Opportunity, risk in Canada: Part One

Pat McHugh, Canadian Equity Strategist at Manulife Asset Management, is positive on the outlook for the Canadian marketplace. “From a big picture perspective,” he says, “the Canadian market has advantages we don’t think any other market really has.”

McHugh’s assessment is based on three key factors. “Number one is that we’re the U.S.’s largest trading partner, and the U.S. is now just starting to recover. Our chief economist, Bill Cheney, believes that when we get through 2011 and look back, we’ll see the U.S. in fact came out a little bit better than what we’d expected.

“Expectations are pretty low. That doesn’t mean the U.S. economy is going to leave skid marks, but we think there will be a number of positive surprises as we go through 2011,” McHugh adds.

His second point: over half our index is pinned to commodities, which means we have a direct leverage to the emerging markets’ growth prospects.

The last point is risk. “When you look at the Canadian landscape — our balance sheets, the government, or our banking system — the risks versus other areas an investor can go are fairly low.”

McHugh adds the mood surrounding our currency is positive, which is critical for investors. “If you have investments in a market, and that currency has taken a hit, there’s a risk to the value of your investments in that market from a global perspective.”

So this, McHugh says, is “how things look from 30,000 feet.” In his assessment, however, the landscape looks no less promising from ground level.

As 2011 unfolds, he expects Canada, absent an exogenous shock, to be among the strongest performing stock markets of the G8 countries. “We are expecting the market from this point going forward to advance 10%, plus a dividend yield. So what we’re calling for is another double-digit return. Call it mid-teens.” This would put us in double digits for a third straight year.

“This always throws people off. But when I look at the numbers, it just seems like the most likely scenario. An advisor reading this may be saying, ‘We’ve had two great years of double-digit returns, and McHugh thinks we’re in for a third — no way.’ But if it looks like there’s further room to grow, that means maintaining or increasing your exposure to equities, if it’s prudent.

“When you look at the valuation of the 10 sub-sectors in the index on a price-to-book basis, they’re trading below their long-term average. So there’s more room, and one could argue there’s more appreciation potential in all 10 sectors, especially given the fact that one could argue it’s still early in this economic cycle, given the circumstances of the U.S.”

That said, there are sectors clients don’t need to look at right now, specifically the defensive sectors like healthcare, telecommunications, and consumer staples.

“At this stage, we should look at the economically sensitive sectors: energy, materials, consumer discretionary. That’s things like Magna International (TSX:MG), Canadian Tire (CTC.A), and cable stocks, industrials, railways, SNC-Lavalin (SNC), Russel Metals (RUS), the high-technology sector and financial services. These are areas we think will do well from this cycle forward. But each one really depends on a whole pile
of factors.”

For example, McHugh likes energy more than materials because materials have had a really good run, while energy hasn’t. He also likes insurance companies more than banks. “Banks have had a good run, and the insurance companies have leverage to higher interest rates; as bond yields increase, it will benefit insurance companies.

“But we think there’s money to be made in all these sectors,” McHugh adds.

When choosing which sectors to home in on, investors need to stay attentive to the factors that drive markets up. One of these factors is the flow of foreign investment capital. “We know foreigners are putting money into Canada. Are they buying healthcare and Bell? Or Canadian Natural Resources (CNQ), Imperial Oil (IMO), and Teck Resources (TCK.B)?” The latter, McHugh explains, are “the ones they’re going for.”

Another factor to be mindful of is earnings expectations, where the defensive sectors are lagging. “So just because you’re trading below the long-term multiple doesn’t mean you’re going to make your clients a ton of money,” McHugh explains. “But there’s room for capital appreciation across all sectors — some more than others.”

McHugh emphasizes his strong preference for equities should not be taken to mean there’s no room for bonds in a sound portfolio. “Bonds definitely belong in a diversified portfolio — they are the cornerstone. But an advisor who is increasing his clients’ allocations to bonds must know that above inflation, they’re getting a very small return based on historic standards. That’s another reason why we like Canadian equities.’

