There was an interesting article in The Globe and Mail a couple weeks ago introducing readers to the Canadian "TULF" Dividend Growth Portfolio. Personal finance columnist Rob Carrick suggests readers follow the guidance of Tom Connolly when constructing a portfolio of quality Canadian dividend growth stocks. For those of you not familiar with Tom Connolly, he has published The Connolly Report investment newsletter since 1981 and is perhaps the best known dividend growth guru in Canada. Mr. Connolly suggests readers focus on telecoms (T), utilities (U), low-yielding dividend stocks with growth potential (L), and financials (F) to construct their Canadian "TULF" Dividend Growth Portfolio.
In order to ensure that the companies selected are of the highest quality, Tom instructs investors to limit themselves to the 75 dividend-paying stocks in the S&P/TSX dividend aristocrats index. Next Mr. Connolly suggests eliminating any “high yield” stock with a payout over 6% (currently 9 stocks are "high yield"). Lastly, cyclical stocks (i.e. energy and mining) are off the table as they are perceived to be too risky for a dividend investor (currently 17 stocks from energy and mining sectors).
By now you’re probably wondering which types of the remaining 49 companies meet all of Mr. Connolly’s criteria to include in the "TULF" portfolio. Here are some examples cited in the article:
Telecoms – BCE, Rogers and Telus
Utilities – Fortis, Emera and Canadian Utilities Ltd.
Low-yielders – Canadian National Railway Co. and Metro Inc.
Financials – The big 6 Canadian banks (RY, TD, BMO, BNS, CM and NA)
Granted, I’m likely not the target audience that Mr. Connolly is looking to attract to his newsletter by offering his advice is in the article, but I can quickly identify some rather serious drawbacks with his theory of dividend growth portfolio construction.
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.
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%.
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.
Although there are some flaws with his advice, Mr. Connolly’s strategy of using high quality companies to form the base of a dividend growth portfolio is a good starting point. Like any investment strategy, it should be tailored to meet the needs of the individual investor, and not taken as gospel.
Does your portfolio include all of the TULF components?