Sector Watch: Giving the benefit of doubt to equities

“Certainly, 2016 ended better than anticipated,” says Stephen Groff, principal at Cambridge Global Asset Management, a unit of Toronto-based CI Financial Corp., and portfolio manager of CI Cambridge Canadian Dividend Fund.

“We were fairly happy with how our stocks held up. And from an economic and market standpoint, things are more robust. [In the future], the risks will be different from 2016. My concern is that expectations are quite high.”

Groff argues that there is much optimism embedded in the market: “People are assuming that a lot of positive follow-through will come. But when I look at the combination of sentiment, valuations and potential risk factors, I am not overly enthusiastic with what I see out there. We have built our portfolios accordingly.”

One of the risks in the global market is the possibility of a “hard landing” in China’s economy.

“What is going on there is unsustainable and will ultimately require some form of adjustment, given what’s happening in terms of capital flows,” says Groff, noting that there is potential for a devaluation of the renminbi, China’s currency, which could have global implications. Moreover, there are many troubling unknown risks surrounding trade policy and exchange rates.

“And what will happen if interest rates start to move very rapidly in a world in which corporate leverage is high?” Groff asks. “A lot of people are dismissive of these risks and are putting too much faith in the fiscal stimulus in the U.S. That’s something to watch.”

From a valuation perspective, Groff says, share prices are at the upper end of their range, due in part to a business cycle that is long in the tooth. “Without a doubt, we are many years into [economic] recovery. Earnings have recovered, but so have multiples,” Groff says. “When you pay a higher multiple, you’re expecting future growth. We’re of the view that in some cases, growth will materialize; but, in other cases, it won’t. There are a lot of areas in which you are not being paid adequately to take the risk.”

He adds: “Many banks are not overly attractive at current prices. But we are starting to see more value in higher-quality consumer staples firms, as people are rotated into more cyclical areas as part of the so-called “Trump rally.”

Groff is a bottom-up stock-picker. About 21% of the CI fund’s assets under management (AUM) is held in cash, 15% is in consumer staples, 15% is in industrials and 12% is in financials, with smaller holdings in sectors such as real estate and consumer discretionary.

One top name in the 34-holding CI fund is Metro Inc., a leading supermarket chain. “[Metro is] excellent at operations and capital allocation,” says Groff, noting that the firm generates a 15% return on invested capital. “Over time, [Metro] has been very successful at creating shareholder value.”

Metro stock, which pays a 1.4% dividend, is trading at about $40.60 a share, or at a price/earnings multiple of 17.2 times. There is no stated target.

Although making short-term forecasts is difficult, Conrad Dabiet, senior managing director, Canadian value equity team, at Toronto-based Manulife Asset Management Inc., and lead portfolio manager of Manulife Dividend Income Fund, says that from a fundamentals perspective, 2016 was a tale of two markets.

“The first half was very much about fears of recession and looming issues in Europe and Brexit. “The second half was about the resurgence of cyclical stocks.” says Dabiet, who shares portfolio-management duties with Alan Wicks and Jonathan Popper, both senior portfolio managers at Manulife.

“We did very well relative to the market in the first half; but in the last half we treaded water, as the businesses we don’t buy, such as oil and gas producers, had a strong rally. But we will see how 2017 unfolds,” he adds.

“A lot of the stable businesses we like, which have strong competitive positions and the ability to grow either organically or through acquisition, have been forgotten. Or people have sold them to chase the more cyclical stocks.”

Dabiet notes that at the beginning of 2016, about 20% of the Manulife fund’s AUM was held in cash. Some of that was spent on new positions – such as pipelines and railways. At yearend 2016, about 19% of AUM is held in cash.

“We are picking our spots in 2017 and focusing on fundamental research,” says Dabiet. “We have our targets; and if companies don’t meet those targets, we will be patient and wait for the opportunities because we know they will happen.”

