Sector Watch: A strong start marred by crisis

These funds invest 60%-90% of their total assets under management (AUM) in equities, including U.S. securities, and a smaller portion in fixed-income securities. These funds can offer up to 50% greater exposure to equities than fixed-income balanced funds and thus are more suitable for moderately aggressive investors.

Canadian equity balanced funds were not left unscathed by unprecedented market volatility stemming from the Covid-19 pandemic and compounded by historically low oil prices.

Les Stelmach, senior vice president and portfolio manager with Franklin Bissett Investment Management, a unit of Franklin Templeton Investments Corp., in Calgary, is co-lead portfolio manager (along with Ryan Crowther, vice president and portfolio manager) of the $332-million Franklin Bissett Dividend Income Fund and the $1.5- billion Franklin Bissett Dividend Strategy. (Fund valuations are as of March 31.) Stelmach says the income fund was defensively positioned prior to the market decline.

“Although no sectors were spared from losses, the fund’s defensive tilt, instituted in the latter half of 2019 and into 2020, allowed it to outperform its equity benchmarks,” Stelmach says.

The defensive position was taken in anticipation of potential market risk. The extended bull market that ended in March created “an environment where fundamentals and valuation took a back seat to momentum and potential,” Stelmach says. “The pandemic is reversing this trend, and business fundamentals, capital structure and allocation are again predominant.”

The Franklin Bissett (FB) dividend income fund seeks to generate higher risk-adjusted returns than its benchmark — a blend of 60% S&P/TSX composite index, 20% S&P 500 composite index, 15% FTSE TMX Canada universe bond index and 5% S&P/TSX preferred share index — while delivering stable to rising cash distributions.

Stelmach says the FB fund employs a “growth at a reasonable price” philosophy with bottom-up security analysis: “Valuations are regularly fine-tuned based on factors such as changing industry dynamics, appraisal of business risk and changes in underlying interest rates.”

The FB fund portfolio’s asset mix as of March 31 is 58.7% Canadian equities, 20.6% U.S. equities, 15.5% bonds and 4.1% preferred shares, with the balance in cash. The largest exposure to Canadian equities is in financials (23.3%), followed by utilities (16.5%), communication services (13.1%), energy (12.3%), consumer staples (12.2%), materials (8.9%), real estate (8.8%) and industrials (4.3%).

The largest exposure to U.S. equities is information technology (21.6%), followed by health care (19.8%), consumer staples (17.9%), industrials (10%), financials (9.7%), utilities (6.4%), energy (6.3%), consumer discretionary (4.9%), and communication services (3.4%).

One of the FB fund’s major holdings is Fortis Inc. (power generation and distribution). Stelmach says the company is “committed to a strong investment-grade credit rating with a manageable payout ratio to support a self-funding growth model.”

Another major holding is Royal Bank of Canada (RBC). Stelmach praises its leading banking-product market share, strong capital markets franchise and full-service wealth-advisory business, the largest in Canada. He adds that RBC went into the Covid-19 crisis with a strong capital position, and he believes the bank will continue to pay regular dividends.

During the first quarter of 2020, the FB fund added to its existing position in Nutrien Ltd. (fertilizers), the shares of which are attractively valued with a well-supported dividend. Nutrien “offers some defensive characteristics that could prove valuable in the current environment,” Stelmach says. “Being agriculture-driven, its performance is not necessarily tied to GDP growth.”

The FB fund also established its initial position in Wheaton Precious Metals Corp. (royalty and streaming assets in the precious metals space). “The business generates robust cash flow through market cycles and is committed to paying dividends,” Stelmach says. “Its capital-light model and strong balance sheet leave it well positioned to weather the current economic downturn while positioning it to add accretive royalty streams from miners seeking financing.”

Stelmach recently trimmed the FB fund’s position in Brookfield Renewable Properties LP on its strength in January and February of this year. The fund still holds a significant position in the company, but, Stelmach says, it was “garnering a significant premium valuation, likely in part due to the pre-Covid-19 preoccupation [with] investing in renewable power assets.”

Stelmach also reduced the FB fund’s position in WSP Global Inc. (professional services). “The shares were no longer trading at as significant a discount to our estimate of intrinsic value as they once did,” he says.

