Potholes on a highway

Canada’s stock markets enjoyed a rewarding year in 2019 and the S&P/TSX composite index reached new highs. But Canadian stocks didn’t quite keep up with their bigger and more powerful U.S. counterparts.

For the 11 months ended Nov. 30, 2019, the S&P/TSX composite index rose by 18.97%, while the S&P 500 composite index boasted a superior gain of 24.68% (in US$).

The second-place position of Canada is consistent with the three-year period ended Nov. 30, which saw the S&P/TSX composite index reap an average annual compounded gain of 4.15% while the S&P 500 (US$) raced ahead with 10.73%.

The Canadian stock market, heavily weighted in financials and resources stocks, is more cyclical and less diverse than its U.S. counterpart, which offers a wider choice of companies in such industries as health care, entertainment and technology.

The Canadian energy sector has had an especially difficult time. Companies have been plagued by stagnant commodity prices, limited pipeline capacity and bottlenecks in transporting product to international markets.

However, active mutual fund portfolio managers have been able to achieve robust returns by dodging the potholes, aided by the tailwind of loose monetary policy.

Tyler Hewlett, director, portfolio manager and head of Canadian growth equities with Toronto-based BMO Global Asset Management Inc. (BMOGAM), says low interest rates have been the most influential trend affecting stocks since the global financial crisis of 2008.

“Traditional interest rate-sensitive stocks such as REITs and utilities have benefited, but so have global growth companies,” says Hewlett, who co-manages BMO Canadian Stock Selection Fund with David Taylor, vice president and portfolio manager, fundamental Canadian equities, with BMOGAM.

The BMO fund had a top- decile, three-year average annual gain of 9.3% as of Nov. 30.

While Hewlett says the global economy is “late cycle” after more than 10 years of growth, he doesn’t foresee an imminent recession. “Recessions can arrive quickly, but what we’re seeing from an economic perspective is an environment that will continue to allow companies to enjoy growth,” Hewlett says. “It’s possible that this slow-growth environment could persist for some time without a recession or significant downturn.”

Hewlett says his style is to run a concentrated portfolio of about 35 names, paying careful attention to bottom-up analysis and focusing on companies that will thrive even in a downturn.

“We are mindful that [the economy is] late in the cycle,” Hewlett says. “It’s not a time to take excessive risks or invest in companies that need a strong economy to make their business plans work.”

For example, Hewlett avoids cyclical firms and companies with extended balance sheets that must rely on external financing rather than internally generated cash flow to expand. He seeks companies with strong free cash flow and the ability to allocate it profitably.

The dominant sector in the BMO fund, financial services, comprises almost one-third of assets under management (AUM). The fund’s top holding in this sector is Toronto-based Brookfield Asset Management Inc., an alternative asset-management firm focusing on real estate, renewable energy, infrastructure and private equity. Hewlett says Brookfield has better growth potential than the big Canadian banks. “Brookfield has one of the best management teams in Canada and is an amazing capital allocator,” Hewlett says.

Hewlett continues to favour the banks due to their steady growth. His largest position in this group is Toronto-based Royal Bank of Canada.

Most holdings in the BMO fund are Canada-based, although the fund currently has about 5% of AUM in U.S. stocks. U.S. holdings include Microsoft Corp. and Becton Dickinson and Co., a maker of medical devices.

The BMO fund’s primary focus is on large-capitalization stocks, but the fund’s portfolio also holds a handful of small- and mid-cap names to add juice to returns.

Hewlett and Taylor have backgrounds in managing small-cap portfolios. The pair also co-manages BMO Growth Opportunities Fund and BMO Canadian Small Cap Equity Fund, resulting in cross-pollination of ideas.

“Because of our experience, we can add some small- and mid-cap companies that offer higher and longer growth than large-caps,” Hewlett says. “We may find stocks that are off the radar of other large-cap fund managers. Ideally, we like to hold [those stocks] long-term as they grow.”

For example, the BMO fund has had a long-term holding in Parkland Fuel Corp., a Calgary-based independent fuel distributor and a leading convenience-store operator that has enjoyed healthy growth and strong share-price appreciation in recent years.

“We look at risk on a company-by-company basis, not by asset class or sector,” Hewlett says. “The small-cap sector may be riskier overall, but special companies can provide greater return potential with less risk.”

The BMO fund also has benefited from its long-term holding in Winnipeg-based Boyd Group Income Fund, one of the largest collision-repair centre operators in North America. Another smaller company is Waste Connections Inc., a waste-collection and -management company that’s been a successful acquirer and consolidator in a fragmented industry. It has headquarters in Texas and Ontario.

Recent purchases for the BMO fund include Calgary-based Parex Resources Inc., an oil and gas firm that operates in Colombia and doesn’t face the pricing disadvantages and transportation bottlenecks currently plaguing many Canadian firms. Another is Morneau Shepell Inc., a Toronto-based human resources consulting firm and provider of employee assistance programs and group benefits that commands a leading position in a growth industry.

ANDREW MARCHESE, president and chief investment officer with Toronto-based Fidelity (Canada) Asset Management ULC and lead manager of Fidelity Disciplined Canadian Equity Fund, adheres to his proven method of sticking fairly close to the S&P/TSX composite index in terms of sector diversification, but adding value through superior stock picking.

The Fidelity fund’s sector exposure matches the index’s 11 main industry sectors, plus or minus 300 basis points.

“Rather than style bias, sector shifts or market-cap tilt,” Marchese says, “we concentrate on stock selection.”

This well-diversified approach has allowed the Fidelity fund to ride through various bull and bear markets and economic cycles with less volatility than its competitors. While sectors move in and out of favour as conditions shift, Marchese says, his strategy is to always have a balanced mix of businesses. “During any 12-month period, there is always a best and worst sector,” he says. “But, ultimately, there is a reversion to the mean. We don’t try to call the turn. Our approach is consistent and allows us to ride through all phases of the market cycle.”

Marchese has honed his approach during 21 years working on the Fidelity fund. He became lead manager in 2009, having joined the team as an equities analyst in 1998.

The Fidelity fund has beaten the average returns of the Canadian focused equity category and the benchmark index in both short and long periods. It posted a 15-year average annual compound return for the F series as of Nov. 30 of 8.52%, placing the fund in the top 2% of its category. Its three-year average annual gain as of Nov. 30 was 7.9%.

Marchese is prepared to hold smaller companies that aren’t part of the index and a small amount of foreign content, typically less than 10% of AUM combined.

“The focus is on bottom-up fundamentals, and we look for the best risk/reward opportunities,” Marchese says. “We’re prepared to look ‘down-cap’ to find new ideas and potentially hold stocks for many years.”

An important component of building a high-quality portfolio is to put extra weighting in the best ideas, and Marchese will go close to the legal limit of 10% of fund assets in any one stock. For example, among the Fidelity fund’s top holdings is more than 7% of AUM in each of Royal Bank of Canada and Toronto-Dominion Bank. (No holdings of other banks are among the top 10 holdings in the fund.) Also in the financial sector, the fund has a large position in Brookfield Asset Management.

Marchese likes to buy when stocks are undervalued to provide a “margin of safety.”

“We look to buy securities when the market does not fully appreciate them,” he says. “Or they may have balance sheet value that is greater than the stock price would suggest.”

The Fidelity fund’s holdings in the Canadian energy sector, one of the poorest performers this year, include Suncor Energy Inc. and TC Energy Corp. (both based in Calgary) rather than exploration and production companies, which rely on strong global growth.

“As economic growth has slowed,” Marchese says, “investors are gravitating toward energy companies with stable businesses, such as pipelines and midstream operations.ยป