad investment if you’re able to stomach the price and dividend fluctuations.

Last thoughts about high yield Canadian stocks

As you know, I prefer higher total return over high yield. Overall, low yield high growth stocks provide higher total return, so I favor them for my dividend growth investment strategy. However, a few solid higher yield companies that match or exceed the market can be good assets to have in a portfolio. Be sure to monitor them quarterly though, to ensure they don’t become dividend traps!

 

What’s Happening with Renewables?

What’s happening with renewables? Renewable stock prices dropped spectacularly in the last few weeks, as shown here. If you have renewable energy stock in your portfolio, you might be in shock.

Graph showing stock price dropping for 6 renewable energy companies dropping from 15 to almost 58% since late September 2023

What caused that chaos?

It’s not a dividend cut or an absence of dividend growth. On September 27, NextEra Partners (NEP) lowered its guidance for the growth of its distribution per unit from 12%-15% per year down to 5%-8%, with a target growth rate of 6% per year. The CEO explained the reasons in this press release. NEP’s distribution rose 89.78% over the past 5 years with an annualized growth rate of 13.67%.

Earlier in May, NEP had announced a strategic shift by confirming its intention to sell its natural gas pipelines.

The goal of selling assets and lowering the dividend growth policy is to give NEP more financial flexibility and maintain its ability to invest in new projects to pursue growth. It’s also to pay off debts that are coming due.

NEP’s debt

Companies can use debt or issue more stocks/units to finance projects. Convertible Equity Financing Portfolio (CEFP) is a way to get financing where you pay the debt either in cash or in units when it comes to maturity.

NEP uses a mix including convertible equity financing; it gets money “today”, betting that its unit price goes up before the debt comes to maturity, thus getting a good deal by issuing units at a higher price to pay it off. NEP has roughly $1.5B of convertible equity financing debt to pay off through 2025. With the stock dropping nearly 60% recently, you can count on them not issuing additional units for near term financing.

This highlights how sensitive most renewable utilities are to rising interest rates. NEP is stuck between a rock and a hard place. Future debt will carry interest rates of 7%-8% while issuing units with such a depreciated stock price would only drive the price lower by diluting shareholders’ investments.

Want a portfolio that can withstand all this economic turmoil and provide you with enough income? Download our Dividend Income for Life Guide!

 

What’s next for NEP?

NEP is walking is on the edge, but that doesn’t mean it’ll fall. Numbers seem to work until 2025, assuming no further major interest rate hikes. However, it’s not out of the woods.

The pessimistic scenario has NEP facing higher interest rates while its unit price doesn’t bounce back. NEP would eventually face a possible dividend cut or see NextEra Energy (NEE) buy all its units. A leader in renewable energy with a market cap of $97B, NEE owns 51% of NEP, whose market cap is $2B. NEP shareholders wouldn’t be happy with this outcome because they wouldn’t get much for their units.

The optimistic scenario sees NEP on the edge for a few years, with interest rates decreasing before 2026, when more debt (including CEFP) comes to maturity. We’d see NEP’s unit price slowly but surely go up, the dividend paid, and growth back on the table. At this point, however, NEP would be a high-risk, high-reward investment.

What about other renewable utilities?

Now’s the time to make sure you have a solid portfolio. This implies digging deeper to ensure companies you hold show strong financial metrics. Unfortunately, utilities aren’t easy to analyze; they use both GAAP (generally accepted accounting principles) and non-GAAP (like homemade calculations), and often use Funds from operations (FFO) per unit, found in press releases and quarterly earnings reports.

Renewable energy: Solar panels seen from the ground, behind pink flowers Look for investors’ presentations and quarterly earnings reports on the company website. Doing that reveals that another renewable, Brookfield Renewable (BEPC/BEPC.TO), hosted its investors day in September. Contrary to NEP, BEPC reaffirmed its growth expectations and distribution growth targets…business as usual for BEPC.

Different companies, different business models, different debt structures. When a NEP-like situation happens, solid companies are also punished, unfairly, because the market puts them in the same basket as the one with the problem.

It’s clear that all utilities will suffer for a while. Higher interest charges hurt their balance sheet and cash flow, while simultaneously drawing retirees to bonds and GICs and away from utilities. In fairness, when 10-year government bonds offer over 4.5%, income-seeking investors would be fools to go for stocks paying the same yield.

