National Post (National Edition)
AS THE RATE CYCLE TURNS
FUND MANAGER SEES RISKS AMID OVEREXTENDED REACH FOR YIELD
You don’t have to be a macro-focused investor to take notice of what the Bank of Canada has been doing this year. Two surprise interest rate increases from the central bank have been accompanied by surges in the 10-year Government of Canada bond yield, as investors appear to be finally looking ahead to the beginning end of an extremely long period of low or declining rates.
“It seems like the sentiment is that rates have bottomed out, so that’s really on investors’ minds,” said Tim Caulfield, portfolio manager at Calgary-based Franklin Bissett Investment Management. “
The co-lead portfolio manager of $3.2 billion Franklin Bissett Canadian Equity Fund, which he runs with the firm’s chief investment officer, Garey Aitken, believes valuations in many parts of the Canadian equity market pose a fair amount of risk to future potential returns — and low rates are largely responsible.
“The grab for yield has been going on for a long time, but we continue to see much too much emphasis on dividend yield,” Caulfield said.
Dividends are just one component of the total return picture at Franklin Bissett, where a bottom up, growth at a reasonable price (GARP) approach rooted in fundamental research, supersedes any attempts to make macroeconomic predictions.
It also includes a long-term focus targeting businesses that demonstrate good visibility for the next five to 15 years.
When investors overemphasize the importance of yield when selecting stocks, it can lead to pricing that is beyond the intrinsic value of those securities.
“We see that all over the Canadian equity market, and I think that is something to be mindful of,” Caulfield said, highlighting areas like telecom services, real estate, REITs and utilities. “Dividends that feature prominently in the total return stream can draw too many people in, and leads companies to want to satisfy that demand.”
The portfolio manager also highlighted the valuation risk posed by long-duration assets, or significant amounts of debt within companies’ capital structures. While businesses like this have benefited handsomely from the declining rate environment, in a rising rate scenario, their valuations become very sensitive.
“I believe we’re seeing too much complacency around this issue, and there is some danger given what was considered the new norm for quite some time,” Caulfield said. “If we are seeing a rising interest rate environment, it is going to be really difficult for equities that have this emphasis on yield, and where the underlying business has long duration assets.”
He pointed out that the low interest rate environment has made money very easy to come by for households and companies looking to make deals.
“Ultimately, we don’t believe all the M&A being done in the market is good M&A, as companies start to do reckless things when money comes easy,” Caulfield said. “It’s not necessarily being done for the right reasons, because you need to take into account a full cycle cost of capital.”
Low rates are often cited as the driving factor behind potential credit risks posed by Canadian homeowners with stretched balance sheets. That’s a big reason why the banking sector — and its exposure to the domestic housing market — has prompted caution among investors.
However, Caulfield noted that not only are the businesses of Canada’s big banks much more diversified than they used to be, and they remain very profitable, the risk appear to be priced into their share prices.
“That makes the opportunity more attractive,” he said, adding that banks also benefit from a rising rate environment through expanding net interest margins.
CIBC (CM/TSX) is the name he highlighted as having most of its profitability centred around Canadian retail banking, and therefore tends be punished more when people become worried about the domestic economy.
“We believe that risk is pretty heavily discounted into the current share price,” Caulfield said. “That makes it an more attractive risk reward, despite investors seemingly moving away from it given its exposure to what we think is a really good business.”
The portfolio manager also highlighted the fund’s large positions in Brookfield Asset Management Inc. (BAM.A/TSX) and Onex Corp. (ONEX/TSX). As a private equity business, Onex is constantly looking for businesses to acquire at the best price, fix them up, and earn a healthy return.
“Ultimately, we believe that business will continue to earn the high returns on capital it has historically,” Caulfield said.
Brookfield offers investors something similar, although it typically owns long-duration assets.
“They are very opportunistic in buying assets on the cheap, can look globally, and can take advantage of distresses situations,” Caulfield said. “They use their financial clout to take advantage of some of those situations, and on top of that, they now have an extremely profitable asset management franchise.”
WE’RE SEEING TOO MUCH COMPLACENCY AROUND THIS ISSUE.