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In the last post, I examined the potential returns and risks of investing in a condo for Pete.  However, the analysis isn’t complete until we consider alternate investment vehicles. For instance, there are many studies illustrating that the stock market outperforms residential real estate in the long run: here is one from Ibbotson. Logically this makes sense: businesses pay a portion of their revenues to employees who use this income to pay for their homes. Real estate cannot appreciate faster than business revenues indefinitely, otherwise where would the money come from to afford these homes? The fact that real estate has appreciated so much faster than earnings for so long suggests a market imbalance in need of a correction.

Specifically, this blog is focused on the benefits of wide moat, dividend paying equities, and this is the sector of the market I would recommend to Pete. There are a number of strategies Pete could consider. Most simply, he could invest in an ETF like the XDV which focuses on quality dividend payers. However, this wouldn’t be my first choice since XDV is heavily weighted toward the financial sector (over 60%). In the May issue of Moneysense, Norm Rothery provides an alternate portfolio of quality dividend payers which is not as heavily weighted in financials, see Generous Dividend Growth Portfolio. Another method that I’ve discussed on this blog is David Stanley’s Beating the TSX index which will also generally be weighted toward financials, but guarantees buying the cheapest stocks amongst a basket of quality dividend payers. This strategy has returned 10.2% annually from 1987-2009 (see Investing by the Decade CanadianMoneySaver February 2010).

To illustrate the benefits of investing in a wide moat, dividend paying company over a condo, I am going to consider an investment in Enbridge Inc. – a boring pipeline company rarely discussed with much enthusiasm. However, it is one of the largest and most successful pipeline operators in North America. In general, pipelines are a great business since there is no other economical mode of transporting oil or gas  and therefore the only competition for a pipeline is another pipeline. However, obtaining the rights to build a pipeline once one already exists is very difficult, thus rendering  existing pipelines near monopolies for the routes they serve. Finally, pipelines get paid based on the volume of energy transported, not on the price, insulating them from fluctuations in energy prices and enabling them to provide steady cash flow. Simply, as one of the largest pipeline operators in North America, Enbridge is a wide moat business.

Enbridge has paid a dividend since 1955 that has grown from $0.0075 to $1.48 per share annually (an average increase of 10% per year). The company has generally maintained a payout ratio between 60-70% though it currently sits at 84%, a little on the high side. The 5 year EPS consensus growth forecast for Enbridge is 8.00% (see here), which is slightly lower than the company’s long-term average of 10%. Currently, Enbridge stock is trading in a range between $46-$50 with a P/E of 13.2 and P/B of 2.5, which are slightly lower than the 5 year averages for both these measures (17.5 and 2.8 respectively). So Enbridge is trading at a slight discount.

Using history as our guide, let’s examine what Pete could expect to make over 10 years if he invested $250K in Enbridge. Currently, the dividend yield is 3.5% and assuming that earnings and dividends increase 8% annually, Pete’s Enbridge stock would be worth $654,599.49 in 10 years (compared to $499,751.16 for the condo, plus $20,482.09 in cumulative rent). This is assuming Pete uses his dividends to pay the interest on the loan first and then reinvests whatever remains after tax. In ten years the yearly dividend income after interest and tax would be $9,538.66 (compared to $3,688.44 for the condo). Unlike apartment rent, dividends are taxed at a lower rate than regular income. Exactly how much lower is dependent on your tax bracket. I’ll assume an income of roughly $90K, which translates into a dividend tax rate of  22.25% although Pete could further enhance his returns by sheltering some of his Enbridge stock in an RRSP or TFSA.

Since Enbridge is free to increase its dividends as it sees fit and those dividends are tax advantaged compared to rent, an investment in Enbridge would outperform Pete’s condo by quite a bit even assuming both investments grow at the same rate. However, unlike my assumptions about the future of the real estate market, my assumptions on the future growth of Enbridge  are below its long term average and unlike Pete’s condo, the stock is trading at a slight discount to its traditional valuation. Based on this, I would be more confident with my forecast for Enbridge’s future performance  than  for the  likelihood of Pete’s condo continuing to appreciate.

