Though inflation and rising rates have dominated the headlines this year, it was not that long ago that investors were scrambling for income through a decade of low interest rates. Realizing the appetite for yield, many companies increased their dividend by any means necessary, hoping to become attractive income options for investors.
One such company is Algonquin Power & Utilities Corp (AQN), of which the Globe & Mail recently declared, “Algonquin’s days as a dividend growth darling are over.”
While on the surface AQN seemed to be the ideal company for our approach, we sold it from our Canadian high dividend growth strategy in 2018 (ETF ticker: BGC). We believe the sale highlighted how Bristol Gate’s integrated human + machine approach led to a better long-term outcome for investors.
At the time of sale, our dividend growth prediction model continued to forecast attractive dividend growth for the company. Yet, our portfolio managers became concerned about several trends: operating cash flow per share was stagnant despite significant investment in the business and the company needed the capital markets to finance that investment.
Exhibit 1: Algonquin Operating Metrics
Source: Bristol Gate Capital Partners, Canalyst, FactSet
These characteristics were not consistent with those we seek in our investments and our portfolio managers concluded the dividend growth was not sustainable.
After we sold the shares, Algonquin continued to grow its dividend (8.9% compound annual growth rate from 2018-2022) and its shares performed well as the renewable energy sector took off. However, the trends our portfolio managers had identified continued and the company’s payout ratio increased substantially along with its leverage.
We avoid companies with poor returns on investment and a reliance on capital markets to continually fund their business models. Today, market turbulence has raised the cost of issuing debt or equity to prohibitive levels for many companies, including AQN.
Since 2020, our machine learning model’s predictions for the company’s dividend growth have been on a downward trend. By the end of September this year, our predictions had become markedly negative, confirming our team’s fundamental work.
Exhibit 2: Algonquin Power & Utilities Corp. Dividend Prediction History
Source: Bristol Gate Capital Partners, FactSet
Bristol Gate’s investment strategy is built on buying businesses that are poised to substantially grow their dividend over the next 12 months and beyond. Where many dividend investing strategies focus on a security’s dividend yield today, we have our eyes firmly on what lies beyond the horizon. We think our process and focus on sustainable dividend growth is a more sustainable investment strategy that ultimately leads to attractive long-term returns for our clients and partners.
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