Sector Watch: Cautiously finding balance

The equities component of equity balanced funds benefited from relatively buoyant North American equities markets this year, in spite of a forecast of a slowdown in global economic growth overall.

The S&P/TSX composite index gained 12.4% in the first quarter of this year, reversing a loss of 11.6% in 2018. The gain was fuelled largely by the health-care sector, which benefited from investor enthusiasm toward marijuana stocks. Information technology (IT), real estate, utilities and industrials also did well, outperforming the benchmark index.

In Canada, rising household debt and a muted housing sector, the latter of which stalled on the backs of stricter mortgage guidelines and higher interest rates, have weighed on the economy. But higher oil prices provide some relief and benefit the Canadian dollar, which has been among the best-performing major currencies this year vs the U.S. dollar.

In the U.S., the S&P 500 composite index rebounded from a loss of 4.38% in 2018 for a first-quarter gain of 13.6%. IT was the top-performing sector, followed by industrials, real estate, energy, consumer discretionary and communication services, all of which have outperformed the benchmark index.

The U.S. Federal Reserve Board lowered its economic growth expectations and indicated that it would not proceed with further interest rate hikes in the near term to stem the impact of a slowdown in the economy. In addition, the potential for a resolution to U.S./China trade tensions appears likely, alleviating concerns about an all-out trade war.

On the fixed-income front, an inverted yield curve in both the U.S. and Canada typically points to an impending recession. However, views are mixed over this possibility. (See Misreading the curves on page 8.)

Alex Sasso, CEO of Norrep Capital Management Ltd. in Toronto and lead portfolio manager of NCM Income Growth Class fund, suggests that both the U.S. and Canada will avoid a recession and will in fact experience a soft landing. Both countries will benefit from a “recalibration of growth in late 2019 and early 2020,” fuelled by a pickup in demand from China and emerging markets at large.

“The global slowdown is inventory-driven,” Sasso says, and it is led by China stockpiling inventories in warehouses in the second half of 2018 and early 2019 in the wake of protectionist measures by the U.S. “Now, those inventories are being depleted and factory floors are speeding up again.”

The NCM fund is ranked No. 1 in its category by Morningstar Canada among funds with a minimum track record of 10 years and at least a three-star Morningstar rating. The fund invests mainly in high-yielding small- and mid-cap securities “with a focus on capital preservation and yield without sacrificing upside potential on equities growth,” Sasso says.

The $62-million NCM fund holds 88% of its portfolio in equities and the remainder in fixed- income, the latter of which consists mainly of short-dated, high-yield corporate bonds. “The [portfolio] manager [can] move between equities and fixed-income securities, depending on market conditions,” Sasso says.

The NCM fund’s portfolio managers use a qualitative and fundamental investment methodology to select stocks. This “differentiated approach” in selecting stocks for the portfolio, Sasso says, does not “look at the TSX and decide to be in striking distance of [global industry classification standard (GICS)] weightings.” Rather, the fund invests in companies that have a history of growing dividends and focuses on companies that have a 50% dividend payout ratio.

“I’m not a big fan of companies that distribute all their income,” Sasso says. “I prefer companies that pay out half and reinvest the other half to grow the business.”

The NCM fund’s portfolio is light in the resources sector, Sasso says, and overweighted in industrials and consumer discretionary. The companies in which the NCM fund invests typically are “underfollowed and underloved and exhibit growth in excess of the market,” Sasso says. For example, one of the fund’s long-term holdings, which he classifies as “well managed” and a “perpetual outperformer” is First Service Corp., North America’s largest manager of residential communities and a leading provider of essential property services to residential and commercial customers. He says the firm grew by 25% during the most recent quarter, with 14% from organic growth.

Another of the NCM fund’s largest holdings is Badger Daylighting Ltd., which provides non-destructive hydrovac excavation services in industries such as oil and gas and power throughout North America.

