The Canadian stock market has lagged some of the larger markets around the world in recent years, particularly the powerfully influential U.S. market.
For the three years ended Dec. 31, 2018, the S&P/TSX composite index showed an average annual gain of 3.3%, less than half the 7% racked up by the S&P 500 composite index in the U.S.
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Canada lacks diversity of industries, with a slimmer choice of investments in the industries that have propelled portfolio returns in the U.S.: health care, technology and entertainment. The cyclical performance of the S&P/TSX index reflects that narrow focus: financials recently accounted for a 34% weighting in the index, and resources-oriented energy and materials accounted for a combined 28%.
Difficulties in the energy sector mean Canada has other problems to contend with. Oil prices have been weak and concerns are rising about weakening global demand and burgeoning world production. Canadian producers have been hurt by lack of pipeline capacity and transportation bottlenecks in getting to world markets.
James Cole, senior vice president with Burlington, Ont.-based Portland Investment Counsel Inc. and portfolio manager of Portland Canadian Focused Fund, has outperformed market indices and peers in Morningstar Canada’s Canadian-focused equity category. The fund’s highly focused portfolio typically holds large positions in no more than a dozen stocks and bears no resemblance to S&P/TSX index’s weightings.
The Portland fund recently held shares in only four industries among the S&P/TSX index’s seven sectors: 62% of fund assets under management (AUM) were held in financials, 15% in utilities, 10% in consumer discretionary and 8% in consumer staples.
“I’m the most unindex-like portfolio manager that you’ll find,” Cole says. “I concentrate on what I believe are the most attractively valued companies, and the best [industries].”
Cole’s concentration on favourite holdings is significantly higher than that of most fund portfolio managers. The majority of holdings in the Portland fund are close to the permitted limit of 10% of AUM in any one stock, the threshold set by mutual fund regulations.
“I seek to avoid significant, permanent losses,” Cole says, “by investing only in high-quality businesses with above-average predictability [and] at sensible prices. My experience has been that if you avoid losses, the portfolio returns take care of themselves.”
Although Cole makes his home in Calgary, in the heart of energy-rich Alberta, the Portland fund has not held shares in an energy-producing company for four years.
“In 2014, you couldn’t miss what the tea leaves were saying, which was that OPEC was tired of losing share to U.S. shale production and the market would be flooded,” Cole says. “I sold whatever energy companies I had and haven’t owned any since.”
Instead, Cole focuses on opportunities that look enticing. The Portland fund has almost 10% of its AUM held in each of four Canadian banks – Toronto-Dominion Bank, Royal Bank of Canada, Bank of Nova Scotia and Canadian Imperial Bank of Commerce – with a smaller holding in Bank of Montreal.
“The Canadian banks proved during the global financial crisis that they are among the best banks in the world,” Cole says. “Their capital positions are stronger than they’ve ever been; they’re extremely cash-generative; and they are out of favour, trading with healthy dividend yields of more than 4% and low price/earnings ratios.”
Although the Portland fund’s inclusion in Morningstar Canada’s Canadian-focused equity category allows Cole to invest up to 49% of the fund’s AUM outside Canada, the fund recently held only 15% in foreign stocks. Included in the fund’s foreign holdings are Citigroup Inc., a top bank in the U.S.; and a small stake in Warren Buffett’s diversified business empire, Berkshire Hathaway Inc.
Cole took advantage of stock price dips this past autumn to make his Citigroup purchase, and also bought shares in Canada-based autoparts giant Magna International Inc. He says Magna and Citigroup both are using some of their healthy cash flow to repurchase large amounts of their own shares at attractive prices.
Conversely, Cole capitalized on a price jump in the Portland fund’s holding in Walgreen’s Boots Alliance Inc. to sell at a healthy profit. The stock had risen by more than 40% from its low in June 2018.
Duncan Anderson, senior managing director and senior portfolio manager with Manulife Asset Management Ltd. in Toronto and a member of the team managing the Manulife Dividend Income Plus Fund, says his perspective on the fund’s portfolio is to view it as a successful business conglomerate. Each company in the fund is carefully selected to be a cog in a diversified enterprise made up of non-correlated businesses with growing revenue and profit.
The Manulife fund’s top 10 holdings don’t include a single Canadian bank or resources stock and, as a result of the portfolio managers’ bottom-up approach, the fund’s portfolio bears no resemblance to the S&P/TSX index.
Eligible companies must have an attractive valuation, as well as a low level of financial leverage. With interest rates rising, a company’s vulnerability to increasing borrowing costs is growing in importance, says Anderson: “We don’t like financial leverage and that keeps us out of a large chunk of stocks on the [Toronto Stock Exchange].”
The Manulife team casts its eye around the globe to find opportunities for the Manulife fund’s 49% allowable foreign content. Recently, the fund held about 38% of AUM outside Canada, about two-thirds of which were based in the U.S.; 12 other countries were represented, including the U.K., Switzerland and New Zealand.
The Manulife team is responsible for all its own idea generation and stock analysis, and that’s an important part of their competitive edge, Anderson says.
The Manulife fund recently held about 64 companies. The maximum weighting in any one holding is 6% of AUM for Canadian stocks, based on purchase price, and 3.5% for international holdings, for which there is a larger universe of opportunities.
The Manulife team thinks in terms of “subindustries” rather than traditional market sectors. The Manulife fund recently had 8% of AUM allocated to Internet software and services; 5.8% to apparel, accessories and luxury goods; 5% to railways; 4.5% to restaurants; and 4.4% to food retailers.
“Part of our risk-control strategy is to have no concentrated bets in terms of subindustries or individual stocks,” Anderson says.
A key holding in the Manulife fund is Constellation Software Inc., which, Anderson says, has achieved a high rate of growth through carefully targeted and well-integrated acquisitions without using a lot of debt. The firm still has a long “growth runway” ahead.
Another top holding is Aritzia Inc., a Vancouver-based young women’s clothing retailer that has found the sweet spot between “fashion-forward” and consumer affordability, Anderson says.
A more recent addition to the portfolio is a significant holding in Canadian National Railway Co., which benefits as railcars take up some of the slack in transporting Canadian oil.