Manager monitor: Equities “the place to be”

For the first time in many years, the bond market “is facing the headwind of rising interest rates,” says Frost. The fixed-income market is anticipating a reduction in the US$85-billion-a-month bond purchases by the Federal Reserve, known as quantitative easing. “Bond markets on both sides of the border sold off sharply recently, and high-profile equity-income securities, which are also interest-sensitive, took a beating.”

Frost says that both Canadian and U.S. market interest rates are “currently establishing higher trading ranges.” The benchmark 10-year Government of Canada bond, which was trading in the 1.6% to 2% range, has “broken out to 2.5%-2.6%.” The 10-year U.S. Treasury note reached a recent two-year high of 2.8%, he says.

At AGF, Frost’s responsibilities include two income-oriented balanced funds: AGF Monthly High Income Fund ($850 million in assets under management (AUM)) and AGF Traditional Income Fund ($350 million). He also manages the domestic equity flagship AGF Canadian Stock Fund ($1.5 billion).

The two balanced funds combine tactical asset allocation with both stock and bond selection. The strategic long-term asset-mix for both funds is 50-50, (with cash holdings included in the fixed-income component.) The tactical asset-mix ranges are from 80% to 20% in each asset class for AGF Monthly High Income Fund and 70% to 30% for AGF Traditional Income Fund.

“Tactical asset allocation means that I have the ability to move around the long-term asset-mix yardstick, within the respective policy ranges, to add value by taking advantage of shorter-term trends in financial markets,” says Frost.

Over the past few months, Frost has been using cash holdings in each fund to add to the equity component. At the same time, he has been keeping the bond component in each fund “steady and at a significant underweight.”

The emphasis in the bond sleeve in both funds is on corporate bonds. There is little exposure to “plain vanilla” government bonds in AGF Monthly High Income Fund, says Frost. There is a higher weighting in these bonds in AGF Traditional Income, “but with low duration, as these bonds are the most vulnerable to interest-rate increases.”

Generally, says Frost, the duration of the two funds’ bond holdings has been kept “aggressively short, which has been a good strategy given the increase in interest rates.” He points out that at low interest-rate levels, a 100-basis-point increase in yields has a much greater impact on bond prices than such an increase would have at high levels of interest rates.

At recent count, AGF Monthly High Income Fund had 70% of its AUM in equities with an emphasis on companies with high dividend yields, 25% in fixed income securities and 5% in cash. By contrast, AGF Traditional Income Fund, which focuses on stocks of companies growing their dividends rather than on the absolute dividend yield, had 67% of its AUM in equities, 19% in fixed-income securities and 14% in cash. There are some stocks that are common to both funds. Foreign content is 35% in AGF Monthly High Income Fund and 28% in AGF Traditional Income Fund.

Of the equity sectors, Frost notes that he has been maintaining a strong weighting in energy and an underweight position in financials. Within the materials sector, he has been adding to his holdings in gold stocks in both funds. “I sold down my gold holdings in the fall of 2012, as they had reached my targets.”

Gold stocks have pulled back sharply since, he says, in the wake of the falling gold price, in part due to the rising U.S. dollar, and operational problems at some of the global mining companies. “This represented a buying opportunity.”

Frost likes gold-royalty companies and has been purchasing stock in a major Canadian royalty company, Franco-Nevada Corp. (TSX:FNV). He is also focusing on companies with good growth profiles. An example, he says, is Yamana Gold Inc. (TSX:YRI). On the outlook for bullion, Frost sees the recent pullback as a “correction.” While gold might not have reached its lowest level, “the bull market in bullion is not over.”

Canadian heavy-oil prices, says Frost, have benefited from the recent rise in the oil price in U.S.-dollar terms against a weaker Canadian dollar and a substantial narrowing of discounts to the benchmark West Texas Intermediate price, which has been in evidence since the beginning of the year.

Frost has added to his already significant holding in the integrated energy company Suncor Energy Inc. (TSX:SU) in both funds. The company has been raising its dividend and has boosted its share-buyback program, he says. CEO Steve Williams, who has been at the helm now for more than one year, “is committed to returning cash to shareholders.”

An energy-services company that Frost likes is Calfrac Well Services Ltd. (TSX:CFW). As activity in the oil patch increases, this company will see higher utilization and better pricing, he says. The stock has “a good dividend yield of more than 3%.” There is “high insider ownership of the stock, which helps to align the company’s interests with those of shareholders.”

Turning to pipelines, which are included in the energy sector, Frost says that he has been adding to his holding in Enbridge Inc. (TSX:ENB) in AGF Traditional Income. The stock, he says, pulled back, along with other prominent equity-income names, with the rise in interest rates. “Enbridge has a good growth profile and good dividend-growth prospects.”

	Calfrac Well Services Ltd.	Enbridge Inc.	Suncor Energy Inc.
July 15 close	$30.86	$45.92	$32.30
52-week high/low	$32.50-$20.33	$49.17-$37.74	$34.99-$27.50
Market cap	$1.4 billion	$37.9 billion	$48.9 billion
Total % return 1Y*	56.6	16.0	11.8
Total % return 3Y*	15.8	24.5	0.9
Total % return 5Y*	1.7	19.0	-9.9

*As of July 15, 2013
Source: Morningstar

Frost sold his holdings in the natural-gas mid-stream player Keyera Corp. (TSX:KEY), from both funds. “I took profits in the stock.” The company’s dividend growth has slowed, he says, and the dividend yield was compressed, given the rise in the stock price.

Finally, a favourite stock in the Canadian utilities sector that is held in both balanced funds is Brookfield Infrastructure Partners L.P. (TSX:BIP.UN). It invests in long-life infrastructure assets around the world, including a number of European ports, says Frost. There are “high barriers to entry” in these businesses, he says, and Brookfield’s assets generate predictable and growing cash flows. “These are important criteria in equity-income selection.”