Dividend Investing

2023 Year-End Review

Our 2023 year-end review in four words: Different Investors, Different Returns. Some investors had a great year and are happy that the market is “finally back”. Others saw their portfolio value decline. What explains these discrepancies in returns in 2023?

Asset and Sector Allocation

Asset and sector allocation is what made the difference between happy and disappointed investors in 2023.

As you can see in this graph, the year was quite different depending on whether you were invested in Canada, the U.S., or heavily in the technology sector…

Excluding the latest mini bull run provoked by hints that interest rate hikes are over, the Canadian market was heading toward a flat year or worse. Across sectors, the performance in Canada and the U.S. was quite different for 2023. Next, we look at the total returns for each sector in 2023.

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Total Returns by Sector

Below are the year’s total returns per sector in the U.S.

We see the surging technology sector leading the way, followed by the communication services sector. It wasn’t the AT&T’s and Verizon’s of this sector that pushed it to such heights but rather tech-focused communications stocks such as Meta (META), Alphabet (GOOG) and Netflix (NFLX). I must add the communication services ETF in the graph is a isn’t really a good representation; it skews the results favorable because it’s 47% invested in Meta and Alphabet.

While the energy sector was the savior in 2022, it was flat in 2023. The utility sector is the biggest loser, hurt by higher interest rates and poor performance from all renewable energy stocks. For more on that, see What’s Happening with Renewables?

On the Canadian side, shown in the next graph, we see similar trends, but with a stronger performance from the energy sector than in the U.S. Take the BMO’s technology, communications, and consumer discretionary ETFs with a grain of salt because each includes several U.S. stocks. Banks and telecommunications companies disappointed in 2023 as did utilities and REITs.

The investment year 2023 could be summarized as follows:

If you focused on low-yield, high dividend growth stocks, it was a success.
If you focused on income and high yield, it was a bad year.

What’s next?

We have been spoiled over the past twelve years. In general, an economic cycle lasts about 5 to 8 years. That includes a bear market and a bull market and everything in between. The last real bear market we had began in 2008 and ended in 2009. That was 14 years ago.

Currently, we live in a strange world: inflation hurts consumers’ budgets forcing them to tighten their belt with high interest rates putting even more pressure on them and yet, the unemployment rate remains low. Why? Demographics: as our population ages, many retire, and we don’t have enough babies to take those jobs.

During the second part of 2023, we saw signs that higher interest rates were finally catching up with the economy and slowing it down. Inflation has lowered, GDP isn’t as strong (Canada even reported a negative GDP late in 2023), and unemployment rates on both sides of the border are going up by a bit.

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If you focus on your portfolio yield, you were unhappy with your results in 2023 and my guess is that it won’t be easy in 2024 either.

New inflation data hints at a pause in interest rates. We might even talk about rate decreases later in 2024. However, as the steak price won’t get back to 2021 levels, we are not going to see 2% mortgages or debentures in 2024. Companies will have to deal with higher interest rates when refinancing.

I said it over and over; we will continue to feel the lagging impact of those interest rate increases for many years.

Different Year, Same Plan

Studies show that most individual investors like you and me lag the market… big time. Think of famous investor Peter Lynch who managed the Fidelity Magellan Fund from 1977 to 1990 generating an annualized return of 29%. Fidelity later revealed that the average Magellan Fund investor lost money during this period. How is that possible? Investors were simply not investing with conviction, and they didn’t stick to their plan, especially at times when the market dropped.

In 2022, I was overconfident, and I drifted away from my investment rules and process. As a result, I suffered from three bad investment decisions, Algonquin (AQN.TO), Sylogist (SYZ.TO), and VF Corp (VFC), in a brief period of time, which is never good for the investor’s ego.

In early 2023, I quickly got back into the driver’s seat and acted. I sold the three dividend cutters, took the loss of roughly 50% on each stock, and moved on by focusing on dividend growers with strong dividend triangle.

I could have prevented part of those losses by following my own rules, but I didn’t. Fortunately, my investment structure protects me from major negative impacts from bad investments as they are limited in size in my portfolio. Again, this highlights the importance of following your plan and sticking to your investment strategy.

For 2024, I intend to follow the same plan. My investment strategy stays the same: have a strong investment thesis backed with numbers and select companies with minimal downside.