The fixed-income portion of the NCM fund’s portfolio is invested in short-duration, high-yielding corporate bonds issued by companies that can finance their coupon payments. “These bonds are less interest-rate sensitive than traditional bonds,” Sasso says, “and provide exposure to an inefficient segment of the market.” Their short duration reduces investment risk, he adds.

Les Stelmach, senior vice president and portfolio manager with Franklin Bissett Investment Management in Calgary, also favours corporate bonds “with a preference for higher-quality credits, given the yield cushion they provide against any sharp or unexpected increase in government rates,” he says.

Stelmach says he anticipates that bond spreads will remain rangebound, but acknowledges that risks are to the downside: “Much will depend on the macroeconomic backdrop and the pace of central bank normalization as it relates to effects on credit spreads.”

Stelmach co-manages the $599-million Franklin Bissett Dividend Income Fund, along with Ryan Crowther, vice president and portfolio manager.

The Bissett fund seeks relatively high current income and long-term capital appreciation by investing primarily in dividend-paying or income- producing Canadian and U.S. common shares, as well as Canadian fixed-income and preferred shares, says Stelmach.

North American equities markets have posted strong gains so far this year, Stelmach says, and he is cautiously optimistic about their future growth. “Equities market excesses over the past few years have been in part driven by investor exuberance regarding specific equities’ momentum and potential rather than true fundamentals and valuation of the underlying businesses,” he says.

Stelmach suggests that the recent increased volatility reflects “increased global uncertainty and the unwinding of very easy financial conditions,” both of which are expected to continue to drive market volatility.

“Despite certain sectors and individual circumstances continuing to present attractive investment opportunities,” Stelmach says, “the strong recent advance in Canadian and U.S. equities naturally tempers our enthusiasm for ‘go forward’ absolute returns.”

In the Bissett fund’s securities selection process, Stelmach says, the Franklin Bissett equities team applies a bottom-up research approach to identify companies with a history of sustainable, profitable growth. “One of the many selection criteria in this process,” he says, “is that chosen stocks have attractive valuations relative to the intrinsic value of the business.”

Portfolio managers on the equities side are committed to a GARP-style of investing, says Stelmach: “Each fund holding is identified for growth prospects and purchased at what the portfolio manager considers to be a reasonable valuation. Income generation is a key focus and, as such, all investments must pay a dividend at the time of purchase.”

In addition, Stelmach says, the Franklin Bissett investment committee discusses economic, political and relative value factors that affect outlook and weight targets for asset classes. The objectives of any weighting and strategic adjustments is to capitalize on anticipated shifts in the markets and protect portfolios from emerging risks.

“Purchase and sales of securities are opportunity-driven rather than being tethered to a particular time frequency,” Stelmach says. “In order to mitigate risk, we will trim outsized equity positions in the event they exceed certain ownership thresholds.”

As of March 31, the Bissett fund held 60.4% of its AUM in Canadian common shares, 20.7% in U.S. common shares, 17.8% in Canadian fixed-income and 4.4% in Canadian preferred shares. The fund’s typical neutral asset mix is 60/20/20 (Canadian common/U.S. common/fixed- income and preferred shares).

“We do not target specific sector weightings,” Stelmach says. “However, for risk mitigation and diversification purposes, we maintain a minimum ownership requirement in seven of 11 sectors and currently have positions in eight of 11 GICS sectors in the Canada equities sleeve, and in eight of 11 sectors in the U.S. sleeve.”

In Canada, the largest equity allocation is in financials, followed by energy, utilities and communication services. In the U.S., health care and consumer staples have almost equal weightings, followed by IT, financials and industrials.

Enbridge Inc. is the Bissett fund’s largest energy holding. Stelmach says the company features an attractive valuation and a high, sustainable dividend, and has made great strides in enhancing its competitive position.

The Bissett fund also holds shares in Canadian National Railway, which, Stelmach says, “features best-in-class profitability among North American railways and boasts high operating margins, free cash-flow generation and a strong balance sheet.”

On the fixed-income front, the Bissett fund holds corporate and government bonds and generally limits exposure to Canadian issuers, but does have some exposure to Maple bonds.