In This Issue

NEW LIFE FOR THE INSURERS

By Gordon Pape

The past few years have been nightmarish for the big life insurance companies. The crash of 2008-09 hit them especially hard, knocking down their share prices by more than 75% in some cases.

The woes of the industry have been well-documented. Aggressive competition in the early part of this century resulted in the creation of high-risk products which came back to haunt the companies when the credit crunch hit. Low interest rates sliced returns on their big bond portfolios while falling stock prices battered their equity holdings. Profits dwindled to the vanishing point as the companies scrambled desperately to regroup, withdrawing most of their riskier products from the market and selling off assets.

How bad did it get? Look no further than Manulife Financial (TSX, NYSE: MFC). In late 2007, it was trading at over $42 a share. By the first week of March 2009, it had plunged to below $10 – a loss of more than 75%. It was a humbling experience for what had once been regarded as a blue-chip stock. The company was forced to cut its dividend in half and undertake a major reorganization while recording huge losses. A year ago, you could still buy the shares in the $11 range. Now, Manulife finally seems to be on the way back, with the stock closing at C$17.30, US$16.38 on Friday.

Although Sun Life Financial (TSX, NYSE: SLF) never cut its dividend, its share price was equally battered. In December 2007 it was trading in the C$55 range. Fifteen months later it was below $16 for a loss of more than 70%. Like Manulife, it went through a long period of regrouping and the stock is finally on the upswing again, closing on Friday at C$31.62, US$29.94.

It was the same story – in some cases even worse – with the big U.S. insurance firms. AIG International Group (NYSE: AIG) was the most dramatic example, almost going under during the crash as its stock plummeted. The company only survived with the aid of a US$85 billion bailout from the Federal Reserve Board, the largest government bailout of a private company in U.S. history. Today the company is profitable again and the price is back in the US$44 range.

Like their Canadian counterparts, U.S. insurers have benefitted from the rise in interest rates, which improves returns from their bond portfolios. But they have also enjoyed good gains on the equity side as all the American indexes are in double-digit profit territory so far this year. We’re seeing this reflected in their stock prices, which are on the rise in almost every case.

MetLife (NYSE: MET), the largest life insurance company in the U.S., saw its share price drop from US$71 in October 2007 to US$12.22 in the first week of March 2009 – a loss of more than 80%. However, the company never applied for a federal government bail-out and in November 2010 it scooped up American Life Insurance Company (Alico) from AIG for what today looks like a bargain price of US$16.4 billion. Alico was one of the largest and most diversified international insurance companies in the world and the first foreign life insurance company licensed to sell in Japan. The acquisition transformed MetLife into a global life insurance and employee benefits powerhouse, with 90 million customers in more than 50 countries.

Today, MetLife is comfortably back in the black, its stock is trading at a 52-week high of US$47.52, and the company’s prospects going forward appear strong.

First-quarter results beat analysts’ estimates with the company reporting operating earnings of $1.6 billion ($1.48 per share, figures in U.S. dollars), up 12% over the first quarter of 2012. The importance of the Alico acquisition was reflected in the results as operating earnings in Asia increased 11% (12% on a constant currency basis) and while they grew by 21% (17% constant currency) in Europe, the Middle East and Africa (EMEA). Net income for the quarter was $956 million ($0.87 per share).

A week before the results came out, MetLife announced a whopping dividend increase of 48.6%, a sure sign that management and the directors are confident about the company’s future. It was the first increase since 2007 and it brought the quarterly payment to $0.275 per share ($1.10 annually) for a yield of 2.3% based on the current price. CEO Steven A. Kandarian commented that the move “makes our dividend more competitive and demonstrates our commitment to delivering value to shareholders.”

Even at the higher level, the payout ratio is only in the 20% range, leaving room for more dividend increases in the future.

The share price has moved up about 20% since the beginning of May but I think there is a lot more upside potential here over the medium to longer term. We do not have a life insurance company on our U.S. Primary Core list so I am adding MetLife with a one-year target of $52 on the shares.

Action now: Buy MetLife at $47.52.

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THE MARKET OVERREACTS – BIG TIME!

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Contributing editor Tom Slee is back this week with his thoughts on the big drops we have seen in the stock and bond markets in recent weeks and some suggestions on what to do now. Tom is a former professional money manager who looked after billions of dollars in pension fund money during his career. Here is his report.

Tom Slee writes:

Like most fundamentalists, I was astonished by the markets’ response to the news that the U.S. Federal Reserve Board may begin tapering off its quantitative easing (QE) program later this year.

Fed Chairman Ben Bernanke’s decision to rein in his stimulus was a vote of confidence in the recovery. After pouring US$3 trillion of freshly printed, highly inflationary, money into the system, the central bank has signaled it is prepared to step aside. It means the recovery is self-supporting.

Investors should have been delighted at the announcement. Instead, bond and stock prices plummeted. There was panic. People acted like junkies as the Fed suggested it might yank away their low interest rates – not immediately but in the months to come.

Five weeks later, the markets are still volatile and uncertain. Widespread selling continued and an initial overreaction developed into a major market correction. Most important, the mood has altered. Investors have lost a lot of their confidence. But has anything basically changed? Here is what happened.

In late May, the S&P/TSX Composite Index was at 12,900 and the S&P 500 had climbed to 1,670. Analysts were confidently forecasting another two years of rising stock prices. There were some big question marks but the bull market was intact. A lot of stocks represented good value. As a matter of fact, on May 21 the S&P 500 was trading at 16.3 times reported earnings. That was 16% below the average multiple since 1998.

Then, as we all know, the Federal Reserve stated that it would gradually rein in its quantitative easing program. Incidentally, the central bank had withdrawn the program once before in 2010 and there had been little fanfare or investor reaction. This time, though, there was widespread alarm. Interest rates were going to rise. The longest bond bull market on record was over.