Wishing you a successful investing year in 2024!

DDM Stock Valuation to Compare Stocks

One of the most debated topics among investors is how to assess the value of a stock. I like to use stock valuation models like the Dividend Discount Model (DDM) to compare similar stocks I have already thoroughly analyzed and find interesting, to see which one might be the best deal.

I don’t use valuation to determine if the company is undervalued or not because, to be honest, your guess is as good as mine. If you put ten financial analysts in a room and ask them to determine the valuation of a company, you’ll likely end up with ten materially different answers.

They’re all smart folks, but each of them has a different perspective. However, using a valuation tool with the same perspective and applying it to two or more companies in the same sector makes it easier to identify which one is the best deal and the best fit with my investment thesis.

To clarify this process, let’s compare two Canadian banks: Royal Bank (RY.TO) and National Bank (NA.TO).

Analyzing RY.TO and NA.TO

Before looking at the fair value of Royal Bank and National Bank as per the DDM, any investor interested in them should analyze both; study their business model, look at their dividend triangle, evaluate the safety and growth potential of their dividend, identify their growth vectors and their risks. For details about what I do to analyze stocks, read this article.

Our diligent investor might summarize the analysis like this:

Business model:

Both RY and NA are regulated and diversified Canadian banks
RY is much larger than NA ($181B market cap vs. $35B)
RY is more distributed geographically than NA, which is heavily concentrated in Quebec

Dividend triangle, dividend safety and growth:

Both banks have a strong dividend triangle showing growth in revenue, EPS, and dividend
NA shows slightly faster dividend growth since early 2022 and higher growth numbers over 5 years for all three metrics
Dividend payout ratios are under control for both, with RY near 45% and NA near 37%

Growth vectors:

RY has diversified revenue streams and is increasing its activities outside Canada
RY targets growth in wealth management, capital markets, and insurance, with this trio already representing over 50% of its revenue
NA follows a growth by acquisition strategy, targets wealth management and capital markets
NA is more flexible and quicker to move due to its smaller size

Risks:

RY capital markets and insurance growth vectors are inclined to variable returns
RY has high exposure to Canadian housing market and the effects of rising mortgage rates
NA is dependent on the Quebec economy, although it has been expanding with private banking in western Canada and investments in emerging markets, such as the ABA bank in Cambodia
NA takes more risks to find growth vectors

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With all this analysis information on hand, our investor still hesitates between Royal Bank and National Bank and now turns to the DDM valuation to compare them.

Comparing NA.TO and RY.TO Valuation

Here is the DDM valuation data for both Royal Bank and National Bank taken from their respective stock cards on the DSR website.

At the time of writing, National Bank was trading at about $103 per share and Royal Bank at around $131.00 per share.

Looking at this data to compare both banks, including the value circled in red for each bank, observe the following:

	RY	NA
DDM Intrinsic value	$190.80	$99.77
Current stock price	$131	$103
Stock currently trading at	45% discount	3% over its value

At 45% discount, RY looks like an amazing deal, a slam dunk, right? It certainly does, but…there is a crucial difference to understand here, which is the discount rate. The discount rate, also known as the “expected return”, represents the minimum acceptable rate of return that an investor expects to earn on their investment to compensate for the risk and opportunity cost of investing in that particular stock.

Compare Apples to Apples

Notice below that the discount rates used for the intrinsic value of RY and NA are not the same. Due to RY’s geographic distribution and revenue stream diversification mentioned earlier, we used a discount rate of 9%, whereas NA’s more audacious approach made us use a 10% rate.

If we compare both banks with the same discount rate of 10%, we see that the difference between the two is significantly reduced.

	RY	NA
DDM Intrinsic value	$143.10	$99.77
Current stock price	$131	$103
Stock currently trading at	9% discount	3% over its value

If you hesitate between RY and NA, a look at the DDM value confirms that your dilemma is between two really good stocks. RY might seem a better deal at current prices, but NA could be a better pick if you want more growth potential and are prepared to live with more volatility in the stock price.

I have both Royal Bank and National Bank in my portfolio because both fit my investment thesis. I appreciate National Bank’s significant growth potential and Royal Bank’s more stable and steady approach. As a reliable source of income that also shows growth vectors, RY.TO is also included in the DSR Canadian retirement portfolio model.

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!