How to look at renewable utilities

Renewable energy companies: Headlines of 3 articles on Seeking Alpha about NextEra showing very different opinions about how it should be ratedFirst, ignore the noise, or you’ll get lost in a myriad of conflicting information. Here are three articles on Seeking Alpha for October 6 (Strong Buy, Sell, and Hold ratings).

I read all three; each makes solid points. If I rely on their opinion, I have no clarity.

Best to develop your own opinion. How? Follow the same process as always: make sure your investment thesis (the narrative) is backed by the numbers.

1 – Start with the dividend triangle.

The EPS won’t be of much use for utilities; review the revenue and dividend growth trends.

Weak dividend growth, or none, raises a huge red flag. If you’re choosing between two stocks and one shows no or weak dividend growth, eliminate it as a candidate.

2 – Look at the FFO/unit (common replacement for EPS for utilities) on the company’s website.

3 – Look at the company’s debt structure and maturity in its investor presentation.

There’s a big difference between fixed-rate debt over a long period of time vs. floating rates or short-term maturities that will push interest expenses higher.

4 – Look at the company’s past track record to see how it performed in other difficult periods. You’ll have to go back to the 2008 crisis to see how they fared, but it’s time well spent if you’re unsure of some stocks.

Create yourself a large enough paycheck. To learn how…download our Dividend Income for Life Guide!

 

Renewables aren’t dead, just facing substantial headwinds

Renewables are facing stronger headwinds than classic utilities due to their business model. Many classic utilities—Fortis, Canadian Utilities, Xcel, and WEC Energy—operate regulated assets. They’re granted a monopoly over an area to ensure quality, stable service. In exchange for that monopoly, utilities cannot raise their rates as they see fit. They must present a case for increasing rates to the regulator, who assesses whether the increase makes sense for both the utility and its customers. When interest costs increase, regulated utilities have more pricing power because it’s easier to justify rate increases.

Renewables don’t enjoy a monopoly because their energy source is less stable and complements other sources. They can raise prices freely, but they face more competition. In the current economic environment, I bet they’d love to negotiate rate increases with a regulator!

Renewables and other capital-intensive businesses (Telcos, REITs, pipelines, etc.) will have a rough ride until we know that interest rate increases are over and that we’re heading toward reductions. We’re not there yet; you must decide if you want to “walk in the desert”. Again, focusing on dividend growers helps.

 

 

Buy List – October 2023: Canadian National Railway

My buy list for October 2023 has a new entry: Canadian National Railway (CNR.TO /CNI). I just love buying Canadian National Railway when the market expects a recession!

Railways are incredibly stable because there aren’t any other assets that can replace them in North America. Yet each time transportation volumes go down, the market tends to sell them off. It happened last in 2016, and we highlighted CNR.TO / CNI back then as well. Here we go for another round!

Canadian National Railway logoCanadian National Railway has been known as “best-in-class” for operating ratios for many years. CNR continuously worked on improving its margins and was among the first to do so. Today, peers have caught up and all railways are managed the same way.

CNR’s transportation activities are well diversified across seven different industries. Its exclusive access to the Prince Rupert port is advantageous for intermodal transportation. CNR enjoys a very strong economic moat as railways are virtually impossible to replicate.

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CNR.TO Business Model

A transportation and logistics company, Canadian National Railway’s services include rail, intermodal, trucking, and supply chain services. CNR rail services offer equipment, customs brokerage services, transloading and distribution, private car storage, and more.

Cute toy train set with wooden rails, trees, a station, signage and conductorCNR’s intermodal container services help shippers expand their door-to-door market reach with about 23 strategically placed intermodal terminals, with services including temperature-controlled cargo, port partnerships, logistics park, moving grain in containers, custom brokerage, transloading and distribution, and others.

CNR’s trucking services include door-to-door service, import and export dray, interline services, and specialized services. Its supply chain services offer comprehensive services across a range of industries and product types. CNR transports more than 300 million tons of natural resources, manufactured products, and finished goods throughout North America every year.

Investment Thesis       

Canadian National Railway owns unmatched quality railroad assets. With its strong economic moat, we can rely on increasing cash flows each year. There isn’t a more efficient way to transport commodities than by train.

The good thing about CNR is that investors can always wait for a down cycle to buy. Since we see railroads as attractive investments, we usually spot the opportune moment. Considering Q2 2023 results, it seems such a moment is here.