U.S. Treasury bond yields spiked but that was to be expected. They had been artificially suppressed. As I write, 10-year U.S. government bonds are paying 2.6%, up 53% from 1.7% at the beginning of May. That may seem like a startling move but keep in mind that government traders had distorted the market. We are now adjusting to normal levels.

Everybody knew that this would happen. Dr. Jared Bernstein, economic advisor to Vice President Joe Biden, said it best: “As day follows night, key sectors such as housing improve, the economy strengthens, the Fed pares back and interest rates go up&”. Exactly!

Bonds sold off, of course, but the stock market carnage is difficult to explain. Why did share prices plunge? There were no fundamental changes in June. As a matter of fact, some of the economic indicators, such as durable goods orders, are now looking better. Stock markets, however, are still being battered. As I write, the TSX Composite is down 7.5% from the May 21 level and the S&P 500 is off 81 points. European and Asian markets have also been falling since the Fed’s announcement. Even worse, investors are now much more pessimistic. The glass is half empty. It makes little sense.

Dividend stocks

The end of quantitative easing should have boosted confidence. Instead we have reached a stage where, as one commentator pointed out, any bad news gives stocks a lift because investors hope that it will make Mr. Bernanke change his mind. Of course, bonds and, to some extent, REITs were bound to weaken but stocks should be benefitting from a strengthening recovery. The flight from defensive income stocks is particularly odd, almost bizarre. Canadian pipelines have sold off and the Dow Jones Utility Average has shed 10% since April 30. CNN had a glaring headline that said: “The Dividend Craze May Be Over.&”

This is a massive overreaction and is bound to create some excellent buying opportunities. I had expected to see some downward pressure on dividend paying stocks as money managers adjusted their portfolios. Because of the prolonged low interest rates, a great deal of institutional fixed-income money had ended up in utilities and trusts. This is being switched back into bonds and a lot of actuaries are breathing easier. Performance-driven managers are also selling defensive issues and buying cyclical stocks. The selling, however, has continued. We have seen a mass exodus.

The problem, I suspect, is that because of the prolonged low interest rates people have begun to regard dividend paying stocks as hybrid bonds, quasi fixed-income issues. Nothing could be further from the truth. For a start, most of these stocks are growth situations and likely to do very well in the new environment. Take banks for example. A new BMO report points out that Canadian banks will welcome rising interest rates. An orderly increase should open their profit margins and ease the current squeeze on returns from commercial loans. Demand for credit should improve. Insurance companies will also generate more profit as their huge bond portfolios start producing more income. Major dividend paying corporations will prosper and increase their distributions as the economy picks up.

My point is that this is not the time to abandon dividend paying stocks, quite the contrary. Every study shows that these investments provide better returns than the general market. A recent Goldman Sachs White Paper showed that since 1926 dividends have accounted for more than 40% of the total return on the S&P 500 Index. Ned Davis Research Inc., a research firm in Florida, conducted a survey that showed dividend payers generating an annual return of 8.76% from January 1972 to December 2012. The S&P 500 Total Return Index provided a 7.05% return with much higher volatility during the same period. I could go on but there is every indication that dividend paying stocks will participate fully in any market growth.

Preferred shares

That having been said, I do think the end of quantitative easing will radically change the outlook for preferred shares. These stocks will feel the full impact of rising interest rates therefore this is a good time to review your holdings and perhaps rebalance the portfolio.

Canadian preferred shares are extremely sensitive to interest rate fluctuations. The truth is they are even more vulnerable than bonds. To give you an example, if interest rates rise 1% the price of a 20-year-bond yielding 5% will decline about 11.5%. However, because there is no maturity date, a straight (perpetual) preferred share that yields 5% will drop approximately 14%. Preferred share prices are already starting to slide.

We have another problem. Normally when interest rates start rising investors switch from straight preferred shares to reset or floating rate issues that have dividends linked to Prime or Government of Canada bond yields. That way they are protected. In Canada, though, these flexible issues are few and far between. The entire Canadian preferred share market, which has doubled in size during the last seven years, still totals a little more than $60 billion.

Moreover, almost 34% of the issues are perpetual, only 3% are true floaters, and 58% are reset shares. There is not a lot of room to maneuver.

However, if you shop carefully, it’s possible to find preferred shares that will suit your needs. With perpetual issues you can earn about 5% compared to 2.25% from a 10-year bond. This may still be a good move if interest rates move sideways and then only gradually move higher. True, floating rate preferreds are an option but they yield about 2% On the other hand, it’s possible to buy a reset issue that pays 3.5% and gives you access to a better return at some time in the future.

Following are updates on the preferred shares that we currently recommend. I would like to point out that our policy during the last few years has been to stay with top-quality perpetual issues because interest rates were likely to remain low. That proved correct and my feeling is that after the initial surge rates are still likely to remain well below traditional levels for some considerable time. If I am wrong and they start to move up rapidly the chances are that the Fed will start buying bonds and drive them down again.

TOM SLEE’S PREFERRED SHARE UPDATES

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BCE First Preferred Shares Series Y (TSX: BCE.PR.Y)

Originally recommended on Jan. 11/10 (#20102) at $19.40. Closed Friday at $24.10.

The BCE Series Y Preferred Shares are trading at $24.10 and currently paying a $0.75 dividend to yield 3.1%. This is equivalent to 4.4% from a bond in a non-registered account after adjustment for the dividend tax credit. Rated Pfd 3 (high), stable by Dominion Bond Rating Service (DBRS), these are secure investments with a floating dividend that provides a return equal to 80% of Prime (currently 3%).

Based on a $25 par value, the present $0.75 dividend provides a 3% yield, rather than the 2.4% required by the formula so we may not see an upward adjustment in the distributions until Prime increases significantly.