Of course, getting a loan for $200K to invest in a stock is not as easy as getting a mortgage to buy a condo.  However, if Pete has enough equity in his existing home he could borrow against that. This tactic is known as the smith maneuver. Certainly, if Pete only invested the $50K he has available, in 10 years his total return would be lower at $135,044.67  and a dividend income of $4248.66 annually. It is important to understand that the outsized returns mentioned above in both the condo investment and the Enbridge stock come as  a result of leverage which implies added risk.  Of note, leverage is something that Pete can choose to take on when considering an investment in a stock, but not a choice when electing to invest in a condo since you can’t buy 1/5th of a condo, but you can buy a small piece of a company.

As well, I am certainly not advocating a 250K investment in a single stock. I am simply comparing the logic of making a large investment in a single condo with a safe dividend, paying company. Reservations about the lack of diversification are equally legitimate when considering a stock as they are when considering a real estate investment. Once again, however, the opportunity to diversify  exists when considering stocks but not for real estate.

A final word about reliability: I cannot predict whether Enbridge will outperform the stock market in general (nor can I be sure that the red hot real estate market won’t continue its run for  some time yet), but I can be reasonably confident that its wide moat business will remain intact and that its 55 year history of increasing earnings and dividends through good times and bad provides some insight into the quality and longevity of its business. Certainly, a company such as this, trading at a reasonable valuation is likely going to be a better performing investment than a condo at the height of a real estate boom.  So if I were advising Pete today on a major investment with a large leveraged position, I believe he would be better served by a basket of boring dividend payers comprised of companies like Enbridge rather than a condo in his building.  My advice to Pete is to hold off on the condo and instead consider quality dividend paying companies trading at a discount.

Full Disclosure – Enbridge is currently on my watch list and I would consider a purchase if at some point it trades at a greater discount.

My friend Pete asked me recently whether he should invest in a condo in his building. Understandably, soaring real estate prices have mesmerized many and there is a pervasive feeling that there is money to be made.  I suggested Pete consider the following 3 questions:

1) What return can you reasonably expect from this investment?

2) What are the risks?

3) Have you considered the opportunity cost of not making another investment?

In this post I will address the first two questions and consider the opportunity cost in a follow-up article.  First, a little background: Pete lives in a new condo building in a very desirable area of Ottawa, Ontario. He has lived in the building for a few years and is very happy there – no horror stories of shoddy workmanship or skyrocketing condo fees that would suggest caution. He has about $50K in savings ready to invest and is considering the purchase of another unit in the building as an income property. Outwardly, this seems reasonable.  He is familiar and happy with the building and there probably won’t be a lot of maintenance or unforeseen increases in condo fees. Furthermore, although mortgage rates are on the rise, rates are still near historic lows and remain attractive. Finally, Ottawa in and of itself is a safe government town with a stable workforce and although real estate has done well there, it is still relatively affordable compared to other major Canadian cities.  So, all that remains (but is often overlooked) is a careful analysis of the real returns and risks of such a venture.

What is a reasonable return for this investment?

I sat down with Pete to consider the kind of return on investment he could expect.

Price of Condo $250,000
Down Payment $50,000
Rental Income Monthly $1,500
Rental Income Yearly $18,000
Taxes $2,500
Condo Fees $3,600
Income after expenses $11,900
Rental Yield 4.76% ($11,900/$250,000)
Mortgage $200,000
Mortgage Interest (5.5%) $11,000
Income after interest payment $900
Rental Yield based on Down Payment and Interest 1.80% ($900/$50,000)
Tax Rate 43.41% (Pete’s highest tax bracket)
After Tax Income $509.31
Personal Time 0

The rental yield is 4.76% meaning that for a $250K investment Pete can expect a 4.76% return based on the rent he can charge. He will need to obtain financing to purchase the condo and I’ve assumed a 5 year fixed mortgage rate of 5.5%. This is below the current posted rate of the banks but still achievable. If we factor in the cost of servicing debt, the rental yield goes down to 1.8% and the rental income becomes $900 or $509 after tax (assuming a tax rate of 43%). As per Ontario law, landlords can increase rents based on the inflation rate as measured by the Ontario CPI index (see here). The 10 year average of rental increases is 2.55%. I am going to be optimistic and assume 100% occupancy and that Pete actually implements the  rental increases. Furthermore, I have not allocated any dollar value to the time Pete will spend managing the condo. This is something that could significantly reduce returns if properly factored in, but is rarely given proper consideration.

