Detecting winners

Sentry Canadian Income Fund, which Simpson has steered since 2002, has had an outstanding run. As of Oct. 31, the fund’s 10-year average annual return was 11.2%, a far superior performance to the 6.5% return generated by Morningstar Canada’s Canadian focused equity fund category and the 8% earned by the benchmark S&P/TSX composite total return index. The Sentry fund also has consistently outperformed both the index and the category during shorter time frames of one, three and five years. Further enhancing the Sentry fund’s attractiveness is the fund’s history of low volatility.

“You must factor a lot of inputs into investment decisions,” says Simpson, age 51. “It’s great if you’re naturally curious. It’s not an easy or simple formula, and you have to look at whether a company and its management team are right for the times.”

Simpson employs an approach that primarily is bottom-up. He examines the attributes of individual companies but doesn’t ignore “big picture” economic trends, seasonal patterns or a stock’s technical history. The $5-billion Sentry Canadian Income Fund currently pays investors a regular monthly distribution equal to about 4.5% of net asset value, and most of this income comes from gains and dividends derived from the 90% of the fund’s assets under management (AUM) that are held in dividend-paying equities.

There is a scant 2.5% of AUM in bonds, mostly of the corporate variety. (Although Simpson’s mandate allows the fund to hold up to 25% in bonds, he is content to be underexposed.) With the U.S. economy picking up and interest rates likely to rise, he sees better opportunities in stocks than in bonds, which could be hurt by a rate increase. He also has relatively low exposure to interest rate-sensitive stocks such as utilities and real estate investment trusts.

“We are holding more economically sensitive stocks,” he says, “as opposed to interest rate-sensitive securities.”

The Sentry fund also holds small amounts in cash and preferred shares, and employs option strategies such as covered calls to enhance the portfolio’s income and provide some downside protection.

“The fund is designed for the person who is 55 or older who needs current income, and also for younger people who appreciate the power of dividends,” Simpson says.

The Sentry fund’s biggest challenge, says Chris Davis, director of (portfolio) manager research at Toronto-based Morningstar Canada, will be to replicate its past performance, now that size limits the fund’s ability to invest in potentially high-return small-cap companies. Davis points out that the lofty management expense ratio of 2.7% also is a hurdle to overcome but adds that Sentry’s disciplined style should continue to deliver attractive returns.

“One of the Sentry team’s strengths is its willingness to look different from competitors and from the index,” Davis says. “With Sentry Canadian Income’s greater size, the team is increasing its capacity to pick stocks outside of Canada, which gives it more options geographically – but that is also a different ball game. [The fund’s] biggest competitor is itself – the fund’s past performance is a tough act to replicate.”

IE Mutual Fund Manager of the Year Michael Simpson talks strategy

Simpson, in taking his magnifying glass to potential investments, first zeroes in on a company’s balance sheet, which he calls “the heart” of a company. Low debt gives a company the ability both to survive tough times, he says, and take advantage of opportunities in good times.

“The starting point is the balance sheet, and it’s indicative of the overall health of the company,” Simpson says. “[Those figures] need to be strong for the company to withstand any internal or external shocks.”

Shocks could include such things as a new competitor, a rise in the price of key inputs necessary for production or lower prices charged by a competitor. In periods of relatively low economic growth, such as today, companies with strong balance sheets are valued more highly in the market than firms with heavy debt or a lot of floating-rate debt, he says.

Simpson also seeks companies that pay healthy dividends and have the ability to increase their dividends. He terms these companies “dividend champions.” As these firms’ dividends increase with the growth of the business, he says, their stock prices will rise in tandem. He also likes companies that have cash flow that is healthy enough both to pay dividends and invest in business expansion.

Simpson occasionally will buy shares in a company that doesn’t pay any dividends if he thinks dividends will come in the future. The Sentry Fund holds shares of one company in this category, U.S.-based Catamaran Corp., a manager of corporate pharmaceutical benefit plans and medical record-keeping services. The firm is making growth a priority but is likely to pay dividends as it matures.

“A bond isn’t going to give you a higher interest rate every year for 10 years, but a company can increase its dividend,” Simpson says.

In choosing stocks, Simpson also takes a close look at corporate management, looking for an impeccable track record and ownership in the firm: “We like to see managers with some ‘skin in the game,’ representing a meaningful portion of their net worth.”

Simpson meets frequently with management teams, and values open and frank conversation in both good and bad times. He also keeps his detective eye open for information revealed in nuances, facial expressions and other non-verbal clues:”It’s a red flag if management is evasive. A company can’t grow based on management’s hopes and expectations; there must be a realistic plan of how [the firm] can grow in a slow economy.”

Recently, Simpson took advantage of opportunities in the U.S. Foreign content, primarily U.S.-based stocks, accounts for about 34% of the Sentry fund’s AUM. Simpson expects that allocation will increase to 40% within a year, and eventually could rise to 49%.

Opportunities in Canada are limited – 80% of the TSX’s market capitalization is in resources and financial stocks, Simpson says, while the U.S. market offers world-class companies specializing in health care, food, consumer products and technology. He likes to have exposure across a variety of sectors and companies; typically, the Sentry fund will hold around 50 names.

Lower commodity prices have hurt some Canadian resources stocks but have been a boon to the consumer. Simpson cites research that found that for every US10¢ decline in the retail price of gasoline in the U.S., about US$3 billion is unlocked in available consumer spending.

A Toronto native, Simpson became interested in the stock market after his high-school class took a trip to the trading floor of the Toronto Stock Exchange. Simpson was captivated by the floor’s intense energy. By participating in a stock-picking contest at school, he learned that hard work and research could pay off when he saw his picks’ stock prices rise in value.

Simpson obtained a BA in political science and history from York University in 1987, and subsequently joined investment firm Nesbitt Thomson & Co. in its bond back office. A year later, he moved to Burns Fry Ltd., then made his foray into the mutual fund business by joining Dynamic Funds Inc. in 1993. (All firms are based in Toronto.) There, he began in the sales and marketing department but gradually moved into research and portfolio management, which led to a job at Sentry in 2002.

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