Nevertheless the Series Y provides protection against rising interest rates. One caveat – BCE can call the issue at any time at a price of $25.50. So do not chase the shares up above this level and expose yourself to a possible capital loss.

Action now: BCE Series Y Preferred Shares are a Buy at $24.10 for income and some growth.

Bombardier Series 4 Preferred Shares (TSX: BBD.PR.C)

Originally recommended on March 8/04 (#2510) at $25.01. Closed Friday at $24.20.

These are to some extent a special situation. Priced at $24.20 and paying a $1.562 dividend, they yield 6.45%, equal to about 9% from a bond in a non-registered account. The handsome return is because DBRS has issued a Pfd 4 rating as a result of Bombardier’s erratic earnings. The company can call the shares at any time at a price of $25 and the feeling is that if DBRS ever upgrades the shares, management will exercise its option and refinance at a lower rate.

The odd thing is that while Series 4 is a straight issue, its high yield provides some protection against rising rates. It will be a long time before we see corporate bonds paying 9%.

Action now: Bombardier Series 4 Preferred Shares remain a Buy at $24.20 for investors seeking above average income who are able to assume some risk.

George Weston 5.25% Series 3 Preferred Shares (TSX: WN.PR.C)

Originally recommended on Nov. 11/11 (#21144) at $25.24. Closed Friday at $24.28.

The George Weston 5.25% Series 3 Preferred Shares are a straight (perpetual) issue. Trading at $24.28 and paying a $1.30 dividend, they yield a well above average 5.35%. With a DBRS rating of Pfd 3 (midway between Pfd 1, the highest, and Pfd 5) it means the dividends and principal are adequately protected. The shares are, however, vulnerable now that interest rates are rising.

My feeling is that after the initial surge, rates will move up very slowly and the Weston Series 3’s excellent yield is going to remain attractive for a long time. Nevertheless, there is the danger that the market price will slip as investors move away from perpetual issues. Keep in mind that Weston can call the shares at $25 after July 1, 2014.

Action now: George Weston Series 3 Preferreds become a Hold for investors seeking secure above average income. Those looking for some growth as well should consider selling their positions.

Enbridge Series A Preferred Shares (TSX: ENB.PR.A)

Originally recommended on Jan. 10/05 (#2502) at $26.30. Closed Friday at $24.90.

These Enbridge preferred shares have remained firm despite the spike in rates. Priced at $24.90, the shares pay a $1.375 dividend and yield 5.52%, equal to about 7.8% from a bond in a non-registered account. The company can call the issue at a price of $25. A DBRS rating of Pfd 2(low) means that the shares have substantial protection.

Here again we have a relatively simple straight preferred share issue that is now likely to decline in market value as long term interest rates increase, although I would expect a gradual weakening rather than a sell-off.

Action now: Enbridge Series A Preferred Shares become a Hold at $24.90. Investors concerned about a possible capital loss should reduce their positions.

Power Financial 5.5% Series D Preferred Shares (TSX: PWF.PR.E)

Originally recommended on April 5/05 (#2502) at $25.85. Closed Friday at $25.00.

This is another perpetual issue. Priced at $25 and paying a $1.375 dividend, these shares yield 5.5%. The company can call them at $25.

We added the Series D to our Buy List in April 2005 for reliable, above average income. Since then, through a worldwide financial collapse and prolonged recession, they have delivered. Now, however, the shares are likely to decline in value as interest rates increase. The dividend remains safe.

Action now: The Power Financial Series D Preferred Shares become a Hold for income. Investors concerned about being locked in with an unrealized loss should reduce their positions.

TD Bank 4.85% Series 0 Preferred Shares (TSX: TD.PR.O)

Originally recommended on Nov. 11/11 (#21144) at $25.80. Closed Friday at $25.23.

Finally, the TD Bank 4.85% Series 0 Preferred Shares are trading at $25.23 and pay a $1.21 dividend to yield 4.8%. The bank can redeem the shares at $25 after Oct. 31, 2014. They carry the highest ratings from DBRS and Standard & Poor’s.

The yield remains attractive but these perpetual shares are vulnerable despite their extremely good quality. We could see the shares moving gradually lower.

Action now: TD Bank Series O Preferred Shares become a Hold at $25.23.

– end Tom Slee

MUTUAL FUND REFORM EDGES CLOSER

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Slowly – painstakingly slowly – we are edging towards what could be a complete overhaul of the way mutual funds are sold in Canada.

With consumer advocacy groups facing off against industry associations, the move away from the current system, with its inherent conflicts of interest, is not a sure thing. But regulators are pushing hard for reform, citing precedents in Great Britain and Australia as examples of the ideal goal.

At the core, there are two fundamental issues at stake.

The first is dealer compensation. Right now, anyone who sells you a mutual fund receives two forms of payment: a commission from the initial sale and an annual trailer fee for as long as you retain the units. The trailer fee is supposed to be the fund industry’s way of compensating financial professionals for the advice they render.

Not all funds carry both expenses. No-load funds, such as those purchased at your local bank, charge no up-front sales commission although most do pay trailer fees. Only a few companies, such as Vancouver-based Steadyhand and Leith Wheeler, have neither sales commissions nor trailers.

As a first step, Canada’s securities regulators are proposing to have all fees shown in terms of actual dollars spent on year-end statements. That way, investors will be able to see how much they are actually paying for mutual fund “advice” – and decide whether it is worth it.

But that’s only a stop-gap measure, at least if investor advocates get their way. The end game is to eliminate trailer fees entirely, a move that is being vigorously fought by the industry.

The second issue is one of responsibility. Polls show the majority of investors believe their financial advisers are legally required to act in their best interests. This is not the case. An adviser’s only requirement is to ensure an investment is appropriate for the client. It may not be the best security of its type, or the cheapest, but as long as it is deemed to be appropriate the adviser has done what is required.