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CNR.TO Last Quarter and Recent Activities

With its Q2 results Canadian National Railway sent a strong signal that the economy is slowing down with revenue down 7% and EPS down 8% for the quarter. Revenue decreased mostly because of lower volumes of intermodal, crude oil, U.S. grain exports, and forest products. Volumes shrunk as demand for freight services to move consumer goods lowered and Canadian wildfires caused customer outages.

Rounding up the reasons for the decline were lower ancillary services including container storage, and lower fuel surcharge revenues as fuel prices decreased. CNR updated its full-year outlook, now expects flat to slightly negative year-over-year growth in adjusted EPS.

Potential Risks for CNR.TO

Railroad maintenance is capital intensive and could adversely affect CNR in the future. It’s a difficult balance to obtain an efficient operating ratio and well-maintained railroads. To maintain its network, CNR must make substantial reinvestments continually. However, CNR continues to boast one of the best operating ratios in the industry.

From time to time, CNR’s growth can be negatively affected by its dependence on the Canadian resource markets. When demand for oil, forest, or grain products is low, demand for CNR’s services obviously slows down accordingly. For example, the pandemic caused a slowdown in weekly rail traffic of about 10% over the summer of 2020. As you can see in the graph below, even that didn’t derail (couldn’t resist) CNR’s revenue much or for very long.

Line graph showing CNR's revenue growth over 10 years- steady growth except in 2020-2021 due to the pandemic.

When the oil price is low, trucking steers some business away from railroads. CNR is a captive of its best assets since you can’t move railroads!

Get acquainted with other great Canadian stocks, read Canadian Forever Stock Selection.

CNR Dividend Growth Perspective

Canadian National Railway has successfully increased its dividend yearly since 1996. The management team ensures they use a good portion of CNR’s cash flow to maintain and improve railways, while rewarding shareholders with generous dividend payments. CNR exhibits an impressive dividend record with very low payout ratios. To learn more about payout ratios read this article.

Line graph of Canadian National Railway dividend amount for the last 10 years; yearly increases, with a generous increase early 2022 as business normalized after the peak of the pandemic.

While the business faces headwinds periodically, its dividend payment will not be affected. Shareholders can expect more high single-digit dividend increases. The railroad company kicked off 2023 with an impressive dividend increase of 8%. If you can grab CNR with a yield of approximately 2%, you’re making a good deal!

Learn strategies for generating income for life. Download our guide now.

Final Thoughts on Canadian National Railway

Despite CNR’s capital-intensive requirements and reliance on the Canadian resource markets, we believe Canadian National Railway will come sailing through the current economic downturn and maintain its dividend increases.

With CNR’s unmatched-quality railroad assets almost impossible to replicate, and its management taking on the challenges of the current environment, we could see more growth emerging from all this. Also, CNR will benefit from the cancellation of the Keystone XL pipeline which will drive demand for oil transport via railroads. With a current yield above 2%, CNR is definitely worth a look.

High-Income Products: Split-Shares and Covered-Call ETFs

Continuing last week’s article about whether high-income products rally make your life easier, we now look at two other types of high-income products: split-shares and covered-call ETFs.

Split-share corporations

Specialized investment corporations are created primarily to provide investors with a choice: a regular income stream or potential for capital appreciation. They do so by splitting their shares into two classes.

A split-share corporation is created by purchasing a diversified portfolio of common shares of other corporations, often blue-chip stocks. Then, the corporation issues shares:

  • path in forest splits in two, with fall foliagePreferred Shares: usually offer regular dividends, have a set redemption value, and take precedence over other shares if the company is dissolved.
  • Capital Shares (or Class A): are more volatile but provide potential capital appreciation. They receive the residual value after preferred shareholders are paid in full. They can show high returns if the portfolio appreciates, and large losses when the reverse happens.

Using the dividends of the underlying portfolio, split-share corporations pay the preferred shareholders first. They reinvest excess dividends into the portfolio or distribute them to capital shareholders.

Split-share corporations usually have a maturity date, when their sell their assets and pay the proceeds to shareholders. Again, preferred shareholders are paid first, up to their original investment plus accrued dividends. Remaining funds go to capital shareholders.

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Advantages and risks

Advantages of split share corporations include the choice between a more stable income or potential capital appreciation, tax advantages for some investors due to how they distribute the income, and potential for high income, as long as the company pays.

Unfortunately, they come with many risks. Not immune to market fluctuations, both preferred and capital shares can suffer if the portfolio’s stocks drop, with capital shares most vulnerable.