Stelmach believes normalized economic and business conditions will eventually resume and a secular growth pattern will be re-established. Whenever this happens, “we would look to tilt back toward more cyclical equity investments,” he says. “With respect to [corporate] fixed-income, with interest rates currently very low, a discerning eye to creditworthiness will serve us well.”

Colin Ramkissoon is vice president, U.S. and international equities and chair of the balanced fund asset mix committee of Beutel Goodman Investment Counsel, a unit of Beutel Goodman & Co. Ltd., in Toronto. The committee manages the $3.37-billion (valuation as of March 31) Beutel Goodman Balanced Fund.

“The enduring discipline of our process is designed to remove emotion from the equation — precisely in market environments such as the one we are currently experiencing,” Ramkissoon says.

Ramkissoon is “focused on investing in businesses with competitive differentiation, sustainable free cash, strong balance sheets and management teams that are aligned with shareholders.”

Ramkissoon adds: “The individual component portfolio weights of the fund are driven by the relative attractiveness of their long-term expected returns. We do not make top-down strategic asset-mix shifts, and capital preservation is paramount.”

Normally, the Beutel Goodman (BG) fund’s target asset mix is 60% equities and 40% fixed-income.

Ramkissoon explains that when returns in equities are attractive, the equity component of the BG fund’s balanced portfolio will approach the higher limit of the investment policy range. As stock prices reach the BG team’s targets, the shares are sold and the proceeds reallocated to existing holdings with lower valuations and higher anticipated returns or to new stocks. If market conditions are such that the anticipated returns on equities portfolios are unattractive, the equities allocation is reduced and reallocated to fixed-income and cash.

As of March 31, the BG fund’s asset mix of the portfolio comprises 66% equities, with 33% exposure to the Canadian market, 15% to the U.S. market and 18% to the international market. The fund has a 32% weight in fixed-income securities, composed of 4% federal bonds, 11% provincial and municipal bonds, and 17% corporates.

From a sector standpoint, the BG fund portfolio’s greatest exposure is to financials (24.9%), followed by communication services (12.9%), consumer staples (12.3%), industrials (11.8%), health care (8.3%), information technology (8.2%), materials (7.3%), consumer discretionary (6.3%), energy (4%) and utilities (0.4%), with the balance in cash.

“We are bottom-up stock- pickers and sector allocation in equities is an outcome of that process,” Ramkissoon says. “In fixed-income, we believe certain sectors in the corporate bond market are attractive — financials and telecoms, specifically.”

One of the BG fund’s major long-term holdings is Rogers Communications Inc. (communications networks and media holdings). “We view Rogers as very well positioned, given its substantial spectrum position and network investment, its strong balance sheet and low payout ratio, and its small percentage of legacy business,” Ramkissoon says, adding that regulatory intervention remains a risk, but is manageable over the long term.

Another major holding is Toronto-Dominion Bank (TD), which, Ramkissoon says, “has excellent retail-banking assets and a strong risk culture. TD has the best mix of businesses in the Canadian banking sector. [It focuses] on its core Canadian and U.S. retail bank segments and grows them incrementally while managing business risk.”

Even after stress-testing for Covid-19 scenarios, Ramkissoon says, TD continues to hold significant market share and good businesses outside Canada.

Over the past six months, the BG team conducted partial trims of two holdings as they hit target prices: Roche Holding AG (a pharmaceutical company) and NortonLifeLock Inc. (software). Earlier, the fund sold one-third of its position in NTT Docomo Inc. (mobile phone networks), but upon further review, “the relative attractiveness of other names in the portfolio led us to sell the remainder of our position,” Ramkissoon says.

In addition, the BG fund sold its position in Cenovus Energy Inc. (integrated oil operations) “due to the significant drop in oil prices following a concerted effort of major market participants to secure market share without regard to any cost.”

Ramkissoon says investors’ short-term focus and increased volatility in equities markets have caused stock prices to be significantly discounted. As a result, he is finding attractive opportunities in new and existing companies that have been indiscriminately sold off. He believes the market will eventually differentiate between companies that possess solid balance sheets and strong free cash flow generation, and those that do not.

On the fixed-income front, Ramkissoon believes the economy is likely to experience a deeply negative second quarter, as most businesses are shut down and consumer spending is constrained. However, with the aid of myriad monetary policy responses as well as fiscal stimulus, he anticipates “we will likely experience a U-shaped recession.”