The potential conflicts of interest are obvious. An adviser may recommend a U.S. equity fund as a good choice for a client. The idea may be perfectly valid. But there is nothing to prevent an adviser from suggesting a load fund that offers better compensation instead of a no-load fund that pays little or nothing in trailer fees. Both are suitable under current standards. But in the case of the latter fund, the adviser gets a better payday while the client may lose out because higher expenses translate into reduced returns.

Investor advocates want regulators to implement a system of fiduciary responsibility similar to that which exists between lawyers and clients. This means an adviser would be required to put the client’s interest first in any recommendation, regardless of the personal cost to him.

Last month, the Ontario Securities Commission (OSC) held a round-table discussion to examine these ideas. Predictably, there were heated exchanges on both sides. Investment Executive, the trade newspaper of the advisory community, quoted Greg Pollack, CEO of Advocis, an association of financial advisors, as saying that if the proposals were adopted “financial advice would become unaffordable, and therefore inaccessible to the average Canadian”. Joanne De Laurentiis, head of the Investment Funds Institute of Canada, took a similar stance, claiming such moves would either force small investors to pay higher fees or squeeze them out of the market leaving them with no advice at all.

Obviously, the industry is going to do everything is can to prevent these changes from ever coming into effect.

However, the Canadian Securities Administrators, an umbrella group for Canada’s provincial and territorial securities commissions, seems determined to effect some meaningful, change this time around. The problem is that it is taking far too long to achieve results to satisfy investor advocates.

“Canadian investors cannot afford this slow pace of reform,” commented the Investor Advisory Panel of the OSC. “Justice delayed is justice denied…We need to move beyond talking.”

Right on! All the arguments are now on the table. It’s time for our regulators to take action. – G.P.

GORDON PAPE’S UPDATES

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Shaw Communications (TSX: SJR.B, NYSE: SJR)

Originally recommended on Feb. 4/08 (#2805) at C$20.53, US$20.64. Closed Friday at C$25.03, US$23.72.

Shaw isn’t an exciting company but it continues to churn out good results and the latest numbers beat expectations.

For the 2013 fiscal third quarter (to May 31), the Calgary-based cable and broadcasting company reported consolidated revenue of $1.33 billion, up 4% from the same period a year ago. Free cash flow was $138 million, down from $203 million last year. However, for the first nine months of the fiscal year cash flow increased from $379 million in 2012 to $543 million.

Net income was $250 million ($0.52 per share) compared to $248 million ($0.53 per share) for the same period last year. For the first nine months of the year, net income was $667 million ($1.40 per share), up from $628 million ($1.34 per share) a year ago. The company said that the improvement in net income was due to increased operating income and a gain on the sale of the Hamilton cable system partially offset by increased income taxes.

In an announcement of special interest to income-oriented investors, the company said that the board of directors plans to aim for dividend increases of between 5% and 10% over each of the next two years. CEO Brad Shaw said this commitment was made possible by the improvement in free cash flow and “continued favourable market conditions”.

Shaw is one of the few companies to pay a monthly dividend, which is currently $0.085 per share or $1.02 annually. That translates into a yield of 4.1% based on the current price. If the company were to increase the payout by the mid-point of its announced range (7.5%) the annual dividend by 2015 would be about $1.18 per share. Based on the current price, that would increase the yield to 4.7%. This is important because it offers some share price protection against rising interest rates.

Despite the attractive dividend and the two-year commitment, analysts don’t see much upside potential in the stock over the next year. RBC Capital Markets recently raised its price target to $24 but that is actually below where the shares are currently trading. So Shaw should be considered as strictly a yield play at present. As a result, I do not advise taking new positions at current levels.

Action now: Shaw is a Hold for investors seeking steady income.

Brookfield Asset Management (TSX: BAM.A, NYSE: BAM)

Originally recommended on April 7/97 (#9713) at C$6.13 (split-adjusted). Closed Friday at C$37.41, US$35.45.

Brookfield’s shares were hit by the sell-off although they held up somewhat better than the broad market. Part of the reason may have been the June 16 announcement that the company is selling its interests in Longview Timber and Longview Fibre Paper and Packaging in two separate transactions for a total of $3.675 billion (figures in U.S. dollars).

Analysts saw the deal as a big win for Brookfield, which purchased Longview in 2007 for $1.6 billion plus $500,000 in assumed debt. In a research report by a team led by analyst Neil Downey, RBC Capital Markets said the deal, expected to close in the third quarter, could generate net cash of about $850 million for BAM.

Longview Timber is being sold to Weyerhaeuser Co., also an IWB recommendation, for $2.65 billion including the assumption of debt. Its assets include about 645,000 acres of prime timberland in the U.S. Pacific Northwest.

Longview Fibre Paper and Packaging is being bought by KapStone Paper and Packaging for $1.025 billion. Longview operates a large integrated paper mill in Washington State and seven container plants in the Pacific Northwest. It produces Kraft paper, container board and corrugated boxes.

The RBC report suggests that the deals are part of Brookfield’s strategy to begin harvesting profits from some of the non-core investments made in recent years and suggests there may be more sales to follow.

In May, the company reported first-quarter financial results, highlighted by a 34% increase in funds from operations (FFO) to $689 million ($1.03 per share).

“Our financial results reflect increases in a number of our operations including significant contributions from housing related businesses and an increased contribution from asset management and other service activities,” the company said in a statement. “We also benefitted from improved pricing in our renewable power operations, contributions from recent capital expansion projects in our infrastructure operations and favorable rental growth in our property portfolios.”

Action now: Buy. Take advantage of the pull-back to add to positions. – G.P.

That’s all for this week. We’ll be back on July 15.

Best regards,

Gordon Pape

In This Issue

NEW LIFE FOR THE INSURERS

By Gordon Pape

The past few years have been nightmarish for the big life insurance companies. The crash of 2008-09 hit them especially hard, knocking down their share prices by more than 75% in some cases.

The woes of the industry have been well-documented. Aggressive competition in the early part of this century resulted in the creation of high-risk products which came back to haunt the companies when the credit crunch hit. Low interest rates sliced returns on their big bond portfolios while falling stock prices battered their equity holdings. Profits dwindled to the vanishing point as the companies scrambled desperately to regroup, withdrawing most of their riskier products from the market and selling off assets.

How bad did it get? Look no further than Manulife Financial (TSX, NYSE: MFC). In late 2007, it was trading at over $42 a share. By the first week of March 2009, it had plunged to below $10 – a loss of more than 75%. It was a humbling experience for what had once been regarded as a blue-chip stock. The company was forced to cut its dividend in half and undertake a major reorganization while recording huge losses. A year ago, you could still buy the shares in the $11 range. Now, Manulife finally seems to be on the way back, with the stock closing at C$17.30, US$16.38 on Friday.

Although Sun Life Financial (TSX, NYSE: SLF) never cut its dividend, its share price was equally battered. In December 2007 it was trading in the C$55 range. Fifteen months later it was below $16 for a loss of more than 70%. Like Manulife, it went through a long period of regrouping and the stock is finally on the upswing again, closing on Friday at C$31.62, US$29.94.

It was the same story – in some cases even worse – with the big U.S. insurance firms. AIG International Group (NYSE: AIG) was the most dramatic example, almost going under during the crash as its stock plummeted. The company only survived with the aid of a US$85 billion bailout from the Federal Reserve Board, the largest government bailout of a private company in U.S. history. Today the company is profitable again and the price is back in the US$44 range.

Like their Canadian counterparts, U.S. insurers have benefitted from the rise in interest rates, which improves returns from their bond portfolios. But they have also enjoyed good gains on the equity side as all the American indexes are in double-digit profit territory so far this year. We’re seeing this reflected in their stock prices, which are on the rise in almost every case.

MetLife (NYSE: MET), the largest life insurance company in the U.S., saw its share price drop from US$71 in October 2007 to US$12.22 in the first week of March 2009 – a loss of more than 80%. However, the company never applied for a federal government bail-out and in November 2010 it scooped up American Life Insurance Company (Alico) from AIG for what today looks like a bargain price of US$16.4 billion. Alico was one of the largest and most diversified international insurance companies in the world and the first foreign life insurance company licensed to sell in Japan. The acquisition transformed MetLife into a global life insurance and employee benefits powerhouse, with 90 million customers in more than 50 countries.

Today, MetLife is comfortably back in the black, its stock is trading at a 52-week high of US$47.52, and the company’s prospects going forward appear strong.

First-quarter results beat analysts’ estimates with the company reporting operating earnings of $1.6 billion ($1.48 per share, figures in U.S. dollars), up 12% over the first quarter of 2012. The importance of the Alico acquisition was reflected in the results as operating earnings in Asia increased 11% (12% on a constant currency basis) and while they grew by 21% (17% constant currency) in Europe, the Middle East and Africa (EMEA). Net income for the quarter was $956 million ($0.87 per share).

A week before the results came out, MetLife announced a whopping dividend increase of 48.6%, a sure sign that management and the directors are confident about the company’s future. It was the first increase since 2007 and it brought the quarterly payment to $0.275 per share ($1.10 annually) for a yield of 2.3% based on the current price. CEO Steven A. Kandarian commented that the move “makes our dividend more competitive and demonstrates our commitment to delivering value to shareholders.”

Even at the higher level, the payout ratio is only in the 20% range, leaving room for more dividend increases in the future.

The share price has moved up about 20% since the beginning of May but I think there is a lot more upside potential here over the medium to longer term. We do not have a life insurance company on our U.S. Primary Core list so I am adding MetLife with a one-year target of $52 on the shares.

Action now: Buy MetLife at $47.52.

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THE MARKET OVERREACTS – BIG TIME!

Contributing editor Tom Slee is back this week with his thoughts on the big drops we have seen in the stock and bond markets in recent weeks and some suggestions on what to do now. Tom is a former professional money manager who looked after billions of dollars in pension fund money during his career. Here is his report.

Tom Slee writes:

Like most fundamentalists, I was astonished by the markets’ response to the news that the U.S. Federal Reserve Board may begin tapering off its quantitative easing (QE) program later this year.

Fed Chairman Ben Bernanke’s decision to rein in his stimulus was a vote of confidence in the recovery. After pouring US$3 trillion of freshly printed, highly inflationary, money into the system, the central bank has signaled it is prepared to step aside. It means the recovery is self-supporting.

Investors should have been delighted at the announcement. Instead, bond and stock prices plummeted. There was panic. People acted like junkies as the Fed suggested it might yank away their low interest rates – not immediately but in the months to come.

Five weeks later, the markets are still volatile and uncertain. Widespread selling continued and an initial overreaction developed into a major market correction. Most important, the mood has altered. Investors have lost a lot of their confidence. But has anything basically changed? Here is what happened.

In late May, the S&P/TSX Composite Index was at 12,900 and the S&P 500 had climbed to 1,670. Analysts were confidently forecasting another two years of rising stock prices. There were some big question marks but the bull market was intact. A lot of stocks represented good value. As a matter of fact, on May 21 the S&P 500 was trading at 16.3 times reported earnings. That was 16% below the average multiple since 1998.

Then, as we all know, the Federal Reserve stated that it would gradually rein in its quantitative easing program. Incidentally, the central bank had withdrawn the program once before in 2010 and there had been little fanfare or investor reaction. This time, though, there was widespread alarm. Interest rates were going to rise. The longest bond bull market on record was over.

