Investment Thesis
Recently we have made the decision to try to include around 5-10% of preferred shares in our income-oriented family portfolio. The primary goal of this portfolio is to generate reliable dividend income of at least 4% annually and I’d argue that an allocation to preferred shares could help us achieve this goal.
I have found preferred shares of Manulife Financial Corporation (NYSE:MFC), which seem promising. Of course, one should never invest into preferred shares blindly, before doing due diligence on the common stock.
I view Manulife as a healthy company that has a lot of potential going forward, in particular:
- It’s time-proven – it was founded over a 130 years ago in 1887
- It’s very present in Asia (including China, Hong-Kong and Japan) which gives it access to the fastest growing and largest (in terms of potential amount of clients) market in the world.
- It has an A management team that cares about shareholders as they continue to aggressively buy back stock (details follow)
- It has significantly better margins than its competition
- It has an A rated balance sheet with a very healthy LICAT ratio
While the common stock makes for a good investment in itself, I also like two series of preferred shares – in particular Series 11 and Series 25 as they provide an opportunity to “play the yield curve” and get a fixed dividend yield of almost 7% while also providing solid upside in case the macroeconomic situation stabilises and rates decrease.
Manulife Overview
Manulife Financial Corporation is a multinational insurance and financial services company that operates in Canada, Asia, and the United States. The company has approximately CAD 1.5 trillion in assets under management and administration, making it one of the largest life insurance companies in the world.
In terms of segment presence, Manulife has a strong presence in the Canadian market, where it generates approximately 41% of its revenue. The company also has a significant presence in Asia, where it generates 47% of its revenue and has a growing customer base across several key markets, including China, Hong Kong, Japan, the Philippines, and Vietnam. The remaining revenue (12%) is generated in the United States. Manulife’s diverse portfolio includes a range of insurance and wealth management products and services, including life insurance, health insurance, annuities, and mutual funds.
Manulife Financials
2022 has been a difficult year for many companies mainly due to a tough macroeconomic environment and increasing interest rates, and MFC is no exception. Their core earnings fell by 14% compared to the previous year, mainly due to provisions for the Hurricane Ian (one time major event which cost the company CAD256 Million / almost USD200 Million) and poor performance in the US, mainly driven lower new business gains. Still the company generated a solid core return on equity of 10.3% (though this was down from 12.0% last year)
The company has an A rated balance sheet and a very solid LICAT (Life Insurance Capital Adequacy Test) Ratio of 134%. The Ratio has declined slightly over the past year, but still stands much higher than the regulatory requirement of at least 90%, meaning the company is very well capitalized. (For comparison SLF has a LICAT ratio of 129% which is still excellent).
MFC has a decent track record of increasing dividends as they have increased dividends for 9 years in a row (including through the pandemic) with a CAGR of 10%. The company has a relatively low payout ratio of 39% and currently pays a dividend yield of 5.2%. This is quite enticing, but as you’ll see the preferred shares offer an even higher and safer yield.
Management has a history of returning wealth to shareholders, not only through dividends, but also share buy-backs. In 2022, the company has repurchased about $1 Billion worth of their own stock. With a market cap of $37 Billion, this represents just under 3% of shares, thus increasing shareholder value.
I also want to highlight that MFC has significantly higher margins than its biggest competitor Sun Life Financial and this gives the company significant pricing power, which will become increasingly important if we start to experience disinflation or perhaps even deflation. This is because as prices start to decrease or at least don’t increase as fast, companies will be pressured to reduce their prices at a time when their costs are not yet decreasing (a good example are wages which are sticky). This can put serious pressure on margins and it’s therefore essential to look at companies that have the highest potential margins, because those will be the ones that make it through these tough times in the best shape. An EBITDA margin of almost 50% (compared to 20% of SLF) is a great advantage for Manulife.
Preferred Shares
Preferred shares are a hybrid security that offer a combination of features from both stocks and bonds. They pay a fixed dividend, similar to a bond, but also offer potential capital appreciation, like a stock. The advantage of preferred shares is in their seniority in a company’s capital structure. In the event of a financial crisis, preferred shareholders are paid before common shareholders. This makes preferred shares less risky than common stocks, as there is a higher likelihood of receiving the dividend payments. Moreover, it is often the case that the yield on a series of preferred shares is higher than that of common stock. This higher yield obviously usually comes at the expense of lower upside during bull markets.
Because of these characteristics an investing legend Benjamin Graham argues against blindly investing into preferred shares in his best selling book The Intelligent Investor:
Preferred stocks are often considered to be less risky than bonds and more attractive than common stocks. While this may be true in some cases, in my view, preferred stocks are not a particularly good investment. They lack the growth potential of common stocks and are subject to interest rate and credit risks, making them more volatile than bonds.
