Although U.S. equities markets surged in 2017 based on the so-called “Trump effect” following the election of Donald Trump as president, Canadian markets languished and generated relatively low returns, largely due to the gloomy mood around energy and resources stocks.
As a result, some portfolio managers of Canada-focused equity funds, which may hold stocks in both Canada and the U.S., are cautious. The rally is long in the tooth and Canada’s ability to catch up with U.S. markets in 2018 is uncertain.
Brandon Snow, principal and chief investment officer with Cambridge Global Asset Management, a unit of Toronto-based CI Investments Inc., and portfolio manager of CI Cambridge Canadian Equity Corporate Class, sits in the “guarded” camp.
“For Canada to work from here, you need a weakening U.S. dollar, strong energy markets and momentum in emerging markets. It’s hard to see how Canada can catch up, unless there is some currency exposure driving it,” Snow says, noting that a slow-down at home has made raising interest rates again difficult for the Bank of Canada. “The upside in the Canadian dollar is limited.”
Snow maintains that Canada tends to do well when emerging markets are prospering and U.S. dollars are flooding into those regions to finance development.
“It’s hard to foresee a long-term story in that regard,” says Snow. “Brazil, for example, still is struggling from a political and economic standpoint. And China is closer to pulling back on its growth versus stimulating again. Canada is the global macro-environment ‘beta’ – in which materials and energy stocks are linked to the commodities cycle – and you need to have these sectors working well. I’m not certain we’re in that environment again.”
An overriding issue is that the economic cycle is in the late stages and the U.S.’s economy may not keep chugging along.
“Returns have been driven, to some degree, by earnings being better than expected. But the [price/earnings] multiple has been a big driver,” says Snow, noting that investor complacency is a growing concern. “I tend not to extrapolate [from] multiples unless we begin from very cheap levels. And we’re not. Looking at stocks globally, we are at full to overvaluation.”
Snow adds that expectations are running ahead of themselves and valuation multiples could contract sharply when investors realize that economic momentum is slowing.
Given the uncertainty ahead and stretched valuations, Snow is holding about 15% of the CI fund’s assets under management (AUM) in cash.
“We have a list of companies that we believe are long-term value creators. We judge them on a risk/reward basis, based on the upside potential and downside risk,” says Snow, adding that he needs a slightly wider margin of safety before being fully invested. “We don’t have a lot of high risk/reward opportunities right now. There are always opportunities for speculation, but we’re investors, not speculators.”
From a geographical standpoint, the CI fund holds about 38% of AUM in Canadian stocks, 37% in the U.S. and 7% in international markets. On a sector basis, information technology (IT) is the largest holding at 15%, followed by 12.5% in energy, 11% in industrials and 11% in financials.
A top holding in the 45-name CI fund is Walgreens Boots Alliance Inc., a dominant U.S. pharmaceuticals and cosmetics retailer in the U.S. “It’s a good, stable business with a management team that’s focused on growth in cash flow. They are smart allocators of capital through investment and return to shareholders,” says Snow.
Although Walgreens stock is under pressure because of concerns about Amazon.com Inc. entering the pharmacy industry, Snow maintains those fears are overblown. Walgreens stock is trading at US$71.16 (C$88.05) – 12.5 times forward earnings. There’s no stated target.
predicting the canadian markets’ ability to catch up to the U.S. stock market and whether the latter will continue to charge ahead in 2018 is difficult, says Stuart Kedwell, senior vice president (SVP) with Toronto-based RBC Global Asset Management Inc. (RBCGAM), and portfolio co-manager of RBC North American Value Fund.
“[Predicting the markets’ direction] is more a case of stock-by-stock rather than saying the U.S. market is better than Canada’s,” he says. “Although there’s more to choose from in the U.S., making a definitive statement is hard.”
Kedwell, who shares portfolio-management duties with Doug Raymond, SVP with RBCGAM, believes that the Canadian market is highly dependent on two key sectors: energy and housing.