A rental yield of 4.76 % is not particularly attractive when you consider that rents cannot increase more than the inflation rate and the increase rate has been capped to less than 3% for the last 10 years. The investment is made even less attractive because it requires a debt to equity ratio of 4 to 1 ($200K mortgage vs. $50K down payment) with the resultant income fully taxable. However, in my experience, people do not invest in real estate solely for the rental income, but with the expectation of capital gains. That has been a good bet for the last 10 years.  According to the Globe and Mail, real estate in Canada has returned 8% annually since 2000. This is where the leverage associated with real estate investments really pays off.  An 8% ($20K) increase in the value of Pete’s condo would translate into a 40% ($20K/$50K) increase in his investment return. All the while, his renter would be paying to carry the place. That’s attractive but it’s important to realize that the return is related to the leverage employed.  An 8% return itself is not particularly spectacular. According to John Bogle, the father of index investing, a simple indexed stock market strategy can be expected to return 6-7% annually, adjusted for inflation.

Let’s assume for a moment that real estate continues to appreciate at its torrid pace of 8% annually.  In 10 years Pete’s condo would be worth $499,751.16.  Assuming a 2.55% annual increase in rent, the rental income over the next 10 years after tax and interest payments would sum to $20,482.09. In 10 years the rental income will be $3,688.44 per year and assuming only minimum payments are made on the mortgage, the balance outstanding will be $150,312.06. So the condo will double in price and the rental income will pay down the mortgage and contribute to Pete’s income.

What are the risks?

This brings us to the next question: what are the risks associated with Pete buying a condo in his building?  According to Robert Shiller, the inflation adjusted return of residential real estate in the US over the last 100 years is less than 1%.  Here is a clip of Shiller making his case. While the real estate market has posted impressive returns for the last few years, over the long term real estate has not been a particularly rewarding investment.  If you believe in reversion to the mean (a basic tenant of value investing) then the future returns of real estate will be quite poor, possibly even negative. Negative returns in real estate can be particularly disconcerting to investors because leverage works to both magnify returns in good times and losses in bad times. Returning to Pete’s situation, two years of 8% declines in the price of his condo would result in a $38K reduction in price  or a 77% reduction in equity . Compounding this risk is the understanding that real estate is not a liquid investment and in a down market Pete could get stuck holding onto his condo for a long time.

In my opinion, the massive run up in real estate prices has been fuelled by low interest rates and easy money that have allowed Canadians to rack up huge amounts of debt. This cannot continue indefinitely. According to the Globe and Mail, Canadians currently have a debt to income ratio of 147%  which is not significantly different than our American counterparts with 157% (see here).  Furthermore, 70% of this debt is mortgage related, illustrating the point that people are spending an increasing portion of their income paying for their real estate investments. According to Statscan, property prices in Canada are up 23% year over year while personal income is down 1% (as of March 2010). The only way this paradox can exist is by increasing debt loads, which is unsustainable. Given this, the assumption that real estate prices will continue to appreciate at present rates seems speculative at best.

Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.– Warren Buffet

A basic tenet of value investing is to buy assets at an attractive price.  In my opinion Canadian real estate is not cheap and given market headwinds is unlikely to produce satisfactory returns in the future.

In my opinion, a real estate investment should be evaluated primarily on rental yield.  If we could backtrack 10 years by adjusting the cost of Pete’s condo downwards by 8% per year  and rents downward by 2.55% (in order to recreate a real world year 2000 scenario), we would get a price of $125,000 and a rental income after expenses of $9,400. The resulting rental yield would be 7.5%, a much more attractive investment notwithstanding capital gains. I can recall looking at income properties in the late 90’s and calculating rental yields between 8-10%. If rental yields come down to this level again I would consider making another investment in the real estate market. Warren Buffet recently made a major investment in US real estate when he started Berkadia, a large US mortgage broker. However, he only did that after a massive correction in real estate and after he felt the worst was over.  Obviously, this is not the case today in the Canadian real estate market.  In the next post I’ll examine some alternative and possibly more lucrative investment opportunities for Pete.

Beating the TSX (BTSX) is a portfolio published yearly by David Stanley in Canadian MoneySaver (an online subscription can be purchased for ~$20/yr, it’s well worth it). The portfolio applies a Dogs of the Dow strategy to the TSX. Specifically, it tracks the Dow Jones TSX 60 index and extracts the 10 companies with the highest dividend yield. The returns are impressive: the BTSX has achieved a compound annual growth rate (CAGR) of 10.2% from 1987 to 2010 as compared to the TSX Total Return Index which has returned 7.9% over the same period (see Investing by the Decade, David Stanley, Canadian MoneySaver February 2010).