U.S. Treasury bond yields spiked but that was to be expected. They had been artificially suppressed. As I write, 10-year U.S. government bonds are paying 2.6%, up 53% from 1.7% at the beginning of May. That may seem like a startling move but keep in mind that government traders had distorted the market. We are now adjusting to normal levels.

Everybody knew that this would happen. Dr. Jared Bernstein, economic advisor to Vice President Joe Biden, said it best: “As day follows night, key sectors such as housing improve, the economy strengthens, the Fed pares back and interest rates go up&”. Exactly!

Bonds sold off, of course, but the stock market carnage is difficult to explain. Why did share prices plunge? There were no fundamental changes in June. As a matter of fact, some of the economic indicators, such as durable goods orders, are now looking better. Stock markets, however, are still being battered. As I write, the TSX Composite is down 7.5% from the May 21 level and the S&P 500 is off 81 points. European and Asian markets have also been falling since the Fed’s announcement. Even worse, investors are now much more pessimistic. The glass is half empty. It makes little sense.

Dividend stocks

The end of quantitative easing should have boosted confidence. Instead we have reached a stage where, as one commentator pointed out, any bad news gives stocks a lift because investors hope that it will make Mr. Bernanke change his mind. Of course, bonds and, to some extent, REITs were bound to weaken but stocks should be benefitting from a strengthening recovery. The flight from defensive income stocks is particularly odd, almost bizarre. Canadian pipelines have sold off and the Dow Jones Utility Average has shed 10% since April 30. CNN had a glaring headline that said: “The Dividend Craze May Be Over.&”

This is a massive overreaction and is bound to create some excellent buying opportunities. I had expected to see some downward pressure on dividend paying stocks as money managers adjusted their portfolios. Because of the prolonged low interest rates, a great deal of institutional fixed-income money had ended up in utilities and trusts. This is being switched back into bonds and a lot of actuaries are breathing easier. Performance-driven managers are also selling defensive issues and buying cyclical stocks. The selling, however, has continued. We have seen a mass exodus.

The problem, I suspect, is that because of the prolonged low interest rates people have begun to regard dividend paying stocks as hybrid bonds, quasi fixed-income issues. Nothing could be further from the truth. For a start, most of these stocks are growth situations and likely to do very well in the new environment. Take banks for example. A new BMO report points out that Canadian banks will welcome rising interest rates. An orderly increase should open their profit margins and ease the current squeeze on returns from commercial loans. Demand for credit should improve. Insurance companies will also generate more profit as their huge bond portfolios start producing more income. Major dividend paying corporations will prosper and increase their distributions as the economy picks up.

My point is that this is not the time to abandon dividend paying stocks, quite the contrary. Every study shows that these investments provide better returns than the general market. A recent Goldman Sachs White Paper showed that since 1926 dividends have accounted for more than 40% of the total return on the S&P 500 Index. Ned Davis Research Inc., a research firm in Florida, conducted a survey that showed dividend payers generating an annual return of 8.76% from January 1972 to December 2012. The S&P 500 Total Return Index provided a 7.05% return with much higher volatility during the same period. I could go on but there is every indication that dividend paying stocks will participate fully in any market growth.

Preferred shares

That having been said, I do think the end of quantitative easing will radically change the outlook for preferred shares. These stocks will feel the full impact of rising interest rates therefore this is a good time to review your holdings and perhaps rebalance the portfolio.

Canadian preferred shares are extremely sensitive to interest rate fluctuations. The truth is they are even more vulnerable than bonds. To give you an example, if interest rates rise 1% the price of a 20-year-bond yielding 5% will decline about 11.5%. However, because there is no maturity date, a straight (perpetual) preferred share that yields 5% will drop approximately 14%. Preferred share prices are already starting to slide.

We have another problem. Normally when interest rates start rising investors switch from straight preferred shares to reset or floating rate issues that have dividends linked to Prime or Government of Canada bond yields. That way they are protected. In Canada, though, these flexible issues are few and far between. The entire Canadian preferred share market, which has doubled in size during the last seven years, still totals a little more than $60 billion.

Moreover, almost 34% of the issues are perpetual, only 3% are true floaters, and 58% are reset shares. There is not a lot of room to maneuver.

However, if you shop carefully, it’s possible to find preferred shares that will suit your needs. With perpetual issues you can earn about 5% compared to 2.25% from a 10-year bond. This may still be a good move if interest rates move sideways and then only gradually move higher. True, floating rate preferreds are an option but they yield about 2% On the other hand, it’s possible to buy a reset issue that pays 3.5% and gives you access to a better return at some time in the future.

Following are updates on the preferred shares that we currently recommend. I would like to point out that our policy during the last few years has been to stay with top-quality perpetual issues because interest rates were likely to remain low. That proved correct and my feeling is that after the initial surge rates are still likely to remain well below traditional levels for some considerable time. If I am wrong and they start to move up rapidly the chances are that the Fed will start buying bonds and drive them down again.

TOM SLEE’S PREFERRED SHARE UPDATES

BCE First Preferred Shares Series Y (TSX: BCE.PR.Y)

Originally recommended on Jan. 11/10 (#20102) at $19.40. Closed Friday at $24.10.

The BCE Series Y Preferred Shares are trading at $24.10 and currently paying a $0.75 dividend to yield 3.1%. This is equivalent to 4.4% from a bond in a non-registered account after adjustment for the dividend tax credit. Rated Pfd 3 (high), stable by Dominion Bond Rating Service (DBRS), these are secure investments with a floating dividend that provides a return equal to 80% of Prime (currently 3%).

Based on a $25 par value, the present $0.75 dividend provides a 3% yield, rather than the 2.4% required by the formula so we may not see an upward adjustment in the distributions until Prime increases significantly.

