Is the lag in Dividend Paying Stocks versus the TSX behind us?

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1 November 1 st, 2013 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaMcLeod Senior Portfolio Manager, with responsibility for advising the Anchor Is the lag in Dividend Paying Stocks versus the TSX behind us? Stock Market Outlook As described later in this Note, we put the moderate amount of cash reserves in our funds to work when it appeared very likely that there would be a short term resolution of the U.S. government shutdown and the U.S. debt ceiling. Since that time, North American equity markets have moved up sharply with the TSX leading the S & P 500 in terms of performance in October. Between now and year end, we are optimistic that the TSX will continue to outperform the S & P 500. Why would this be? The primary reason is that the TSX has breached the 13,000 mark for the first time since 2011 when it actually hit a peak for the year of 14,200 in April. Clearing the 13,000 resistance level should provide impetus to institutional managers to put more money to work in Canadian equities at least between now and year end. Not that we have pretensions to have technical expertise on markets but we have observed over the years that when an index rises in parabolic fashion and gets well ahead of its 200-day moving average (MA), a correction can be in the offing. For example, on May 22, 2013, the S & P 500 was trading over 12 % above its 200-day average. This was followed by a quick 6.5 % correction although the index thereafter has continued to rise in a somewhat parabolic fashion. Currently, the S & P 500 is trading at about 9 % above its 200-day MA and, we believe is, at risk for a correction of indeterminate extent (the TSX is just over 6 % above its 200-day MA). Is the lag in dividend paying stocks versus the TSX behind us? In an Anchor Note this summer, we examined how a number of the key dividend paying sectors of the TSX has suffered more than the overall market in a period of sharply rising long term interest rates. Will this continue? This Note looks at whether or not this underperformance might continue. i) Shorter term a) The bond market After Fed Chairman Ben Bernanke first mentioned the topic of tapering on May 22, 2013 U.S. 10-year Treasury bond yields rose an incredible 60 % in the space of about six weeks, peaking at 3%. Since that peak, U.S. Government 10-year yields have pulled back to a current level of 2.5 %.With tapering likely off the table until at least March and weak Q4 U.S. GDP growth and disappointing payroll numbers, we see a likely 2.0 % % trading range for the 10-year Treasury yield over the next several months. Government of Canada 10-year bond yields (currently at 2.4 %) are likely to have a similar, although slightly lower, trading range, in

2 our view, over the same time frame. This would represent a benign competitive environment for Canadian dividend paying stocks. b) Recent performance of TSX GIC s TSX GICS Sector Jun 30 - Sep 30 % Chg. Sep 30 - Oct 29 % Chg. Jun 30 - Oct 29 % Chg. Consumer Staples 3.32% 4.57% 8.75% Materials 4.54% 3.06% 8.13% Financials 7.44% 5.89% 14.13% Consumer Discretionary 8.32% 4.80% 14.23% Energy 6.59% 3.15% 10.41% Health Care 10.88% 7.35% 20.44% Utilities -3.09% 5.86% 2.78% Industrials 3.37% 9.38% 13.73% Telecommunications 6.02% 4.22% 11.27% Information Technology 6.24% -0.01% 6.96% Source Bloomberg Markets The TSX has risen by a sharp 5.1 % for October to date and 10.8 % to October 29 from mid-year. The above table shows that the TSX s performance since mid-year has been driven by the financials, industrials, consumer discretionary, telco s and healthcare (the latter group however, has a minimal weighting in the TSX). For October to date, financials, industrials, healthcare and utilities have been the outperformers. The first two groups performance has recently benefited from a number of the banks hitting all-time highs and CN Rail and CP Rail producing Q3 EPS well ahead of consensus estimates. The recovery on the bond market has helped the utilities of late. ii) Longer term factors a) Demographics North American Retirement Assets According to the Investment Company Institute (ICI), U.S. retirement assets grew from $10.5 trillion in 2002 to $19.5 trillion in 2012 or by 6.4 % per year. These assets covered defined benefit plans, federal state and local pension plans, defined contribution plans (chiefly 401K) and IRA s. The fastest growth has been in IRA s, which has averaged 7.5 % per year and, as at the end of 2012 totalled $5.4 trillion. IRA s are most akin to Canadian RRSP s although the maximum contribution to the former is $6,500 for 2013 while the Canadian maximum is $23,820. We could only get Canadian figures for RRSP s from 1999 to 2011 (source: Statistics Canada and CBC). RRSP s during this longer period grew by 5.5 % per year slower than the 2002 to 2012 growth rate for U.S. IRA s. In all likelihood, we think the difference is probably accounted for by the different base years was close to the bull market peak in North American equity markets whereas the end of 2002 marked close to the bottom of the 2 year bear market. (Note: according to ICI, participants in their survey in their twenties held 74 % of their 401K s in equities while 60-year olds held 48 % at the end of 2011) Our guess is that growth rates for like periods for Canadians and Americans in individual retirement accounts would have been very similar. However, given the size of the U.S. and Canadian economies (the latter being roughly one tenth of the former), the amount of

