My Three Smallest Stock Holdings

After my last entry explored my three largest holdings, I thought it would be fun to write about my three smallest positions. Do these companies represent my lowest convictions? Am I uncomfortable with holding these companies? Why do I keep these positions in my portfolio? These are questions I think the below descriptions will help answer.

Smallest position: Orion Office REIT Inc. (using USD / CAD exchange rate of 1.28)

A couple days after Realty Income completed their acquisition of VEREIT earlier this month, Orion Office REIT was spun-out and the shares appeared in my account in a ratio of one for every 10 Realty Income shares I own. Based on the preliminary financials, this looks like a stable office REIT.  Since I received the shares, they’re down about 20% as other Realty Income holders see a small number of shares in this pure-play office REIT appear in their accounts and subsequently get rid of them. My instinct was to sell them as soon as I received them, but I held back thinking I’d wait to see where the shares settle price-wise. That was probably a poor decision, but without any big plans to invest in US stocks at the moment, I can afford to take some time to see how Orion does in the short-term.

 

Second smallest position: Omega Healthcare Investors, Inc.

Omega has a couple factors contributing to being my second smallest position. The fact the share price is down over 30% since reaching it’s 52-week high earlier this year is a material contributor. Omega has at least one operator of their assisted living and nursing facilities in bankruptcy proceedings at the moment. I haven’t added to my position since 2015, given my lack of conviction that the company can return to the type of distribution growth they did in their best days, boosting distributions by a penny each quarter. Instead, distributions have been flat for over two years now, despite the company still bragging about their streak of distribution growth. I’ll admit that I have considered selling this REIT multiple times, but it is hard to replace their current 9% yield, that is covered by FFO even during difficult times due to covid-19 and rent collection challenges from operators. I could still see myself getting rid of this in the next couple months, if an opportunity to reinvest the capital with better growth prospects presented itself.

 

Third smallest position: The Coca-Cola Company

For context, my level of comfort holding onto my shares in Coca-Cola is much, much greater than Omega. Their sales have bounced back nicely from coronavirus linked lows, to around the level they were back in 2019. That said, their elevated EPS payout ratio is a bit scary (102% currently), as is the fact that shares are selling for 26X earnings. Although I haven’t added to my position since initiating it in 2014, I have thought about adding lately. Yes, their dividend growth is barely tracking inflation, but the performance of their shares over the last two years has been resilient. Given this might be a nice play on finally getting over the covid-19 pandemic throughout the world, I could imagine adding a small amount to this position in the short-term so that it would be approximately equal to my next smallest position, the Canadian Imperial Bank of Commerce.

 

In summary, it wouldn’t shock me to sell either Orion or Omega before year end, as opposed to Coca-Cola where I’d consider adding. It was interesting for me that all my smallest positions are US companies, but maybe shouldn’t have been given limited funds each year to invest in my RRSP.

My Three Largest Stock Holdings

 When looking at the position sizes of your portfolio holdings, do your largest positions represent your highest convictions? Philosophically, at least for me, I think this should be the case. At the very least, my largest holdings should be companies I’m very comfortable holding through good times and bad. In that spirit, I thought I’d take a peek at my three largest positions, to ensure my capital was well allocated.

Largest position: Microsoft (using USD / CAD exchange rate of 1.25)

Despite initiating a position in Microsoft in October of 2013, and not adding to it since, it has grown to be my largest holding. Considering the company’s top and bottom line growth, perfect ‘AAA’ credit rating, and the fact they currently have the largest market capitalization of any North American company, I feel secure holding onto my shares. The explosive stock price gain in recent years means dividend yield is currently a paltry 0.7%, but on the flip side, the company continues to boost dividend payouts annually at a rate far greater than inflation. Lately, I’ve even considered adding a small number of shares to this flower that seems poised to continue to grow to the sun.