With an under-performing portfolio, many shareholders could redeem their shares, forcing the company to sell assets at an unfavorable time; capital shareholders might not recover their full investment upon the corporation’s maturity.

Split-share corporations often borrow to purchase assets, which amplifies both gains and losses based on asset performance vs. interest rates and heightens the volatility of capital shares. Poor-performing assets can also hinder loan repayment and affect the corporation’s credit rating.

Rising interest rates can devalue their portfolio just when fixed-income options become more attractive to investors.

Covered call 101

A call is an option granting the right to buy an asset at a set price within a specified period. Imagine DSR trading on the market with a stock price of $100. You buy an option to buy DSR stock at $105 in the next three months. If DSR stock surges to $120 during that time, you can buy the stock at $105, making an immediate profit. The owner of the shares who sells you the call option is writing a covered call.

Apple on top of pile of booksLet’s say DSR trades at $100 with a dividend of $1 quarterly, a 4% yield. You hold shares bought at $100 per share. You write a call option on those shares, granting the buyer the right to buy 100 shares at $110. The buyer of pays you $200 for the option.

If the stock price is stable or decreases, the buyer doesn’t exercise the option at $110, letting it expire. You keep your shares. You earned $200 from selling your option and another $100 in dividend (quarterly dividend of $1 X 100 shares). Selling the option generated additional income without any risk.

What if the stock price reaches $120? The buyer exercises the option; you must sell the shares at $110. You earn $200 from selling the option, $100 in dividend and $1,000 in profit (($110 – $100) X 100 shares), totaling $1,300.

Had you not sold the option, you’d show a paper profit of ($120 – $$100) X 100 shares = $2,000 of stock price appreciation, + $100 in dividend = $2,100. While you made money selling the option, you capped your total returns to the option price.

This is a popular strategy among income-seeking investors. So popular in fact, that there are several Covered Call ETFs offering juicy yields. But are they really worth the risk?

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Covered call ETFs

Writing covered calls can work well for individual investors, assuming they write judicious options; it’s a different story with manufactured covered call ETFs.

I suggest you watch this video about high yield covered call ETFs.

Let’s compare two ETFs, ZWB and ZEB, both manufactured by BMO, and both having a long history.

  • ZWB is a covered call ETF on Canadian banks.
  • ZEB is an equally weighted ETF on the big six Canadian banks.

This graph shows how much money investors leave on the table with ZWB for the sake of higher income. Imagine investing $10K in each product and reinvesting all dividends…

Line graph showing total return growth for banking covered-call ETF is lower than equal-weight bank ETF.

As of 08/17/2023, ZWB offers a 7.18% yield and ZEB about 4.41%.

If you really want the 7.18% yield, cash ZEB’s dividends and sell 2.77% extra of your investment monthly to equal that yield. Over time, you’ll have a lot more money in your pocket. You can withdraw more than 7.18% yield or withdraw 7.18% for longer. In both cases, the pure investment strategy generates better results.

JPMorgan Equity Premium Income (JEPI)

Incredibly popular on the US market is JEPI with its yield >6%. This ETF uses options to generate a high yield from a well-diversified portfolio of 137 holdings.

Top 10% holdings and sector allocation of JP Morgan's Equity Premium Income ETF as of July 31, 2023

Source: JPMorgan

Sadly, we’re limited to a short history. Nonetheless, when comparing JEPI to classic investment strategies, i.e., dividend growth investing or index investing, we see similar results as in our earlier example.

The next graph shows the total return of a $10,000 investment, reinvesting dividends, of JEPI and these three investment vehicles:

Investment vehicle Description
Schwab US Dividend Equity (SCHD) Dividend ETF focused on the Dow Jones U.S. Dividend 100 index
SPDR S&P 500 (SPY) Classic index fund tracking the S&P 500
Vanguard Dividend Appreciation ETF (VIG) Dividend growth ETF

 

Where’s the investment in JEPI after three years? At the bottom. As it was for the Canadian Bank ETF vs. Canadian Bank Covered Call ETFs, the income-focused product finishes dead last.

Line graph showing JP Morgan's JEPI ETF total return growth for 3 years lags behind three other ETFs that aren't covered-call ETFs

Conclusion

While covered call ETFs aren’t the worst products, they don’t provide added value compared to index or dividend growth investing. Focusing on high-income products often means leaving money on the table.

A classic investment strategy that generates a higher total return will serve you better. Then, you can sell a few shares and create your own retirement income.