Beating the Beating the TSX (BBTSX) portfolio is my attempt to improve on the BTSX’s performance, while still keeping the methodology simple.  In short, I hope to show that consistently better returns can be made by incorporating corporate share buybacks into the high dividend yield strategy employed by the BTSX.

Companies return value to shareholders through share buybacks or via dividends. There is debate as to which method of rewarding investors is favourable. When a company repurchases shares, earnings by the company become divisible by fewer shares and thus the value of each individual share is increased.   Dividend purists like to get paid in cash, however share buyback has the advantage of being more tax efficient since there is no distribution to be taxed. Both methods have merit, and it is reasonable to include companies who reward shareholders with buybacks as well as dividends to a screen like the Dogs of the Dow.

Indeed, in his book Your Next Great Stock, author Jack Hough devotes a chapter to the New Dogs Screen which combines share buybacks and dividend payout to a screen of the Dow.  Simply, he uses a measure called Net Payout Ratio rather than dividend yield to sort stocks. Net Payout Ratio is the sum of funds spent on dividends and share repurchases minus any money taken in from share issuance, then divided by the market cap of the company. Sorting the Dow stocks according to this measure and then choosing the 10 companies with the highest net payout ratio is the New Dogs of the Dow strategy. Hough points to a study that compares the performance of Dogs of the Dow to the New Dogs screen over a 22 year period (1983-2005).  The comparison shows that the Dogs returned 16.2% over the time period while the New Dogs significantly outperform with a return of 19.1%.

Further support for this hypothesis can be found in What Works On Wall Street by James P. O’Shaughnessy.  Although not a light read, this book provides excellent analysis of a number of investing strategies and incorporates  measures such as the Sharpe Ratio (see here for a definition) to determine the performance of each strategy in risk adjusted terms .  Most specific to my purpose, O’Shaughnessy provides a comprehensive study on the performance of dividend yield strategies compared to Net Payout Ratio strategies.   In the first edition of the book (1996), O’Shaughnessy concludes that one of the best strategies in risk adjusted terms is the Cornerstone Value strategy. This strategy is a variation of the Dogs of the Dow which picks the top 50 stocks by dividend yield from a universe of Market Leaders (see What Works on Wall Street for a definition of this index). However, interestingly, in the latest version of the book(2005), O’Shaughnessy adjusts the Cornerstone Value strategy to include share buybacks and concludes that this strategy not only outperforms the original Cornerstone Value strategy in both real and risk adjusted terms, but indeed, outperforms all strategies analyzed in risk adjusted terms. Between December 1952 and December 2003 the average annual compound return for the Cornerstone Value method was 15.78% with a Sharpe Ratio of .65 while the Cornerstone Value method adjusted for shareholder buyback yielded a return of 17.09% with a Sharpe Ratio of .73.

The Beating the Beating TSX portfolio is my attempt to factor in share buybacks to the Beating the TSX portfolio. Here is my BBTSX portfolio as calculated for February 25 2009:

Rank Name Symbol Net Payout Ratio
1 Husky Energy Inc. HSE 5.19%
2 Sun Life Financial Inc. SLF 4.42%
3 EnCana Corp. ECA 3.97%
4 Shaw Communications Inc. SJR.B 3.85%
5 Imperial Oil Ltd. IMO 3.72%
6 Thomson Reuters Corp. TRI 2.96%
7 Canadian Imperial Bank of Commerce CM 2.93%
8 Canadian Oil Sands Trust COS.UN 2.75%
9 Enbridge Inc. ENB 2.24%
10 Bank of Nova Scotia BNS 2.02%

I have used Jack Hough’s methodology as described in Your Next Great Stock and taken data from MSNMoney.com. One of my favourite characteristics of this portfolio is that it penalizes companies that dilute shareholder value by issuing shares. For example, Bank of Montreal (BMO) paid out $1.312 billion in dividends in 2009 but raised $1.662 billion in share issuance which results in a negative payout ratio. A straight dividend analysis would reward BMO for maintaining its dividend however, factoring in share buybacks penalizes BMO for maintaining its dividend at the cost of massive share dilution (here is a link to the company’s Cash Flow statement).