 

Second largest position: A&W Revenue Royalties Income Fund

As easy as it has been to hold Microsoft over the past couple years as the company’s share price kept rising, A&W experienced a rockier road. When the pandemic started in March 2020, A&W’s share price plunged to under $18, down from about $39. When public health measures entailed shutting down restaurants and cutting indoor dining, the company was forced to cut their monthly distribution from 15.9 cents, to 10 cents. However, due to the return to in person dining at many restaurants, more locations being added to the royalty pool, and higher same store sales, the company has steadily increased their distribution back to an impressive 15.5 cents per month. The company’s share price has also rebounded from the ~$18 lows to over $41 today. After not only holding my shares during the difficult period for A&W, but adding to them, I might look to expand my holdings in this company if pandemic restrictions continue to loosen in Canada.

 

Third largest Holding: Telus Corporation

My comfort at holding Telus is probably best demonstrated by my buying shares in the company in 2013 (twice), 2014 (twice), 2015 (twice), 2020 and 2021. Simply, Telus’s management team has been clear and consistent about their intentions to reward shareholders with semi-annual dividend raises in the 7% -10% range. These increases in payouts are supported by generating growing revenue and free cash flows. Although some might argue Bell or Rogers would be better situated for future growth given Telus’ focus on western Canada, I think the fact that Telus has the best rated customer service of the big three Canadian telecommunications companies bodes well for their growth prospects over the long-term. Although I’m not planning to add to my position anytime soon, and would likely add to my relatively smaller position in Bell instead, I’m perfectly comfortable with Telus being my third largest holding.

 

My next largest positions in my portfolio are Granite REIT and Brookfield Infrastructure Partners, both of which I’m considering adding to before year end. In summary, I’m comfortable with my largest three holdings, and hope all my readers feel the same way about their most valuable positions. 

My No-Longer Unwritten Rules

Since I haven’t been posting much over the last couple years, but I’ve kept consistently adding to my portfolio, I thought it was time to formalize the unwritten rules I’ve been following.

-          Make at least one purchase every month: The rationale is that if I get in the habit of regularly adding to my portfolio, I’ll be less likely to hoard money in an attempt to time the market.

-          Only add to positions that have grown their dividend in the past 12-months: Although there are companies in my portfolio who have not grown their distributions in the past year, I simply won’t add to them as I’d rather focus on exceptional companies that are able to grow their distributions regularly over time.

-          Do not add to any position if the result is the holding accounting for more than 5% of my total portfolio value: Although I’m not against holding concentrated positions, I’d prefer that they develop organically via share price growth, as opposed to through my overconfidence.

-          Sell losers, not winners: The analogy of harvesting flowers and watering weeds is pertinent for me, especially in my unregistered account, where tax loss harvesting is an excellent strategy to minimize my long-term taxable capital gains. Plus, I’m almost always wrong when I think “This stock can’t possibly go any higher…it’s already so overvalued!”

-          Never compare myself to anyone else: I used to track my progress against some of you who are reading this, but the reality is that we likely have very different goals, personal circumstances, and investing philosophies. Although I'm always happy to see a peer who is making progress in their journey, I find my joy focusing on my own process of investing. 

That's all for now. I hope to keep updating this post as I find more rules that I'm following.

Thought Experiment: Canadian Apartment Properties REIT + Activist Investor

Having owned shares of Canadian Apartment Properties REIT (TSX: CAR.UN) since 2013, I have benefited from the long-term appreciation in their unit price. However, over the past two years, as the REIT has ceased growing their annual distribution (last increase was in March 2019), the share price has grown a paltry 5%. As a comparison, since March 2019, Granite REIT (TSX: GRT.UN) has increased their distribution twice for a total of 7.3%, and their unit price is up over 21%. 

One of the main differences between CAR.UN and GRT.UN is that in May 2017, two activist investors (Sandpiper Group and FrontFour Capital Group) effectively took control of the Board of Directors of Granite, on the platform of selling non-core assets, increasing leverage, and acting in a more shareholder friendly fashion (i.e. raising distributions). Lately, I have been thinking what a similar type of activist investor strategy might look like for CAR.UN and what results it might yield.

Could an Activist Take Control?
One of the reasons that Sandpiper and FrontFour were able to take control of Granite's board with only 6.2% ownership of outstanding units is the company's prior management team had very little skin in the game. A similar situation exists with Canadian Apartment Properties, with no current management or Directors appearing in the company's top five holders. In fact, CAR.UN insiders only hold a total of 1.2% of outstanding shares, making the company a relatively easy target for an activist investor. Based on the $9.3B market capitalization of CAR.UN, an activist could own more than all the insiders of the company combined for around $120M.