Nevertheless the Series Y provides protection against rising interest rates. One caveat – BCE can call the issue at any time at a price of $25.50. So do not chase the shares up above this level and expose yourself to a possible capital loss.

Action now: BCE Series Y Preferred Shares are a Buy at $24.10 for income and some growth.

Bombardier Series 4 Preferred Shares (TSX: BBD.PR.C)

Originally recommended on March 8/04 (#2510) at $25.01. Closed Friday at $24.20.

These are to some extent a special situation. Priced at $24.20 and paying a $1.562 dividend, they yield 6.45%, equal to about 9% from a bond in a non-registered account. The handsome return is because DBRS has issued a Pfd 4 rating as a result of Bombardier’s erratic earnings. The company can call the shares at any time at a price of $25 and the feeling is that if DBRS ever upgrades the shares, management will exercise its option and refinance at a lower rate.

The odd thing is that while Series 4 is a straight issue, its high yield provides some protection against rising rates. It will be a long time before we see corporate bonds paying 9%.

Action now: Bombardier Series 4 Preferred Shares remain a Buy at $24.20 for investors seeking above average income who are able to assume some risk.

George Weston 5.25% Series 3 Preferred Shares (TSX: WN.PR.C)

Originally recommended on Nov. 11/11 (#21144) at $25.24. Closed Friday at $24.28.

The George Weston 5.25% Series 3 Preferred Shares are a straight (perpetual) issue. Trading at $24.28 and paying a $1.30 dividend, they yield a well above average 5.35%. With a DBRS rating of Pfd 3 (midway between Pfd 1, the highest, and Pfd 5) it means the dividends and principal are adequately protected. The shares are, however, vulnerable now that interest rates are rising.

My feeling is that after the initial surge, rates will move up very slowly and the Weston Series 3’s excellent yield is going to remain attractive for a long time. Nevertheless, there is the danger that the market price will slip as investors move away from perpetual issues. Keep in mind that Weston can call the shares at $25 after July 1, 2014.

Action now: George Weston Series 3 Preferreds become a Hold for investors seeking secure above average income. Those looking for some growth as well should consider selling their positions.

Enbridge Series A Preferred Shares (TSX: ENB.PR.A)

Originally recommended on Jan. 10/05 (#2502) at $26.30. Closed Friday at $24.90.

These Enbridge preferred shares have remained firm despite the spike in rates. Priced at $24.90, the shares pay a $1.375 dividend and yield 5.52%, equal to about 7.8% from a bond in a non-registered account. The company can call the issue at a price of $25. A DBRS rating of Pfd 2(low) means that the shares have substantial protection.

Here again we have a relatively simple straight preferred share issue that is now likely to decline in market value as long term interest rates increase, although I would expect a gradual weakening rather than a sell-off.

Action now: Enbridge Series A Preferred Shares become a Hold at $24.90. Investors concerned about a possible capital loss should reduce their positions.

Power Financial 5.5% Series D Preferred Shares (TSX: PWF.PR.E)

Originally recommended on April 5/05 (#2502) at $25.85. Closed Friday at $25.00.

This is another perpetual issue. Priced at $25 and paying a $1.375 dividend, these shares yield 5.5%. The company can call them at $25.

We added the Series D to our Buy List in April 2005 for reliable, above average income. Since then, through a worldwide financial collapse and prolonged recession, they have delivered. Now, however, the shares are likely to decline in value as interest rates increase. The dividend remains safe.

Action now: The Power Financial Series D Preferred Shares become a Hold for income. Investors concerned about being locked in with an unrealized loss should reduce their positions.

TD Bank 4.85% Series 0 Preferred Shares (TSX: TD.PR.O)

Originally recommended on Nov. 11/11 (#21144) at $25.80. Closed Friday at $25.23.

Finally, the TD Bank 4.85% Series 0 Preferred Shares are trading at $25.23 and pay a $1.21 dividend to yield 4.8%. The bank can redeem the shares at $25 after Oct. 31, 2014. They carry the highest ratings from DBRS and Standard & Poor’s.

The yield remains attractive but these perpetual shares are vulnerable despite their extremely good quality. We could see the shares moving gradually lower.

Action now: TD Bank Series O Preferred Shares become a Hold at $25.23.

– end Tom Slee

MUTUAL FUND REFORM EDGES CLOSER

Slowly – painstakingly slowly – we are edging towards what could be a complete overhaul of the way mutual funds are sold in Canada.

With consumer advocacy groups facing off against industry associations, the move away from the current system, with its inherent conflicts of interest, is not a sure thing. But regulators are pushing hard for reform, citing precedents in Great Britain and Australia as examples of the ideal goal.

At the core, there are two fundamental issues at stake.

The first is dealer compensation. Right now, anyone who sells you a mutual fund receives two forms of payment: a commission from the initial sale and an annual trailer fee for as long as you retain the units. The trailer fee is supposed to be the fund industry’s way of compensating financial professionals for the advice they render.

Not all funds carry both expenses. No-load funds, such as those purchased at your local bank, charge no up-front sales commission although most do pay trailer fees. Only a few companies, such as Vancouver-based Steadyhand and Leith Wheeler, have neither sales commissions nor trailers.

As a first step, Canada’s securities regulators are proposing to have all fees shown in terms of actual dollars spent on year-end statements. That way, investors will be able to see how much they are actually paying for mutual fund “advice” – and decide whether it is worth it.

But that’s only a stop-gap measure, at least if investor advocates get their way. The end game is to eliminate trailer fees entirely, a move that is being vigorously fought by the industry.

The second issue is one of responsibility. Polls show the majority of investors believe their financial advisers are legally required to act in their best interests. This is not the case. An adviser’s only requirement is to ensure an investment is appropriate for the client. It may not be the best security of its type, or the cheapest, but as long as it is deemed to be appropriate the adviser has done what is required.