There appears to be a lot of exuberance priced into markets, says Dabiet, noting that multiples are considerably higher than they were several years ago.

“This doesn’t mean stocks can’t keep going up,” Dabiet says. “But certainly it means that they have a higher hurdle to jump over, in terms of the valuation and expectations of future growth. We like to pay a price that will give us an attractive return and protect our capital on the downside. Prices fluctuate, and as they go down, businesses become more attractive. We are constantly maximizing our portfolio based on the valuation work we do and aim to earn an attractive return.”

A big challenge is that the economic cycle is into its seventh year. “At some point, the cycle will end,” says Dabiet, adding that the U.S. Federal Reserve Board tends to hike interest rates when economies slow down. “Not that we are forecasting that today. But you have to focus on knowing what you own. Whether the Fed is raising or lowering rates, we have processes to find attractive opportunities.”

In addition to holding 19% of AUM in cash, the Manulife fund also holds 19% in financials, 13% in consumer discretionary, 10% in industrials, 8% in consumer staples and 8% in energy, with smaller holdings in sectors such as information technology.

The Manulife fund has about 80 holdings. Dabiet likes Waste Connections Inc., which merged with Progressive Waste Solutions Ltd. in early 2016 and is one of the largest solid-waste management service firms in North America.

Waste Connections stock, which pays a 0.9% dividend, is trading at about $105.50 a share. There is no stated target.

Absent any signs of a recession and of interest rates rising faster than earnings, the benefit of the doubt should be given to equities markets, says Stuart Kedwell, senior vice president at Toronto-based RBC Global Asset Management Inc. (RBCGAM), and portfolio co-manager of RBC Canadian Dividend Fund. He shares portfolio-management duties with Doug Raymond, senior vice president at RBCGAM.

“The major focal point for people in the stock market is [its recent upswing],” says Kedwell, “And there are certainly signs that enthusiasm is at a higher level, [and] sometimes volatility is associated with that. The price/earnings multiple still is reasonable relative to interest rates. But the multiple is at the upper end of absolute levels. Since the [2008-09 global] financial crisis, we are at the top end of valuations, which is why an earnings acceleration is important.”

Based on the benchmark S&P 500 index, price/earnings multiples are about 16. “But if you go back to 2002,” he says, “the range during that 15-year period has been 11 to 18. So, we are in the upper end. The second point is that the companies’ earnings stream had been stagnant for a couple of years, but has started to improve.

“When we look at the return on equity for the market as a whole,” Kedwell adds, “that number still sits a little below average, mainly held back by the financials. So, the earnings themselves could be higher, thanks to the combination of more fiscal spending, less regulatory headwinds, higher interest rates and lower taxes. That would affect valuations because earnings would be better. That’s a big ‘if,’ of course, but that’s the platform that Trump was elected on.”

Thus far, there are no signs of a recession, says Kedwell, noting that the yield curve is positive, credit spreads are “quite benign” and delinquencies in the credit cycle look fairly good.

“The last thing on our checklist is the unemployment rate. If it deteriorates by half a percentage point, that is a strong indicator there could a recession. For now, [this indicator] is quite positive.”

In terms of risk, however, the market hasn’t experienced a 5%-8% correction in quite a while. “In a short-term view, predicting when [such as correction] might happen is very difficult,” Kedwell says. He adds that he is positive on stocks, but acknowledges that there is risk in the market that could surprise on the downside.

The 88-holding RBC fund is fully invested, with about 44% of AUM held in financials, 22% in energy (including pipelines) and 9% in industrials. There are smaller holdings in sectors such as utilities and consumer staples.

Kedwell likes Bank of Nova Scotia, which, unlike many of its Canadian peers, has little in the way of U.S. operations and a share price that hasn’t seen the same enthusiasm as the stocks of banks with U.S. exposure.

Scotiabank stock, which pays a 3.9% dividend, is trading at about $78 a share, or 12.1 times forward earnings. There is no stated target.

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