Bargains proving scarce
Quest for yield has pushed up valuations
The market is later in the equity cycle so valuations aren’t as compelling as they used to be, but another big factor is the ongoing quest for yield.
It’s quite clear that the highest dividend payers have become stretched relative to history, since the top quartile of dividend payers in the S& P 500 are trading almost in line with the index itself.
As Brandon Snow, portfolio manager at Cambridge Advisors points out, it’s the first time that’s happened in 50 years.
“The overvaluation in the bond market has infected this part of the equity market,” he said.
These companies have also boosted their payout ratios to the highest they’ve ever been, while levering up their balance sheets to the point where they’re in bad shape compared to the overall market.
“This group of companies not only has the highest valuations it’s ever had, but the fundamental drivers of value creation for the businesses are probably the worst they’ve ever been,” Snow said.
But eliminating those stocks from consideration still leaves plenty of names that look attractive on an absolute valuation basis, especially if investors concentrate on companies that deliver a balanced return between dividends, share buybacks and internal or external growth.
The valuation challenges are amplified in the Canadian market since many investors have run away from the outsized materials and energy sectors and crowded into other areas.
As a result, dividend payers have moved up to unreasonable levels when compared to their fundamental total returns.
“You really have to tread carefully in the Canada right now,” Snow said, highlighting the multiple expansion in areas such as consumer stocks, and smaller technology and health-care names during the past year.
Complicating matters is that a lot of Canadian companies don’t generate much cash in the domestic market. Snow highlighted the dispersion, or perceived outperform- ance during the past year, and the related risk between companies that sell in the U.S. and more domestic-focused companies.
Two of his holdings in the $4-billion Cambridge Canadian Equity Corporate Class demonstrate this quite well.
Earlier this year, Magna International Inc. (MG/ TSX) faced a headwind since it reports in U.S. dollars, while CGI Group Inc. (GIB/A/ TSX), which probably has the same currency and market exposure, had a currency tailwind since it reports in Canadian dollars.
“One was perceived negatively and one was perceived positively, even though fundamentally there is no difference,” Snow said.
He took advantage of the cloud that hung over CGI — the fund’s largest position — as it grappled with the Obamacare website debacle and short sellers attacking the stock.
CGI is still benefiting from its 2012 acquisition of Logica PLC, which paves the way for further margin expansion, but the company’s cash flow and balance sheet have also improved, and organic growth has started to stabilize.
Snow expects organic growth will provide the next earnings driver for CGI, but he also sees an opportunity for more acquisitions. That bodes well for investors since M&A has proven to be a big source of value creation.
Another name in the portfolio of approximately 40 names that is misunderstood by the market is Electronic Arts Inc. (EA/Nasdaq).
The video-game company has focused R&D spending on its core franchises, allowing it to save a lot on costs. But it’s also poised to benefit from a trend that is very much like the content play seen in the media space in recent years.
In the old days, gamers would buy a disc in store and pay a one-time fee. Now there is a much more dynamic pricing opportunity in terms of how games are consumed. As a result, some intensive players can end up paying as much $5,000 instead of the $70 they used to pay for a game.
Since digital distribution has high incremental margins, and EA has many successful franchises as well as a very large user base to predict player behaviour habits, it has the scale required to pull off this transition.