Could an Activist Repeat the FrontFour/Sandpiper Playbook at Canadian Apartment Properties?
An activist investor could easily make the argument that CAR.UN should divest their interest in European Residential REIT (TSX: ERE.UN), as it takes away the former company's focus on their domestic market. Canadian Apartment Properties' 11% interest in ERE.UN is worth about $45M based on the latter's market capitalization. Beyond the stake in ERE.UN, within CAR.UN's domestic portfolio, a case could be made to sell some buildings in certain Canadian cities whose appreciated values don't translate into higher projected cashflows.

There is also a straightforward case that CAR.UN could take on more leverage given their debt to gross book value ended 2020 at a modest 35%, and the REIT was easily able to cover their interest needs evidenced by their debt service ratio of 2.0X. For a quick comparison, Minto Apartment REIT, reported a debt to gross book value ratio of 39% at the end of 2020, and also had a debt service ratio of 2.0X. Taking on more debt in order to invest in buildings and development, at a time when apartment living becomes more appealing due to rising house prices in Canada could prove to be a very smart long-term strategic decision for Canadian Apartment Properties.

On the shareholder friendliness front, CAR.UN seems to take pride in showing off the decrease in their FFO payout ratio from 65% in 2019, to 61% in 2020. However, as a unitholder, I find it frustrating to see that ratio so low, compared to most REITs that payout closer to 80% of their FFO. Adding to this frustration for me is the fact that CAR.UN has kept their occupancy high throughout the pandemic (98% at year end 2020), and collected over 99% of their rents throughout the year. As a shareholder, I have to wonder why the current management team sees fit to not distribute any of the growing FFO as a distribution to loyal unitholders. 

Thanks for joining me on this thought experiment. It will be interesting to see if any larger REITs or activist investors start agitating Canadian Apartment REIT to change their rather static course.

Revisiting the Canadian TULF Dividend Growth Portfolio

One of the most read entries on this blog is my 2016 take on the Canadian TULF Dividend Growth Portfolio. When re-reading the post and a couple of critical comments that it generated, I thought it would be worthwhile to revisit the entry and take a different perspective. Since it's been almost five years since the entry, my personal viewpoints have changed, and I'm going to attempt to argue in favor of the TULF portfolio by presenting counter examples to invalidate my three criticisms of Tom Connolly's four stock portfolio. 

For any readers who aren't familiar with Tom Connolly, he published The Connolly Report investment newsletter for over 30 years, and is one of the best known Canadian dividend growth advocates. Mr. Connolly set out the idea of the four stock TULF portfolio, with "T" standing for telecommunication companies, "U" for utilities, "L" for low-yielding dividend growth stocks with growth potential, and "F" for financials. To ensure high quality companies, Mr. Connolly suggested investors limit themselves to the S&P/TSX Dividend Aristocrats Index, which consists of 87 members and can be traded under the CDZ ishares ETF. It is worth noting that Mr. Connolly had certain rules regarding eliminating any "high yield" stock with a payout over 6%, and then removing cyclical stocks (i.e. energy and mining) as they were perceived as too risky to include in a four stock portfolio.

My three criticisms regarding the TULF portfolio are include below in italics, with my counterarguments in normal font. 

1. Lack of sector and geographical diversification

Once you’ve filled up your portfolio with telecoms (4 candidates), utilities (5 candidates), and financials (12 candidates), you're left trying to identify low-yielders with above average dividend growth potential in the 28 remaining companies. Since Mr. Connolly fails to define what he considers a low-yielding company, it's fair to focus on the lower yielding half of the 28 remaining companies in search of candidates that would provide above-average dividend growth and sector diversification. 

Although a couple of the larger utility companies and financial firms that Tom recommends have exposure outside of Canada, limiting a portfolio to TULF companies would expose you heavily toward the small, resource-centered Canadian economy. Personally, I aim  to keep at least 30% of my investment capital dedicated to international equities in order to provide better geographical diversification.