I plan to update the portfolio in the third week of May which is traditionally when David Stanley publishes the latest Beating the TSX portfolio and track my performance against that portfolio.

One final technical note, the BBTSX portfolio provided here is based on the Dow Jones Canadian 40 Country Titan Index since that is the index that the BTSX portfolio used for its latest update. That index has since been changed to include 60 stocks and is now the Dow Jones Canadian 60 Country Titan Index. The BTSX now tracks that index, and I will do the same in May when I publish my updated portfolio.

In the last post, I took a look at 3 companies in the healthcare industry to determine if they are the kind of business I would consider investing in. All three passed my initial screen, suggesting that they have wide moats and should continue to increase cash flow and generate high returns on equity into the future. This week I will use a discounted cash flow (DCF) analysis to determine a fair price for these businesses.

A DCF analysis requires the following 4 parameters:

Free Cash Flow (FCF) Growth Rate: an estimate of the rate at which free cash flow will grow over the next 5 years

Discount Rate:  the rate used to discount future cash flows

Long Run Growth Rate: the rate at which cash flows are expected to grow in the very long-term

Margin of Safety: rate at which the projected fair value is discounted

For a more detailed description of the DCF process refer to The Five Rules for Successful Stock Investing.

Given the difficulty of forecasting and the inherent error that forecasts are subject to, a DCF analysis is really only useful for firms that operate a stable business where there can be some confidence that past performance will be an indication of future results. This explains why Warren Buffet applies it to wide moat companies with a long operating history. As discussed in the previous article, BDX, JNJ and SYK have impressive operating histories and pass Dorsey’s tests for ROE, and FCF/Sales indicating that these businesses have wide defensible moats.

Let’s start with the FCF growth rate, I will use the 5 year consensus analysis earnings forecast published on msnmoney for my calculation:

5 year projected earnings growth rate as of (13/2/2010)

Symbol 5 year growth rate
BDX 11.40%
JNJ 7.60%
SYK 11.70%

When considering the discount rate, Dorsey typically assigns a discount rate of 9% for stable companies that represent very low risk, 10.5% for an average company and 13-15% for riskier firms. I have assigned a discount rate of 9% for JNJ and BDX to reflect the stable, non-cyclical nature of their business and 9.5% to Stryker to account for the fact that this business specializes in devices and instruments associated with more elective surgeries and therefore may be more influenced by the business cycle. All the companies have been assigned a low discount rate to reflect the stable nature of their businesses and their past history of consistent returns.

With respect to the long run growth rate, I will use a value of 3%. Dorsey uses this value since it mirrors the long run US GDP growth rate. I considered using a value of 4% to reflect my belief that developed world demographics and the developing world’s desire to increase healthcare expenditures means that the healthcare sector will outperform other sectors of the economy over the long-term. I will provide DCF analysis using both values.

Finally, I will use a margin of safety rate of 30% to discount my fair value. According to Dorsey, Morningstar uses a margin of safety of 20% for stable companies, and 30-40% for less stable companies with inconsistent earnings history or which operate within a cyclical industry. It would be reasonable to use a 20% discount rate for these companies given their previously mentioned characteristics, however I have chosen to use 30% to offset the fact that I am using analyst consensus growth estimates which tend to be overly optimistic. Below, the parameters necessary for a DCF calculation are summarized:

BDX JNJ SYK
Discount Rate 9.00% 9.00% 9.50%
FCF Annual Increase 11.40% 7.60% 11.70%
Perpetuity Growth Rate 3.00%/4.00% 3.00%/4.00% 3.00%/4.00%
Current FCF 1125.70 12636.00 1204.20
Next Year FCF 1254.03 13596.34 1345.09
Shares Outstanding 246.00 2754.34 396.40
Margin of Safety 30% 30% 30%

Table 4 illustrates the 10 year FCF growth forecasts for the DCF analysis. I use a 5 year forecast to calculate the perpetuity values, rather than the 10 year forecast used in The Five Rules for Successful Stock Investing. Ultimately, this should render a more conservative estimate.   The results are as follows:

