CANADIAN EQUITIES MARKETS lagged their U.S. counterparts in 2013, contrary to expectations at the start of the year. Going into 2014, some fund portfolio managers of Canadian-focused equity funds, which can include exposure to non-Canadian stocks, argue that U.S. stocks are fairly valued and sentiment may swing back to Canadian names, many of which are cyclical stocks linked to growth in emerging markets.
“Into 2013, people expected better growth rates out of emerging markets relative to our markets,” says Brandon Snow, a principal with Cambridge Global Asset Management, a unit of Toronto-based CI Financial Corp., and portfolio co-manager of Cambridge Canadian Equity Corporate Class Fund. “But by mid-year, people began to realize that the growth rates were going the other way. Through the year, people felt better about growth rates in the U.S.
“Today, though,” he continues, “U.S. stocks are fairly valued, whereas growth rates in many emerging markets have stabilized. The headwind of falling sentiment in emerging markets will probably not be repeated [in 2014] and you could see a rally in areas such as materials and energy.”
During 2013, multiples on U.S. stocks expanded by two basis points to 15 times earnings – back to historical averages.
“When you’re talking 15 times earnings, unless you get a significant acceleration in growth rates globally, you can probably expect a 7%-10% total return, including dividends, from here,” says Snow, who shares portfolio-management duties with Alan Radlo, chief investment officer with Cambridge. “The market could take multiples to higher levels. But it’s not something I would bet on.”
One of the biggest issues on the horizon is when/if the U.S. Federal Reserve Board will taper its monetary stimulus program, which was initiated to support the flagging economy. Says Snow: “We are getting into a new uncertainty, which is: now that the economy is getting better, what is the Fed going to do? That’s probably going to keep a cap on multiples for the next 12 months.”
He adds that there are two scenarios that could affect the tapering decision: “If we get bad economic numbers, multiples may expand a little bit because tapering will be put off. If we get good economic numbers, expectations go up and the Fed tapers. That will temper the valuation uplift in stocks and the market will say, ‘We can’t take stock multiples too high’.”
Snow is a value-oriented investor. About 50% of the Cambridge fund’s assets under management (AUM) has been allocated to Canada, 15% to U.S., 15% to Europe, 2% to other international markets and 18% to cash.
“With markets reasonably valued, and some uncertainty about the Fed’s intention, the outcome of our bottom-up process has been an increase in the cash position,” says Snow, adding that 10% cash is a more typical level.
One favourite name in the 50-name Cambridge portfolio is Ball Corp., a U.S.-based supplier of metal packaging to the beverage and personal-care products industries. “Historically, it’s a very well-run company,” says Snow, noting the stock was acquired a few months ago. “It focuses on economic value-added, which is something we really like. The underlying business is very simple, but [Ball has] the best operations [in its industry].”
Ball’s share price is about US$50.65 ($51.20), or 14 times earnings. Snow has no stated target.
IT’S UNCERTAIN IF CYCLICAL stocks will come back into favour, says Daniel Dupont, portfolio manager with Fidelity Investments Canada ULC in Montreal. He oversees Fidelity Canadian Large Cap Fund.
“Some things are for sure: commodity prices have corrected and there is a significant amount of uncertainty surrounding China and emerging markets. Quite a few of them are seeing cracks in the fundamentals,” says Dupont, noting that countries such as India and Brazil are experiencing worsening inflation, weaker currencies and current account deficits. “Uncertainty is very high.”
Dupont also expresses concern that rising interest rates at home has affected Canadian telecommunications firms, pipelines, utilities and real estate investment trusts, which he has generally avoided, except for a small telecom weighting.
“Things I can’t predict are areas that I try to stay away from,” says Dupont. “Then, the burden shifts to find companies that are not impacted by interest rates and commodity prices and will do just as well. It’s making my job harder, as I prefer areas that are stable: consumer staples, information technology [IT] and health care, [which are] also getting more expensive.”
He adds that stocks such as Loblaw Cos. Ltd. have had strong runs, yet their earnings have not matched their share price appreciation.