I would never argue with Graham, and agree that in general preferred shares have no reason to be superior to common stock, but I believe that a well selected security that fits ones investment objectives might enhance portfolio performance under certain conditions.
Manulife Preferred Shares
Manulife has at least a dozen series of preferred shares, each with a complex set of characteristics. I have selected two series in particular, that I believe will provide superior safe returns over the next 5 years.
- Series 11 – ticker MFC.PRJ
- Series 25 – ticker MFC.PRQ
Both of these series are structured in a very similar way. They are Non-Cumulative Rate Reset shares. They currently pay a quarterly dividend of 5.6% and 5.8%, respectively (compared to 5.2% for common stock). This dividend is fixed and will be paid until the Reset Date. This is when a new dividend will be determined based on pre-determined rules. The Reset Date is on March 19, 2023 for Series 11 and on June 19, 2023. These dates are important because the new dividend will be calculated on those dates as the 5-year yield on Canadian Government debt that day + a premium equal to 2.61% for Series 11 and 2.55% for Series 25. Importantly the nominal dividend will be calculated by multiplying this rate by $25. But since both of these shares are currently trading well below $25, the dividend yield that you will get could be quite high. Lastly, the shares are redeemable by MFC on each Reset Day for $25. The selection of the series then depends on your view when yields peak. Personally, I allocated a small position into both.
Currently the 5-year yield on Government Debt stands at 3.05%. It is near impossible to predict what the bond market will do in the future. Sure the Federal Reserve and consequently also Bank of Canada will probably raise the funds rate a couple more times, but the exact effect this will have on 5-yr yields is unclear. So for the purpose of my calculation I assume that the yield remains at today’s level until Reset Day for both securities.
Dividend on Series 11 will equal (3.05% + 2.61%) * $25.00 = $1.415. The share trades at $21.40 making your yield on cost 6.6%, fixed for the next 5 years (until the next Reset Day when this calculation will be done again). Dividend on Series 25 will equal (3.05% + 2.55%) * $25.00 = $1.4. The share trades at $20.25 making your yield on cost 6.9%. These expected yields are far higher than what you get on common stock and should also be safer given the nature if preferred shares.
With the next Reset Date exactly 5 years after the first one, the total performance will depend greatly on how yields evolve, which in-turn will depend on the macroeconomic situation. I consider these scenarios:
- If rates decrease, the stock price will likely increase significantly, as the fixed high dividend yield becomes more valuable in a low interest rate environment. Then at some point, as the next Reset Day approaches and investors anticipate a reduction in dividend, the price will likely trend down again. So in this scenario it might be a good idea to close the position in say 2-3 years.
- If rates stay high for a prolonged period of time, perhaps until the next Reset Date in 5 years, you will be earning a solid yield and the preferred share price should move with the common stock. In this scenario I think it’s a good idea to hold on to the share.
Either way, I like this play because I think it provides a safe dividend for the foreseeable future, with potential upside should rates decrease (a gradual decrease in rates through 2024 is my base case). Frankly this is not a security you want to buy and forget as it might make sense to sell in a couple years depending on how yields evolve.
A quick note. Although MFC can be bought with a US ticker, these preferred shares are only traded on TSX in Canada. This can have tax implications for some investors so I encourage you to do your research on this before investing.
Risks to Consider
By now you probably see what the risk is. Apart from risk related to the common stock doing poorly, there is a risk that you buy the share today in anticipation of a Reset Day and a high dividend and yields drop between now and Reset Day leaving you with a not so high yield and a preferred share that no one wants at that point (so likely a price drop). I honestly consider this risk slim to none, especially for Series 11, as the Central banks remain focused on fighting inflation. Then, when you lock in the yield, there’s the risk that rates will not fall fast enough to get the upside in the stock, but will fall in exactly the wrong moment, where the next Reset Date (2028) is too close and the share price will drop in anticipation of a dividend decrease. This is a complex security and should be treated as such, ideally actively managed.
Takeaway
Preferred shares can enhance dividend yield and might be a good idea for some income-oriented investors whose goal is to live of the portfolio yield as they arguably provide safer yield than common stock. Over the long term, common shares will most likely provide a greater total return, but if you’re anything like me and want to add safe yield to your actively managed portfolio, consider adding some preferred shares.
Two series of Manulife preferred shares in particular (Series 11 and 25) seem interesting and depending on exact yield curve dynamics over the next 5 months are very likely provide a safe dividend yield of almost 7%, fixed for 5 years. I rate both securities as a (Speculative) “BUY”.
Investors can expect a solid dividend yield and upside if yields declined within the next year or two. The securities are quite complex so I would caution inexperienced investors, who are not 100% comfortable with the dynamics, against entering into big positions on these shares and looking at the common shares of MFC instead.
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