BDX JNJ SYK
5 year FCF Forecast $1,733.66 $18,163.94 $2,093.94
Perpetuity Value 3% $29,761.13 $311,814.35 $33,180.91
Perpetuity Value 4% $36,060.09 $379,083 $39,594.50
Discounted 3% $19,342.69 $202,657.93 $21,077.44
Discounter 4% $23,436.58 $246,377.90 $25,151.50
Total Equity Value 3% $24,738.91 $263,323.29 $27,471.21
Total Equity Value 4% $28,832.80 $307,164.80 $31,545.30
Per share value 3% $100.56 $95.60 $69.30
Per share value 4% $117.21 $111.52 $79.58
Margin of Safety Price 3% $70.40 $66.92 $48.51
Margin of Safety Price 4% $82.04 $78.06 $55.71

Changing the Perpetuity Growth Rate by 1% has a significant effect on the Margin of Safety Price  Only JNJ is currently trading below its margin of safety price calculated with a 3% Perpetuity Growth Rate, however all 3 companies are currently trading below their Margin of Safety Price calculated at a 4% Perpetuity Growth Rate.  Not surprisingly, the performance of these companies has not gone unnoticed by a famous investor who also likes to concentrate on cash flow and ROE.  Warren Buffet has been a long time holder of JNJ with recent purchases between $50.47 – $56.60 and has also recently taken a position in BDX purchasing it between $60.88 – 70.94 (see GuruFocus).

Full disclosure – long JNJ, SYK.

Previously I took a look at the Canadian Telco and cable sector to determine whether the largest operators in that space met my requirements for investment. My analysis pointed to an inconsistent 10 year record that precludes investment for now.

This week I will take a look at the healthcare space by analyzing 3 of my favourite companies: Becton Dickinson and Company (BDX), Johnson & Johnson (JNJ), and Stryker (SYK). BDX is the world’s largest manufacturer and supplier of needles and syringes. JNJ is a giant in the health care space with diverse operations ranging from pharmaceuticals, medical devices and consumer staples. SYK is a manufacturer of devices and equipment for orthopaedic surgeries.

Table 1 and 2 illustrate the 10 year history of free cash flow and return on equity for all 3 companies. Applying Dorsey’s screen of a consistent 10 year history of FCF/Sales ratio of 5% or better and ROE above 15% illustrates the quality of these companies.

FCF/Sales Ratio and ROE

Symbol 5 year FCF/Sales average 10 year FCF/Sales

average

5 year ROE average 10 year ROE average
BDX 8.96% 11.79% 23.19% 21.46%
JNJ 19.94% 19.38% 28.17% 28.08%
SYK 14.32% 12.99% 20.73% 23.14%

These numbers handily exceed Dorsey’s requirements. Table 2 shows the financial leverage employed. The current leverage ratio for JNJ and SYK is 1.82, 1.31 respectively, both well below the 3 to 4 range that Dorsey considers a red flag. BDX has maintained a higher level of financial leverage (currently 3.6) which is a concern, however the non-cyclical nature of their business should ensure debt obligations are met.  BDX has a credit rating of AA- from S&P.

Lastly, let’s take a look at dividend history. Table 3 illustrates the 10 year dividend history of the companies. All 3 have a perfect record of increasing dividends yearly.  Indeed, JNJ and BDX are dividend aristocrats with a record of 46 and 36 consecutive years of dividend increases respectively. The payout ratio has remained in a steady range for all companies with JNJ the most generous, returning an average of 40% of its earnings to shareholders. Lastly, dividends have been increasing at a healthy rate for all companies with SYK specifically posting a very healthy 5 year increase rate of 49%.  As well, given that the company has close to 3 billion dollars in cash, it seems reasonable to expect further large dividend increases in the future.

The above analysis suggests that all 3 companies have wide economic moats that should protect their businesses long into the future. To paraphrase Buffett, these are great companies, the next question is, are they trading at a fair price? Next time I will try to answer that question by using the discounted cash flow method outlined by Dorsey in The Five Rules for Successful Stock Investing.

When searching for great companies I want to find a company with a history of strong free cash flow generation, high return on equity and a history of consistent and growing dividend payments.   My philosophy is based on ideas taken from The Five Rules for Successful Stock Investing by Pat Dorsey, Director of Stock Analysis at Morningstar (see about me).

In this post I am going to examine the Canadian Telco and Cable sector by analyzing the quality of 4 of the largest companies in the space: Bell, TELUS, Rogers and Shaw. Phone, cable, and internet services are considered staples in most households and as such, should provide stable cash flows to companies providing those services. Additionally, the sector is dominated by large, well established firms and so it would be reasonable to believe that it is a good place to find companies with good return on equity and a history of consistent dividend payment.

Let’s begin with a look at free cash flow (FCF). Specifically, I’m looking for a consistent FCF to sales ratio of over 5% and an ability to maintain that ratio for 10 years or more.  This is indicative of a strong economic moat according to Dorsey.  Table 1 gives the 10 year history of free cash flow and illustrates that all four companies were unable to consistently produce positive free cash flow over this period.  FCF was negative at the turn of the century (2000-2002) due mainly to large capital expenditures incurred while building out high speed internet and cell phone networks. Indeed, large capital spending is an ongoing consideration in this sector given the necessity of maintaining up-to-date data delivery systems on an ongoing basis. The cost of doing this is prohibitive and acts as a major barrier to entry for new competitors, however it also makes consistent generation of free cash flow a challenge. None of the companies have been able to maintain a consistent FCF to sales ratio of over 5% for the last 10 years.  Failure to achieve this key indicator implies the companies being analyzed are less likely to have maintainable competitive advantages.  The returns of the last 5 years however, paint a more promising picture as all companies except Rogers have posted FCF/Sales ratios well above 5% (Rogers has a very good 4 year record but in 2005 only managed a FCF/Sales ratio of -1.69%). Shaw,in particular devotes a section of their annual report to a discussion of their focus on free cash flow generation, which is certainly an encouraging sign. Unfortunately, it is difficult to assume that the 5 year record is an indicator of future performance given the rapid pace of technological change in this industry.  At this point in the analysis, strict adherence to Dorsey’s method would suggest looking elsewhere for safer wide moat companies to invest in. Depending on your appetite for risk however, you may decide that the recent 5 year record will more accurately represent the future performance of these companies.   If this is the case, I would suggest that at the very least a greater margin of safety should be demanded when determining an appropriate purchase price given the uncertainty illustrated by the 10 year record.

A second key indicator is the ability of a company to generate a return on shareholder equity (ROE). According to Dorsey, a good indication of a defensible economic moat is maintenance of an ROE greater than 15% for 10 years or more.   Further, the quality of ROE should be evaluated with respect to the amount of financial leverage used.  In this regard, Dorsey considers any company with financial leverage of 3 or 4 as a red flag.  Table 2 displays the 10 year history of ROE as well as the financial leverage for each company over the same period. Again the 10 year and 5 year pictures tell two different stories. None of the companies have maintained an ROE of greater than 15% for the 10 years, although once again, the 5 year picture is improving. The question becomes whether the 5 year picture represents the future or whether some new event will occur (technological change, new regulatory environment etc) that returns these companies to negative returns on equity. The financial leverage for Bell, TELUS, Rogers and Shaw is 2.7, 2.6, 3.4, and 3.6 respectively.  The degree of leverage for both Rogers and Shaw represents a red flag according to principles set out by Dorsey. While it may be that the stability of the cable business justifies a higher leverage I would again consider a higher margin of safety when determining a purchase price to account for this uncertainty.

Although not a key Dorsey indicator, a record of growing dividend payments is something I look for in a company (see about me).  The record of dividend payment for these companies does not reflect the stable operating cash flow characteristic of the business. In fact, dividend payment is a relatively recent development for Rogers (paid regular dividend since 2003) and Shaw (paid regular dividend since 1998). TELUS cut its dividend in 2002 and did not raise it again until 2005 while Bell cut its dividend in 2000 and again in 2008. Table 3 illustrates the dividend record by giving the 10 year history of dividend payment, dividend increase and payout ratio. The current dividend yields for these companies appear attractive, however the seemingly inconsistent nature of free cash flow and the weak history of maintaining dividend payments make me skeptical of relying on their long-term dividend growth.

Dividend Share Price Yield
Shaw $0.79 $20.81 3.80%
Telus $1.90 $34.32 5.54%
Rogers $1.08 $31.37 3.44%
BCE $1.73 $27.84 6.21%

Note all data is as of 10/1/2010

In conclusion, despite the perception that the Canadian telco/cable sector contains solid companies with stable economic moats, my analysis suggests a number of caveats to consider before making an investment. Namely the requirement to take on large capital expenditures in the face of technological change jeopardizes free cash flow, return on equity and dividend payment. Given this point of view, I would require a significant margin of safety before being comfortable making an investment. In a future post I will take a closer look at the earnings of these companies and give my opinion on their future prospects.

Disclosure – no positions currently held in these companies.