Advising risk-averse clients

For clients with lower risk-tolerance thresholds, McHugh suggests financial services. “In our recent lifetime, none of the banks have decreased or eliminated their dividends. We’ve seen Laurentian Bank (LB) [and] Canadian Western Bank (CWB) increase their dividends. National Bank (NA) increased its dividend last year, and more banks are expected to [do the same],” he says.

“For a client who’s risk-averse, the 3.5% yield you’re getting on financial services is as good as a 10-year [Canadian bond], plus you’re getting a dividend tax credit. So to me that’s a great opportunity. And it’s a sector clients understand. We have confidence in our financial services industry,” he adds.

McHugh suggests other areas for risk-averse investors: “Gas stations and merchandisers, railway stocks, telecom stocks, utilities and pipelines. There are lots of stable companies with long-term growth potential, great balance sheets, good dividends and dividend improvement going forward.”

Planning for long-term gains

“There’s more than one way to skin a cat,” says Garey Aitken, chief investment officer, Bissett Investment Management and co-lead manager of the Bissett Canadian Equity Fund.

“We have a distinct investment style in terms of the types of companies we’re looking for, and we’ve got strong views on the importance of valuation. And all of that we do in pursuit of superior long-term risk-adjusted returns.”

Aitken explains that whether he’s overweight or underweight on a given sector is “really just a function of where we find the best individual ideas at any point in time. That tends to be fairly static. We’ve got a low-turnover approach. Historically, there are sectors where we’re pretty consistently over- or underweight.”

The pillars of Aitken’s approach are the secular growth companies, the companies that “will stand the test of time. They have a business model that gives them a competitive advantage, and we think they’re there for the long term. We’re long-term investors in the way we analyze companies and value companies,” Aitken adds.

Populating a fund with these kinds of companies will mean a slightly lower return-volatility profile than that of the index. “Over long periods of time, our volatility typically runs about 10% to 15% lower than the index. The beta of the strategy is about 0.8 to 0.9,” Aitken explains.

The horses

Aitken’s biggest overweight is financials, but he’s underweight on commercial banks. “We do like the banks and have exposure to five of them; they’re such index heavyweights that they make up a big part of our portfolio. But we’re not in the game of starting with the index weight of a security and then going from there.

“All that overweighting is a function of what we’re doing with what I loosely refer to as the non-bank financials group. So that would be the lifecos, investment managers, and some of the niche plays in that sector,” he says.

Aitken says the Power Group of Companies — Power Corporation (POW), Power Financial (PFW), Investors Group Financial (IGM) — TMX Group (X), Home Capital Group (HCG), and Brookfield Asset Management (BAM.A) are in his non-bank financials lineup.

“Those are the types of long-standing names consistent with our approach. We like the underlying businesses, and we’re comfortable with the valuations,” he adds.

Aitken says he’s also overweight on consumer discretionaries and energy. “On the surface,” he says, “we are pretty close to the energy sector weight in the S&P/TSX Composite Index, 26%-to-27%. So at first blush it looks like we’re not making much of a stance there.

“But when we look at it in more detail we’ve got more exposure to mid-cap oil and gas producers and energy service providers. So the composition of our energy weight is quite a bit different than the benchmark. We like the growth potential of some of the more mid-cap oil and gas producers, and we put a lot of emphasis on track record and management quality.”

Aitken singles out Peyto Exploration and Development (PEY), Celtic Exploration (CLT), and NuVista Energy (NVA) as top-calibre mid-cap oil and gas producers. Aitken also has significantly more exposure to the energy services sector than its representation on the index through five companies that again fall into the mid-cap range. These five horses, Aitken says, are Calfrac Well Services (CFW), Trican Well Service (TCW), Flint Energy Services (FES), Savanna Energy Services (SVY), and Mullen Group (MTL).

While materials represent about 23% of the composite index, Aitken is running only about 7%, consistent with his fund’s historically light positions in this sector. “When we look at that in more detail, that underweighting comes from the fact that we have no exposure to the golds, and golds would represent about 12-13% of the index. We don’t have a bias against gold companies, but they tend not to fit as well with our approach as other businesses in the Canadian marketplace,” he says.