It’s time

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  By Guest Blogger Doug Rowat

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On average, major US corporations raise their dividends by about 6% annually.

This is significant for several reasons. First, share prices tend to track dividends, so dividend increases, over the long haul, usually bring price appreciation. Second, income investors naturally want their dividend growth to exceed inflation. And if the growth can exceed the inflation rate by many multiples, so much the better. In fact, dividend growth is one of the many reasons why equities outperform bonds over the long term—generally speaking, bond payouts (coupons) never increase.

In Canada, our major corporations are dominated by financials. In particular, the Big Five banks, which occupy five of the top-10 largest holdings in the S&P/TSX Composite and have a mean market cap of more than $105 billion. And Canadian banks have kept pace with US corporations in terms of dividend increases, also raising them by about 6% annually.

However, over the past year and a half this certainly hasn’t been the case as Canadian bank dividends have remained completely frozen. But this could shortly change—and in a big way.

First, why has there been a moratorium on Canadian bank dividend increases? As you might expect, it stems from the economic uncertainty created by Covid. At the outset of the pandemic, the Office of the Superintendent of Financial Institutions (OSFI), the Canadian banking regulator, barred dividend increases and common share buybacks in order to ensure that the banks remained well capitalized and had ample liquidity throughout the crisis.

And with collectively hundreds of billions in deposits, trillions in loans outstanding ($1.3 trillion in residential mortgages alone) and more than 300,000 employees nationwide, it’s no exaggeration to say that the stability of the banking system is the most critical factor in weathering an economic crisis.

However, because of the rapid equity market and economic recovery that we’ve witnessed since the outbreak began, the Covid crisis took only a brief toll on bank earnings and balance sheets. For many quarters now, there has been a spectacular rise in bank profits and, equally important, a slashing of loan-loss provisions. In fact, the Big Five banks’ Tier 1 capital ratios, which are a measure of the banks’ core capital (e.g., retained earnings) relative to some of its riskier assets (e.g., mortgages), are averaging 12.9%, well above the 9% minimum currently mandated by regulators.

Many analysts, including myself, believe that it’s simply a matter of time before OSFI green-lights the banks to freely deploy their capital again. I thought OSFI might have given the thumbs-up before the banks reported fiscal Q3 results a few weeks ago, but unfortunately this didn’t happen. It’s now looking like the announcement will come in the fall. And given, as I mentioned, that banks historically raise dividends at a 6% annual pace and we’re approaching 20 months now since the last bank dividend hikes, it’s likely that the upcoming dividend increases will be double-digit, perhaps even as high as 15% for some banks. That’s a lot more cash that will soon to be making its way into the hands of bank investors.

It’s been a good year for Canadian banks, and I understand the argument that these potential dividend increases may already be priced in, but bank valuations aren’t stretched, indicating that investors aren’t factoring in excessive good news. And, in my experience, catalysts are rarely fully priced in until they’re actually announced. Besides, there remains that strong correlation between bank dividends and bank share prices:

Canadian bank dividends are share prices are strongly correlated.

Source: Turner Investments, FactSet (Click to enlarge)

But regardless of whether higher dividends act as a price catalyst, it certainly hasn’t been a bad thing to have held Canadian banks in your portfolio over the long term (via a diversified ETF, of course). The performance history supports this:

Canadian banks have averaged double-digit annual returns for the past decade

Source: Turner Investments, FactSet

OSFI’s a conservative, slow-moving regulatory behemoth. All the proof you need of that is to simply pronounce its full name a few times. It’s a mouthful. And if you still don’t believe it’s conservative and slow moving, be reminded that it’s also a federal government institution.

However, as slow moving as it may be, I believe OSFI’s now very close to removing those dividend restrictions, and when it does, look out: a monster dividend wave is likely coming.

Grab your boards.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.