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A Big Yield at a Bargain Price?

It’s hard out there for value-conscious income investors. Sure, if you already own a portfolio of dividend stocks, you’re probably having quite a year.

Utilities, for instance, are up an astonishing 22.9% so far, even after giving back nearly 2 points during Thursday’s market session. Not bad for a sector that’s designed to deliver annual returns of 8% to 10%.

Real estate investment trusts (REITs) are up 13.7%. Blue-chip dividend payers have generated a 10.6% return.

And even master limited partnerships (MLPs) have returned 12.6%, despite the nearly apocalyptic conditions the energy-oriented sector faced at the outset of the year.

Meanwhile, the S&P 500 is barely back in the black, with a paltry 2.6% gain.

Yes, if you had the good fortune to be fully allocated to solid dividend payers, you’re sitting easy while just about every other investor is a nervous wreck.

But if you’ve got idle cash you’re looking to invest, this situation presents a real conundrum. That’s because many of our favorite dividend payers trade at premium valuations.

Unfortunately, these valuations are ultimately due to fear, not fundamentals. Concerns about global growth have been further exacerbated by the so-called Brexit, which will likely force the world’s central banks to keep rates lower for longer.

Such worries, in turn, have caused investors to pile into safe havens such as bonds, driving yields to what were previously thought to be impossible lows.

For instance, the yield on the benchmark 10-year Treasury hit an all-time low this week, briefly touching 1.32%. Similar bonds issued by governments in Europe and Asia are actually trading with negative yields. Yes, negative!

Consequently, the normally staid land of dividend stocks is dealing with a sudden influx of what some jokingly refer to as bond tourists—investment professionals who ordinarily focus on fixed income, but are suddenly chasing dividend-paying stocks for yield. They’ve not only driven up bond prices, they’re now also driving up the prices of dividend stocks.

Eventually, the usual relationship between dividend stocks and the broad market will reassert itself. So obviously you don’t want to buy in at a premium, just to get clobbered a few months hence.

At the same time, many income investors can’t afford to keep cash idle. After all, we don’t actually know how long we’ll have to wait for bargains to emerge, or at least stocks to trade at a more reasonable price.

One possible solution: Go north, income investor!

Bargain Hunting in the Great White North

Many Canadian companies are even more dedicated to dividends than their U.S. counterparts. Equally important, the Canadian dollar currently trades just below US$0.77, which means you’re already starting out with a significant discount (just a few years ago, the loonie traded at parity with the greenback).

Of course, a lot of Canadian stocks are expensive right now, too. Nevertheless, there’s one high yielder with an intriguing story that currently trades with a forward price-to-earnings ratio (P/E) of just 12.0x. That’s downright cheap compared to the broad Canadian market, at 21.7x, U.S. utilities, at 20.0x, and even the S&P 500, at 19.4x.

Exchange Income Corp. (TSX: EIF, OTC: EIFZF) is a small Canadian buyout firm that specializes in the aviation and specialty manufacturing sectors.

Similar in philosophy to Warren Buffett, management likes to partner with companies that already have strong executive teams. And while EIF works with each company to help grow their business, its subsidiaries largely operate independently and retain their own branding.

In identifying targets for acquisition, management takes a long-term perspective toward its investments by looking for profitable, well-established companies that generate strong, dependable cash flows that are immediately accretive and, therefore, support EIF’s payout.

Management’s disciplined approach to acquisitions is best summarized in its own words:

“Our approach to acquisitions is straightforward, but not easy. We look for the right company in the right market at the right price with the right management team.”

“That takes patience. It takes effort. It takes time. Everything has to add up just right. It’s why we sometimes walk away from deals.”

Since its initial public offering (IPO) in late 2002, this C$859 million company has built its portfolio by acquiring 13 companies, with seven companies operating in the aviation sector and six in the manufacturing sector. Portfolio companies operate in niche markets across the U.S. and Canada.

When most folks think of the airline industry, the long-term operating woes of many of the behemoths come to mind. But small, regional carriers that focus on underserved areas tend to be far more profitable. EIF’s aviation segment is comprised of four regional carriers that offer scheduled service to such areas in Canada. Additionally, these airlines also provide charter flights, cargo flights, and medical transportation among their services.

Early last year, EIF acquired regional carrier Provincial Aerospace Ltd. for C$246 million, its biggest deal to date. The acquisition, which further diversifies EIF’s operating geography, seems to not only be a synergistic fit, but also a game changer by giving a huge boost to revenue and earnings.

The six companies in the specialty manufacturing segment are a diverse set, including a firm that builds towers for wireless communications, a company that manufactures custom tanks for energy transportation, and a subsidiary that designs and manufactures pressure-washing equipment.

Last year’s acquisition of Ben Machine Products actually overlaps with both of the company’s segments—the firm manufactures complex precision-machined parts for the aerospace and defense industries.

Based on 2015 numbers, EIF derives about 76% of revenue from its aviation segment and 24% from its manufacturing segment. Just a few years ago, those numbers were flipped, so investors should expect EIF’s portfolio to continue evolving over time.

Analysts forecast earnings per share will climb 17% this year, to C$2.44, on revenue growth of 11%, to C$897.8 million.

Although the stock currently trades near an all-time high, EIF’s strong growth prospects could mean further appreciation in the share price. Analysts’ consensus 12-month target price is C$36.44, which suggests potential appreciation of 17.3% above the current share price.

EIF has grown its dividend by about 4% annually over the past five years, and its shares currently have a forward yield of 6.4%.

Of course, high yield doesn’t come without high risk, but it’s worth considering partnering with these shrewd investors.


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Stock Talk

Tom

Tom

Hi Ari. I picked up EIC when you wrote this and it’s up 29%. But with such good results lately, I’m wondering it seems to be stalled. Has anything changed since you wrote this? Thanks!

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