3 assets in RRSP s is relatively much higher than in IRA s ($775 billion versus $4.9 trillion at the end of 2011). The Canadian individual retirement scheme started significantly earlier than the U.S. programme. As demonstrated above, retirement assets are already growing strongly in both the U.S. and Canada. However, these growth rates are likely to accelerate as a result of the baby boomers getting to the asset accumulation stage in their careers. Typically that stage starts when someone reaches 50. The peak in the baby boom took place around 1960 and so that bulge of potentially higher investment asset accumulation just started around 2010 and has a good number of years to run. Investors in the 50 plus age category will be looking for income growth in the longer term. As mentioned above, the ICI data shows that participants in 401K s in their sixties held 48% of their assets in equities. This was in a period of declining long term interest rates. With the backup in long term bond yields of 100 basis points since May 2013 and the outlook for rates to normalize at higher levels over the next number of years, the relative appeal to this growing segment of future retirees of equities producing sustainable and growing income will look increasingly attractive relative to bonds. b) The power of dividend growth We have long been preaching the attraction of quality dividend paying companies with the ability to increase their dividends with some measure of predictability. To illustrate the value of such holdings, we would site two companies that we own in our portfolios currently namely Enbridge and National Bank. If an investor had bought Enbridge and National Bank ten years ago, their approximate current yield on original cost would be 10.6% and 9.3% respectively. The very high and rewarding current dividend yield on the cost of purchase ten years ago is a function of the strong dividend growth of each. In the case of Enbridge, the dividend growth has averaged 11.7 % per year over the ten years and in the case of National Bank, 11.8 %. In addition, there have been strong capital gains in each case: over the ten years, Enbridge s shares have increased in value by over two and a half times while National Bank shares have more than doubled. A key part of our investment discipline is the calculation of the earnings, cash flow, free cash flow and dividend growth for each company in our equity universe for the next three to five years. We particularly concentrate on these metrics in our regular face to face interviews with senior management of those companies. Since we do this work for every company we follow, we are also able to calculate the growth in these metrics in particular for EPS and dividends per share for each of our portfolios by applying the appropriate weighting of each holding in the portfolio. In sum we believe the strategy that we have been pursuing in the Anchor funds of emphasizing quality bonds and stocks and, in particular equities with strong balance sheets and predictable free cash flow and dividend growth will combine a potential decent upside with moderate risk c) Competitiveness of equities against bonds in Canada We believe the strategy that we have been pursuing in our portfolios of emphasizing quality bonds and stocks and, in particular, equities with strong balance sheets and predictable free cash flow and dividend growth will combine a potential decent upside with moderate risk. Other than for a brief period in Q and in 2012 and the early part of this year, TSX dividend yields have not been at, close to, or above Government of Canada 30-year bond yields since the late 1950 s. The previous time dividend

4 yields were above bond yields a strong bull market followed through the sixties primarily in growing income generating stocks. This is exemplified in the chart below, which underlines how competitive Canadian stocks are against bonds from the point of view of income at least: Source Bloomberg Markets

5 Portfolio changes Earlier this year, we sold our holding in Enbridge on the basis that valuations had become excessive (it had been selling at a high 25 times P/E). However, subsequently, it had fallen in price while earnings per share continued to grow strongly. We thus repurchased it following our interview with ENB management in Calgary with the shares selling at roughly 21 times earnings at the low end of its P/E multiple range over the last couple of years. In addition, the Company calculates a dividend discount model based on its strategic plan for the next five years ( ) and a 10 % dividend growth rate from , of which it is very confident based on its tilted return profile, and thereafter a growth rate of 5 %. On the assumption of an equity discount rate of 8.5 %, this would provide a present fundamental value of $57 per share. When we purchased the stock, the discount to the fundamental value was about 25 % or roughly double what it has averaged historically. The shares were purchased in our Anchor Dividend Growth and High income funds. In addition, in our Anchor Dividend Growth fund, we added a new position in Fortis, which we had similarly sold earlier this year at higher levels in advance of the increase in long term interest rates. EPS have moved largely sideways over the last couple of years. However, we expect acceleration in 2014/2015 EPS on the strength of higher allowable returns, principally in the West and an improved contribution from the hydro segment. These purchases consumed the bulk of our cash reserves in each fund. Nick Majendie, CA Director, Wealth Management Senior Portfolio Manager Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of Scotia Capital Inc., is the manager of the Anchor. ScotiaMcLeod, a division of Scotia Capital Inc. is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaMcLeod, provides portfolio advice to the Funds. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaMcLeod or on Anchor hold securities of the following issuers referred to in this note: Enbridge, National Bank Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: Enbridge, National Bank This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaMcLeod, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice.