Sector Watch: Being selective in Canadian stocks

“There are tremendous headwinds right now, more so than I’ve ever seen in the past six years,” says Schmehl, portfolio manager of Fidelity Canadian Growth Company Fund. “There is a rate cycle coming. Rates may not go up by much, but they’re going up and financial conditions are tightening. Corporate profits have peaked. It really feels as though the market is long in the tooth. I would say next year looks tough.”

Schmehl notes there has been an energy-sector correction of “epic proportions – and it doesn’t seem to matter. And we’ve had wage and employment growth in the U.S. – but it doesn’t seem to matter. We’ve had a lot of tailwinds that have just disappeared, and no one knows why. The economy is not growing – just look at discretionary spending: it’s horrendous; it’s worrisome.”

Although there still is money to be made in 2016, Schmehl argues, the investment environment will be challenging and opportunities will be confined to a limited number of companies. “Last year was tough,” he says, “and 2016 will be just as tough or worse.”

To boot, he adds, there is little support for valuations, as stocks are neither cheap nor expensive.

“Stocks are not expensive [based] on current earnings, if you believe earnings will be there,” Schmehl says, adding that U.S. stocks are expensive in general. “Canada is not expensive, but that reflects the fact that our economy is not in great shape and not likely to improve a lot.”

Schmehl, largely a bottom-up investor, has allocated about 42% of the Fidelity fund’s assets under management (AUM) to foreign stocks, the bulk of which is in U.S.-based firms. There also is 50% in Canada-based firms and 7% in cash. Financial services represents the largest sector weighting, at 27% of AUM, followed by information technology (18%), consumer discretionary (15%) and energy (11%). There are smaller weightings in sectors such as health care.

One top holding in the 73-name Fidelity fund is BlackBerry Ltd., the Waterloo, Ont.-based telecommunications equipment and software provider. Schmehl, who tends to like firms that have been written off as hopeless (as well as those at the other extreme, such as Google Inc.) views the new focus on the software side of the business as being a positive change.

“[BlackBerry has] a bunch of different software suites,” Schmehl says, “which [the firm] can roll together and create a double-digit grower long term, and that would get a much higher multiple.”

BlackBerry stock is trading at about $10.50 a share, which is the liquidation value of the stock. Because the price/earnings multiple is negative, this metric is meaningless currently. Schmehl has no stated target.

The relentless rise of the U.S. dollar (US$), the imminent hike in interest rates and slowing global economic growth are the three big challenges facing investors in 2016, says Brandon Snow, principal and co-chief investment officer at Toronto-based Cambridge Global Asset Management, a unit of CI Financial Corp., and portfolio manager of Cambridge Canadian Equity Corporate Class Fund.

“In the past 12 to 15 months, there’s been a definite trend of the US$ going up. That’s really choked off growth in many emerging markets,” Snow says, adding that the U.S. Federal Reserve Board’s move toward a “normalized” interest rate policy has caused the greenback to strengthen and effectively slow global growth.

As a major resources provider, Canada has been weakened, he adds: “From a stock market and economic perspective, Canada is definitely one of the victims of weak commodity prices, which have taken another leg down. So, that makes 2016 very interesting. What will happen if the Fed raises interest rates [by] 75 to 100 basis points? How does that change the source of financing for a lot of companies around the world?”

Cheap financing, which fuelled growth for many countries over the past few years, is drying up, Snow says. “And the further interest rates go, and the further we see the US$ go, the worse it will be for the global economy,” he says.

Like Schmehl, Snow maintains that U.S. stocks are expensive in general. And, in Canada, Snow says, “We have seen a dramatic decline in expectations for commodity prices. That’s what’s been driving the S&P/TSX composite index down.

“Fundamentals have driven things lower,” he continues. “And when we look at markets, domestically and internationally, we don’t see a ton of bargains. We remain patient in putting incremental dollars to work.”

About 17% of the Cambridge fund’s AUM is in cash, given the present risks and those on the horizon. There is 38% of AUM in the U.S., 33% in Canada and smaller holdings in Europe.

“As the market skews away from attractive risk/reward dynamics, the cash builds up as we liquidate some positions,” Snow says, adding that cash is a byproduct of the bottom-up stock-picking process. “We’re waiting for the right risk/rewards in the environment we’re in.”

Industrials, at 16% of AUM, account for the largest sector in the Cambridge fund, followed by consumer staples and discretionary (15%), technology (14.3%) and financials (14.1%). There are smaller holdings in sectors such as energy.

The Cambridge fund’s portfolio contains 40 to 45 names. Snow likes Bank of America Corp., a leading U.S.-based bank. “It has a very strong franchise that is undervalued,” Snow says, adding that he expects some of the bank’s capital, which is improving, will be returned to shareholders. “It’s an interesting time to be invested, with little downside risk.”

Bank of America stock is trading at about US$17.50 ($22.75) a share, or 1.7 times book value. There is no stated target.

Another favourite name is Finning International Inc., the leading Canadian distributor of Caterpillar equipment.

“It’s a very good asset, which is now more appropriately managed by a new team,” says Snow. “Although this is a difficult environment, [Finning] can generate a good amount of cash and pay a nice dividend. The valuation is not demanding, considering that end-markets are troughing.”

Finning stock, which is trading at about $19.50 a share, pays a 3.7% dividend.

The canadian economy will show growth in 2016, but the expansion will be largely in non-resources focused provinces such as Ontario, Quebec and Manitoba, says Simpson, the portfolio manager of Sentry Diversified Equity Fund.

Meanwhile the U.S. is a positive market, as unemployment keeps falling and inflation is low.

“The U.S. will show more growth than Canada,” says Simpson. “In fact, we’re trying to leverage the portfolio to Canadian companies that can benefit from an expanding U.S. economy.”

Moreover, the commodity sector is not likely to recover any time soon, thanks to surpluses of steel in China and low demand for Canadian copper, coal and aluminum.

“China is moving to a more consumer-driven economy. Since there’s been some overbuilding [in China], we don’t expect the demand for resources to come back as it did in the past,”

Simpson says, adding that China’s aging population is a contributing factor to that country’s slowing economic growth.

Although the benchmark S&P/TSX composite index was in negative territory in 2015, much of the pain was confined to resources and a few financial services names that are regarded as being vulnerable to rising mortgage defaults in Alberta’s oilpatch. Yet, some perceived safe havens, such as telecommunications, generally have held their own.

“You have to be very selective,” says Simpson, who has taken advantage of cheaper valuations among energy infrastructure stocks. This analysis led to the acquisition of shares of Altagas Ltd., a Calgary-based energy infrastructure company.

About 62% of the Sentry fund’s AUM is in Canada and 29% is in the U.S. About 9% is in cash, as Simpson is waiting for attractive stocks to materialize.

“We’re finding it harder to find good values in Canada, so we are looking more to companies in the U.S., where the economy is expanding. Growth is scarce and you have to look hard.”

From a sector standpoint, 27% of the Sentry fund’s AUM is industrials, 18.4% is in consumer discretionary, 8% is in consumer staples, 8.3% in financials and 8% in energy. There are smaller positions in sectors such as health care.

Altagas is a top holding in the 55-name fund. This company produces power for utilities in British Columbia and provides natural gas to homeowners in Alberta. “Because [Altagas] is part of the energy complex, it’s been beaten down,” Simpson says. “But this is a solid, well-run company with a good balance sheet and, in 2016, [the firm] will grow [its] earnings before interest, taxes, depreciation and amortization [EBITDA].”

Altagas stock is trading at about $31.80 a share, pays a 6.1% dividend and trades at 11 times enterprise value (EV) to EBITDA. The target price within 18 months is $38 a share.

Another favourite is West Fraser Timber Co., the largest provider of lumber and plywood on the continent. In particular, Simpson is focusing on the level of U.S. housing starts, which are running between one million and 1.1 million.

“All [that housing metric] has to do is increase to 1.3 million starts and the demand for lumber will be quite large,” Simpson says. “With more positive economic data, more lumber will go to the U.S.”

West Fraser stock is trading at about $51.40 a share (6.8 times EV to EBITDA). The 18-month target price is $64 a share.

There still will be money to be made in 2016, but the climate will be challenging and the opportunities limited

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