Challenges face Canadian equity funds

Although European policy-makers seem unable to reach consensus, Snow argues that: “One way or the other, these things have to be resolved. It’s hard to say how bad things will get before they resolve the issues. But that’s also why I’m holding a decent amount of cash — to be ready when the resolution comes about.” Cash accounts for 22% of CI fund’s assets under management. “We don’t know when [the crisis in Europe] will end, but we want to have our wish list ready. This macro ‘noise’ does not affect every company. But their stock prices are affected. You have to be prepared to put the cash to work when everyone is running for the exits.”

Snow shares portfolio-management duties with Bob Swanson and Alan Radlo (who also is CI’s chief investment officer). There are about 50 names in the CI fund, and about 60% of the CI fund’s AUM is in Canadian companies, with 16% in U.S. firms.

One top holding is Brookfield Infrastructure Partners LP, a spinoff from Brookfield Asset Management Inc. “[It] recently raised $650 million in equity and has the capacity of about $1 billion to make acquisitions,” says Snow. “With the deleveraging going on in Europe, and stricter capitalization requirements for the banks, there are probably interesting properties in the infrastructure space that will come out at attractive prices. [Brookfield] will be able to take advantage of the situation because [it has] the relationships and the capital to put to work.” Brookfield Infrastructure stock trades on the New York Stock Exchange at about US$25 ($26.25) a share and has a 1.5% dividend yield. Snow has no stated target.

Another top holding is Onex Corp., a diversified firm. “[Onex buys] strong brands and niche companies that maybe are not the best managed,” says Snow. “Then, [Onex] partners with management or existing employees and takes the company to the next level. It’s a case of finding that hidden value.” Onex also has about $1.3 billion in cash. “It’s looking for opportunities in the marketplace, what with the way valuations that are contracting. When you add it all up, the stock is cheap.” Onex shares are trading at about $32.90 apiece.

 

Prospects are murky at best, says Daniel Dupont, a portfolio manager in Montreal with Pyramis Global Advisors LLC (a unit of Fidelity Investments Canada ULC of Toronto) who oversees Fidelity Canadian Large Cap Fund.

“But things are always murky,” he says. “The mid-1970s looked very bleak; and in 1982, everyone was depressed about equities. There are always things to worry about. Sometimes, we put too much emphasis on them and, sometimes, we put too much emphasis on the wrong things.”

Dupont argues that forecasting is extremely difficult, no matter what has happened in the recent past. “Better to expect the unexpected,” says Dupont. “But the correlation between gross domestic product growth and stock market returns is exactly zero.” For instance, he notes, in the 17 years that ended in 1981, U.S. GDP growth went up by 400%, while the Dow Jones industrial average rose by precisely 0.1%. By contrast, U.S. GDP growth was almost 400% for the 17 years ended 1998, yet the DJIA rose by 1,000%.

In 1981, Dupont notes, profits were low, and so were multiples. By 1998, profits were high, as were stock valuations. “Sometimes,” he says, “focusing too much on things that sound commonsensical takes us away from the only things that matter: a stock’s cheapness and sustainability of the business you are buying.”

As a consequence, Dupont focuses on stocks that are cheaper than the broad index, have better than average balance sheets and better returns on capital, and are likely to continue to be superior businesses.

Running a 35-name portfolio for the Fidelity fund, Dupont has a modest 9% of the fund’s AUM in energy companies but avoids base-metals firms. In their place, Dupont favours companies such as Fairfax Financial Holdings Ltd. that, unlike other insurance firms, have short-term products and can reprice them every year. Says Dupont: “[Fairfax] won’t get crushed by the weight of lower rates in offering 30- to 50-year guarantees.”

Moreover, Fairfax is headed by Prem Watsa, who has a successful track record. Lately, Watsa has bet heavily, in contrast to other financial services institutions, that the economy will become deflationary. Fairfax’s share price is about $418, and the stock trades at 1.04 times book value. There is no stated target.

With about 43% of the Fidelity fund’s AUM in foreign content, Dupont likes BP PLC, the Britain-based energy company. “BP has obviously been impacted by the Gulf of Mexico issues [in 2010] and is trading below six times earnings. But [BP is] moving past that slowly. Over time, the payments [BP has] to make will be small enough and far enough into the future that BP can still thrive.” The NYSE-listed stock is trading at about US$39.40 ($41.40) a share and has a 4.2% dividend yield.

Equally reluctant to make market calls is Clayton Zacharias, portfolio manager with Toronto-based Invesco Canada Ltd. and lead manager on Invesco’s Trimark Canadian Endeavor Fund: “We’re not economists, nor do we try to predict the market. The way we manage money is very much a bottom-up, fundamental process, in which we typically own 12 to 15 Canadian companies, and a total of 20 to 30 names. Nor do we care about the Canadian market overall; rather, we care about a small group of firms in our portfolio.”

Zacharias shares duties with portfolio manager Mark Uptigrove. Because of their belief that the Canadian market is too narrow and concentrated in cycli-cal businesses, almost 50% of the Trimark fund’s AUM is in foreign content, with about half of that in U.S. companies. There also is 10% in cash, compared with 20% in the summer. Most of that cash had been deployed during the market decline, with the portfolio managers adding to existing names and acquiring a few new ones.

One holding that has been beefed up is Thomson Reuters Corp., the global financial information firm. “It’s one of the rare examples in which Canada has a world-class business, both in [Thomson Reuter’s] legal and markets business. It has a very strong global franchise,” says Zacharias. “But its markets business is tied to the global financial services industry, and part of that is tied to head count at global banks. The headlines of [layoffs at global banks] will have a negative impact on Thomson Reuters. But our view is that the market has more than discounted that headwind.” A long-term holding, Thomson Reuters stock is trading at about $27.40 a share and has a 4.8% dividend yield.

Another favourite is Interna-tional Rectifier Corp., a California-based producer of semiconduc-tors. “Whether it’s in cars or washing machines that use variable-speed motors,” says Zacharias, “you need semiconductors to provide a greater level of efficiency. International Rectifier is one of the leaders in this area. Market opportunities are opening up in areas such as electric or hybrid cars. “

Although Interna-tional Recti-fier’s stock price declined last autumn, Zacharias is staying the course: “The same reasons why the stock was attractive at US$35 ($36.80) a few months ago still remain, and will be there in three to five years.” IE