Canadian equities roundtable: part 1

Ian Hardacre, vice-president and head of Canadian equities at Invesco Canada Ltd. His mandates include the lead manager role for Trimark Canadian and Trimark Select Balanced funds.

Daniel Bubis, president and chief investment officer and founder of Winnipeg-based Tetrem Capital Management Ltd., which manages money for institutional and high-net-worth clients. Bubis manages a range of mutual funds for CI Investments Inc., including CI Canadian Investment and CI Canadian Investment Corporate Class funds.

Mark Thomson, managing director and head of research at Beutel, Goodman & Co. Ltd. Thomson and his team manage a range of mandates including Beutel Goodman Canadian Equity, Beutel Goodman Canadian Dividend and Beutel Goodman Balanced funds.

Q: The Canadian equity market, as represented by the S&P/TSX composite index, produced a total return of 7.2% in 2012, with financials doing well and natural-resource stocks doing poorly. You are three value managers who run fairly concentrated portfolios. Are you finding value in this market?

Hardacre: It’s generally tough to find new ideas in the Canadian market and even in the global market for the 30% foreign content in Trimark Canadian Fund. We have been net sellers over the last two to three months and have built up some cash. This is unusual, as we tend to run fully invested. We have 6% cash in our Canadian fund. We’re cautious.

A lot of the world’s economic problems still exist. Europe is in a similar situation to what it was six months ago and the United States has its challenges. I’m cautiously optimistic on China. GDP growth at 7% per annum is still good. That should be good for the Canadian market, with its high resource component.

Thomson: We focus on liquidity, the amount of capital and cash that is awash in the world financial system. We focus on valuations and opportunities. We have a three-year investment horizon and have a 50% return requirement over that period. We’re seeing plenty of opportunities, sufficient to keep us fully invested.

Bubis: In Canada over the last two years, equities have struggled, largely because of the more cyclical nature of some of the equities. Investors have been defensive and have bid up less cyclical assets, particularly those that provide an income stream. The opportunity is in those assets that are more economically sensitive and provide an income stream. The global economic problems are showing signs of abating. We’re not having trouble finding investment ideas, but we’re not all that active. We like what we own.

Q: The S&P/TSX composite index substantially underperformed the MSCI world index in 2012, with the natural-resource sectors, at about 45% of the composite, pulling down the Canadian performance. Why did Canadian natural resource stocks do so poorly?

Bubis: On the materials sector, the valuation multiples have been pressured by the macro risk and the companies are also facing operational challenges. But, looking out over the next couple of years, you’re getting better capital discipline in the industry.

Total-return index	1Yr	3Yr	5Yr	10Yr
S&P 500	13.5	9.0	1.8	2.3
MSCI World	14.0	5.7	-0.4	3.2
S&P/TSX Composite	7.2	4.8	0.8	9.2
For periods ended Dec. 31. Total returns, expressed in C$
Source: Morningstar

Hardacre: In energy, we’ve had a big weighting in natural-gas stocks over the past three to three and a half years and it paid off last year. Progress Energy Resources Corp. was one of our largest names and it was taken out at a premium. Nexen Inc. has also been the subject of a takeover bid at a premium. Even though energy underperformed, we had good returns from energy. Why has this sector as a whole done poorly? Investors are concerned about global economic growth. As with base metals, there are concerns about China’s growth. Oil prices have been flat and, in some cases, costs have gone up. We’re seeing value in the sector, but we’re maxed out. We’re happy with the stocks that we own.

Thomson: Beutel Goodman Canadian Equity fund’s portfolio mandate is to invest in Canadian stocks. We’re about half-weight the Canadian energy sector. It’s all about valuations. We use a long-term oil price of about US$90 per barrel, which is what’s required to maintain supply. The stocks have underperformed. The companies are high cost on a global basis. Their incremental capital expenditures are high, although they’re getting smarter at this. We consider that they’re generally not good businesses.

Bubis: CI Canadian Investment Fund has foreign content. Within the Canadian portion, we’re overweight energy. One of the biggest challenges for Canadian energy producers has been the oil-price differential, with Canadians receiving less for their product than other jurisdictions. An issue has been transportation of the product to market. There’s the political drama with the Keystone pipeline in the United States. There will be an increasing use of rail to transport oil. The Canadian producers have been squeezed through this price discount and this has taken down stock valuations. Ultimately, this is the biggest opportunity for the Canadian market going out a number of years. The oil-price discount is going to narrow.

Q: The S&P 500 index is making new highs, yet the Canadian index has not regained its highs reached in June 2008, before the global financial crisis hit.

Bubis: For the Canadian index to regain its previous highs, the energy sector has to do better.

Q: Has investors’ emphasis on dividend yields gone too far?

Thomson: The dividend yield on the S&P/TSX composite index is currently 2.9%. This is high from an historic perspective and higher than the 10-year Government of Canada bond. Equities viewed as bond proxies, such as utilities and real estate investment trusts, have gone to exceptionally high valuations with very low yields. Those dividend-paying companies with earnings that have higher volatility are trading at good valuations. This is giving you the overall higher yield on the index.

Hardacre: We love dividends. They have to be sustainable and ultimately it’s the valuation of the stock. We have deep concerns about the quest for yield and the driving up of the valuations as a result. This has kept us out of certain sectors, such as utilities and pipelines.

Bubis: The dividend play is not over because of low interest rates. There are a lot of strong dividend-paying companies that have good prospective dividend growth that were not bid up in this push for yield, because they were viewed as cyclical. For example, Potash Corp. of Saskatchewan Inc. Potash Corp. has raised its dividend substantially in the last few years. Historically, it’s the dividend growers that have been rewarded by investors. In the last two years, what has been rewarded is the actual level of the dividend yield. This has caused the excesses.

Q: The Canadian financial sector is an important source of dividend-paying stocks. It represents almost 30% of the composite index and is dominated by the banks.

Thomson: I really like the Canadian banks going forward. There is a lot of talk about the Canadian consumer being too leveraged. The reality is that if you want safe earnings and dividends, the banks are a good place to look. The operating earnings of Bank of Nova Scotia, Toronto-Dominion Bank and Royal Bank of Canada were off 5% to7% during the 2008-2009 financial crisis. The banks are huge generators of capital. We have seen that over the past four years. There may be some added global regulatory capital requirements. The Canadian banks are already at high capital levels and they will be able to return a lot more capital to shareholders. Their returns on equity are between 15% and 22%. They are good businesses. Moody’s Investors Services Inc.’s recent downgrade of the credit ratings of several of the Canadian banks is irrelevant.

Hardacre: Canada is one of the only equity markets in the world where the banks are considered to be a safe haven relative to the rest of the market. You get the dividend growth. Having them as a core part of your portfolio, at least for the last 10 years, has been the right thing to do.

Parts two and three of the roundtable will appear on Thursday and Friday, respectively.