“When we look [ahead] into 2018, the price of energy is not far from the marginal cost to produce it. Stocks could do better in this environment. But foreseeing crude rifling through the mid-US$60 a barrel [range] is hard. [The price of crude] is very dependent, in the near term, on [the Organization of Petroleum Exporting Countries’ move].
“And from a housing standpoint,” he adds, “when you get into 2018, you will have to deal with mortgage rule changes.”
Kedwell notes that new regulatory guidelines will make getting the same-sized mortgage harder, which ultimately could impact growth on the mortgage side of Canada’s financial services sector. Still, the banks have been adapting to the coming changes, so all is not lost, he adds: “The Canadian market has three main buckets: energy, financials and the ‘middle’ of the market, which is [composed] of companies that are either exposed to the domestic market or are more international in nature.”
On a valuation basis, Kedwell says, “financials are slightly above average, while energy stocks are reasonable for the current crude [oil] environment. But the middle of the market has seen valuation expansion of the type seen by many U.S. companies. You have to be wary of some of those stocks.”
RBCGAM is watchful for five main factors, Kedwell says: “We continue to give equities the benefit of the doubt. But we are watching several trends. First, there’s the slope of the yield curve. Currently, although it’s not inverted, the slope is not very steep. But we are watching the direction. Second, credit spreads remain very tight. Third, there are no signs of credit delinquencies. Fourth, if interest rates rise faster than earnings growth, that’s a worry. We do believe interest rates will rise, but it will be a very gradual process. Lastly, we’re watching the breadth of the market: it has been narrower than we would like – propelled mainly by a handful of companies. Of the five factors, only two have ‘flashes’ beside them: yield curve and market breadth.”
Kedwell adds that RBCGAM uses a proprietary system to monitor changes in these five factors.
Given prevailing trends, he maintains that the Canadian stock market’s return in 2018 could be in the mid- to high single-digit range.
Still, he urges investors to take a longer-term view and not focus solely on 2018: “When you put capital to work, you want to focus on the 10-year return potential. As a long-term investor, you have to say, ‘I will have money at work when things are good and when they’re not.’ They are pretty good right now. But you want to prepare yourself for that inevitable period when they are not as good. The way you do that is by asking, ‘If I pay these prices and I have a bad period, will I still make reasonable returns over a 10-year period?’ The answer to that is ‘Yes, you can still compound your returns at an OK rate, especially relative to fixed-income, but that’s not likely to be like the preceding decade’.”
A bottom-up investor, Kedwell is running about 9% of the RBC fund’s AUM in cash, mainly because he has sold some stocks and is waiting for others to reach more attractive levels. Otherwise, there’s 56% in Canadian stocks, distributed among 60 to 80 names, and 35% in U.S. holdings, also spread among 60 to 80 names. From a sector standpoint, financials is the largest, at 31.6%, followed by 15.6% in energy, 11.9% in IT and 10.3% in industrials.
One significant holding is Brookfield Asset Management Inc., a diversified firm with interests in asset management, real estate, infrastructure, renewable energy and private equity,
“It’s trading around our estimate of net asset value, and we believe it can compound by about 10%-15% a year,” says Kedwell. “The way they can do that is through ownership in four businesses: Brookfield Property, Brookfield Renewable, Brookfield Infrastructure and Brookfield Business Partners. They receive management fees from these entities and a host of other institutions that are invested in funds that have similar objectives. This combination of businesses will generate cash, which we believe management will reinvest over time.”
Brookfield stock is trading at $53 and generates a 1.33% dividend. There’s no stated target.
Another favourite holding is Potash Corp. of Saskatchewan, the world’s largest potash producer, which is expected to merge with Agrium Inc.; the merged entity will be known as Nutrien Co.
“The merger is expected to produce a lot of cost savings and efficiencies,” says Kedwell. Although the industry is suffering from an oversupply of potash, he believes it’s in the process of bottoming. “In the meantime, the merged company should yield around a 3% dividend.”
The stock is trading at $25. There’s no stated target.
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