The potential conflicts of interest are obvious. An adviser may recommend a U.S. equity fund as a good choice for a client. The idea may be perfectly valid. But there is nothing to prevent an adviser from suggesting a load fund that offers better compensation instead of a no-load fund that pays little or nothing in trailer fees. Both are suitable under current standards. But in the case of the latter fund, the adviser gets a better payday while the client may lose out because higher expenses translate into reduced returns.

Investor advocates want regulators to implement a system of fiduciary responsibility similar to that which exists between lawyers and clients. This means an adviser would be required to put the client’s interest first in any recommendation, regardless of the personal cost to him.

Last month, the Ontario Securities Commission (OSC) held a round-table discussion to examine these ideas. Predictably, there were heated exchanges on both sides. Investment Executive, the trade newspaper of the advisory community, quoted Greg Pollack, CEO of Advocis, an association of financial advisors, as saying that if the proposals were adopted “financial advice would become unaffordable, and therefore inaccessible to the average Canadian”. Joanne De Laurentiis, head of the Investment Funds Institute of Canada, took a similar stance, claiming such moves would either force small investors to pay higher fees or squeeze them out of the market leaving them with no advice at all.

Obviously, the industry is going to do everything is can to prevent these changes from ever coming into effect.

However, the Canadian Securities Administrators, an umbrella group for Canada’s provincial and territorial securities commissions, seems determined to effect some meaningful, change this time around. The problem is that it is taking far too long to achieve results to satisfy investor advocates.

“Canadian investors cannot afford this slow pace of reform,” commented the Investor Advisory Panel of the OSC. “Justice delayed is justice denied…We need to move beyond talking.”

Right on! All the arguments are now on the table. It’s time for our regulators to take action. – G.P.

GORDON PAPE’S UPDATES

Shaw Communications (TSX: SJR.B, NYSE: SJR)

Originally recommended on Feb. 4/08 (#2805) at C$20.53, US$20.64. Closed Friday at C$25.03, US$23.72.

Shaw isn’t an exciting company but it continues to churn out good results and the latest numbers beat expectations.

For the 2013 fiscal third quarter (to May 31), the Calgary-based cable and broadcasting company reported consolidated revenue of $1.33 billion, up 4% from the same period a year ago. Free cash flow was $138 million, down from $203 million last year. However, for the first nine months of the fiscal year cash flow increased from $379 million in 2012 to $543 million.

Net income was $250 million ($0.52 per share) compared to $248 million ($0.53 per share) for the same period last year. For the first nine months of the year, net income was $667 million ($1.40 per share), up from $628 million ($1.34 per share) a year ago. The company said that the improvement in net income was due to increased operating income and a gain on the sale of the Hamilton cable system partially offset by increased income taxes.

In an announcement of special interest to income-oriented investors, the company said that the board of directors plans to aim for dividend increases of between 5% and 10% over each of the next two years. CEO Brad Shaw said this commitment was made possible by the improvement in free cash flow and “continued favourable market conditions”.

Shaw is one of the few companies to pay a monthly dividend, which is currently $0.085 per share or $1.02 annually. That translates into a yield of 4.1% based on the current price. If the company were to increase the payout by the mid-point of its announced range (7.5%) the annual dividend by 2015 would be about $1.18 per share. Based on the current price, that would increase the yield to 4.7%. This is important because it offers some share price protection against rising interest rates.

Despite the attractive dividend and the two-year commitment, analysts don’t see much upside potential in the stock over the next year. RBC Capital Markets recently raised its price target to $24 but that is actually below where the shares are currently trading. So Shaw should be considered as strictly a yield play at present. As a result, I do not advise taking new positions at current levels.

Action now: Shaw is a Hold for investors seeking steady income.

Brookfield Asset Management (TSX: BAM.A, NYSE: BAM)

Originally recommended on April 7/97 (#9713) at C$6.13 (split-adjusted). Closed Friday at C$37.41, US$35.45.

Brookfield’s shares were hit by the sell-off although they held up somewhat better than the broad market. Part of the reason may have been the June 16 announcement that the company is selling its interests in Longview Timber and Longview Fibre Paper and Packaging in two separate transactions for a total of $3.675 billion (figures in U.S. dollars).

Analysts saw the deal as a big win for Brookfield, which purchased Longview in 2007 for $1.6 billion plus $500,000 in assumed debt. In a research report by a team led by analyst Neil Downey, RBC Capital Markets said the deal, expected to close in the third quarter, could generate net cash of about $850 million for BAM.

Longview Timber is being sold to Weyerhaeuser Co., also an IWB recommendation, for $2.65 billion including the assumption of debt. Its assets include about 645,000 acres of prime timberland in the U.S. Pacific Northwest.

Longview Fibre Paper and Packaging is being bought by KapStone Paper and Packaging for $1.025 billion. Longview operates a large integrated paper mill in Washington State and seven container plants in the Pacific Northwest. It produces Kraft paper, container board and corrugated boxes.

The RBC report suggests that the deals are part of Brookfield’s strategy to begin harvesting profits from some of the non-core investments made in recent years and suggests there may be more sales to follow.

In May, the company reported first-quarter financial results, highlighted by a 34% increase in funds from operations (FFO) to $689 million ($1.03 per share).

“Our financial results reflect increases in a number of our operations including significant contributions from housing related businesses and an increased contribution from asset management and other service activities,” the company said in a statement. “We also benefitted from improved pricing in our renewable power operations, contributions from recent capital expansion projects in our infrastructure operations and favorable rental growth in our property portfolios.”

Action now: Buy. Take advantage of the pull-back to add to positions. – G.P.

That’s all for this week. We’ll be back on July 15.

Best regards,

Gordon Pape