Going through the 87 companies in S&P/TSX Dividend Aristocrats Index, I came up with some names to include in portfolios that would provide some geographic and sector diversification:

Sample geographically diversified portfolio: T: Telus (most international Canadian telecommunication player), U: Algonquin (or Fortis, or Emera would provide US exposure), F: Bank of Nova Scotia (Latin and South America exposure) or Brookfield Asset Management (global exposure, but a lower dividend yield), L: Magna (international exposure to vehicle manufacturers)

Sample portfolio to provide sector diversification: F: Onex (multisector holdings), T: Telus (health exposure in addition to telecommunications), U: Capital Power (producer and energy trader), L: Dollarama (general retailer)

Although achieving strong geographic and sector diversification is going to be a challenge with only 87 Canadian based companies to choose from, the sample portfolios above show promise in at least providing some geographic and sector diversification. 

2. Identifying low-yielders who can and will grow their dividends quickly is difficult and not necessarily relevant

Accurately identifying low-yielders who can continue to grow their dividends at a fast rate for an extended period of time is as difficult as timing the market. These special types of companies are even harder to find in the small and often domestically focused Canadian market. Furthermore, I have yet to see a valid case made from a mathematical standpoint of why including low-yielders in a portfolio is necessary. Assuming you get very lucky and select a company currently yielding 1.0% that can grow dividends at 20% for 10 years, your yield on cost would grow to 6.2% at the end of the period. In contrast, if you pick a company currently yielding 5%, that grows their dividend by a paltry 2% over 10 years, you end up with the same yield on cost of 6.2%.

Instead of trying to argue the math presented above, which is futile, I'll instead present the below names of companies (all part of the 87 S&P/TSX Dividend Aristocrats Index) who have relatively low yields, but have been able to grow their dividends annually over prolonged periods of time, which I checked through using the Canadian Dividend All-Star list at December 31, 2020.

Metro Inc.: Yield at Dec 31st = 1.6%, 26 year streak of raising dividends, 1-yr div growth = 12.5%, 5-yr return = 22%

Candian National Railway: Yield = 1.6%, 25 year streak of raising dividends, 1-yr div growth = 7.0%, 5-yr return = 73%

Alimentation Couche-Tard Inc.: Yield = 0.8%, 11 year streak of raising dividends, 1-yr div growth = 19.0%, 5-yr return = 38%

Brookfield Asset Management: Yield = 1.2%, 9 year streak of raising dividends, 1-yr div growth = 12.5%, 5-yr return = 88%

Open Text Corp.: Yield = 1.8%, 8 year streak of raising dividends, 1-yr div growth = 6.7%, 5-yr return = 81%

Keeping in mind that the 5-year returns presented above don't include dividends, the benefit of adding these low-yielding stocks to a portfolio becomes obvious: potential for large total returns. 

3. Energy vs Utility Companies?

While Mr. Connolly suggests removing cyclical stocks such as energy and mining companies, he goes onto say TransCanada (classified in the Energy sector) was the first stock he owned. I also find it odd he advises against including energy companies and yet dedicates a whole category for utilities. There are blurry lines and high correlations between energy and utility companies. For instance, Enbridge Inc is classified in the index as an Energy company which would make it ineligible for the TULF portfolio. However, living in Quebec, Enbridge is viewed as a utility company by its many natural gas customers who pay their monthly bill to Enbridge subsidiary Gazifere. By discounting an entire category of companies he deems to be cyclical, Mr. Connolly leaves the investor with an even smaller potential universe of companies from which to select. 

The best way I can think of  to support Mr. Connolly's argument to include utility companies, and remove energy companies, is to compare the performance of indices representing these two sectors (which I did using www.barchart.com). 

TSX Energy Capped Index ($TTEN) 5-year Performance: -37%

TSX Utility Capped Index ($TTUT) 5-year Performance: +47%

It's hard to argue against 84% outperformance over the past five years. Although I do think a longer time frame would make for an even more meaningful comparison. 

Before wrapping up, I can think of a couple more bonuses for the Canadian TULF portfolio:

- Four stock portfolio is easy to construct, follow, rebalance yearly and would have low transaction costs

- Strict criteria can help automate decisions

- Starting with only quality companies that are part of the S&P/TSX Dividend Aristocrats Index is likely to lead to less big losses of capital.

Does your portfolio include all of the TULF components?