Although Dupont is not overly concerned about the U.S. and its chronic debt-ceiling debates, he maintains that China is a much greater worry, especially its real estate valuations: “The last time we saw this was in Japan in 1990. Real estate [in China] is trading at 10 times household income. The more they postpone the correction in asset prices, the worse it will be when it happens.”
Dupont believes that not only is the potential slowdown in China and emerging markets most worrisome, but it is “also the most overlooked, by a wide margin.” He admits he is more cautious than a year ago: “Valuation levels are higher than average. You should be more cautious than last year.”
Strategically, 51% of the Fidelity fund’s AUM is in Canada, 28% is in U.S. and 21% is in international or non-North American equities. A bottom-up value investor, Dupont has about 24% of AUM in IT, largely because it is among the cheapest sectors, followed by 15.3% in consumer staples, 15.2 in financial services, 12.3% in industrials and smaller weightings in areas such as health care.
One top holding in the 90-name Fidelity portfolio is International Business Machines Corp. (IBM), which has evolved from being a manufacturer into a global services-oriented IT provider.
“[IBM’s] business is very stable and recurring,” says Dupont. “And the management team is dedicated to shareholder value by buying back shares and [offering] a decent dividend. At 10 times earnings and 9% free cash flow yield, for me, this is the kind of stock I want to own.”
IBM shares are trading at about US$178 ($187.90) and pay a 3.8% dividend. There is no stated target.
CLAYTON ZACHARIAS, VICE president of Invesco Canada Ltd. in Toronto and portfolio co-manager of Trimark Canadian Endeavor Fund, believes that equities are no longer cheap, so it’s a stock-picker’s market. He shares portfolio-management duties with Mark Uptigrove, vice president of Invesco Canada.
“Markets have had a significant run,” says Zacharias, noting that the benchmark S&P 500 composite index is up by about 175% since March 2009. “The Canadian market is up less so because of the resources exposure. But the U.S. market continues to hit all-time highs, despite the lingering issues. A part of that is due to a recovery in the underlying earnings, which have improved. But there’s also been an expansion of multiples. That makes us a bit cautious today.”
Zacharias, a bottom-up investor, argues that the bullish flavour of the market is prompted by ultra-low interest rates: “We understand why people are shifting to equities – because the alternative is so terrible. But the result is meaningfully higher valuations. For value investors like [us], it’s a reason for pause and being prudent around the valuations we are comfortable with. It’s certainly become much more difficult to identify high-quality investment opportunities, compared to a few years ago.”
In Zacharias’s view, volatility is likely to continue as investors try to second-guess the Fed’s policy decisions and also will be stoked by questions about the direction of China’s economy. “But we don’t have a strong view on any of these macroeconomic issues,” he says, “or spend a lot of time trying to predict what may happen over the next six to 12 months. Not that volatility is a bad thing. If you have a long-term view, you can take advantage of that volatility.”
Given the dearth of attractive names, about 19% of the Trimark fund’s AUM in cash. There is also about 47% in Canadian stocks, 22% in U.S. and smaller holdings in Ireland and Austria. Currently, industrials are the largest sector weighting at 21% of AUM, followed by 20% in energy, 18.7% in financials, 9.9% in IT and smaller weightings in sectors such as health care.
One favourite name in the 28-name Trimark portfolio is Industrial Alliance Insurance and Financial Services Inc. (IA), the fourth-largest insurance firm in Canada. IA has expanded from its home base in Quebec, especially in wealth management. “It’s very well-managed and the top guys are actuaries. They’ve taken a very conservative approach to managing the business,” says Zacharias, noting the firm successfully sidestepped issues that have plagued other Canadian life insurers after the 2008-09 financial crisis.
The Trimark fund acquired the stock during the summer of 2012, when the market took a dim view of some management decisions. IA’s stock has rebounded and now trades at about $48.75 (13.6 times 2013 earnings) and pays a 1.9% dividend. There is no stated target.
Another favourite is Zimmer Holdings Inc., a U.S.-based maker of orthopedic implants. “It’s in a market,” says Zacharias, “that should enjoy secular tailwinds as baby boomers age and require knee and hip replacements.”
Zimmer stock is trading at about US$90.45 ($95.50) per share. “That’s still attractive for a high-quality business that is growing and benefits from high barriers to entry.”
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