Edmonton Journal

Bargains now proving scarce

Quest for yield has pushed up valuations

- By Jonathan Ratner Financial Post jratner@nationalpo­st.com Twitter.com/jonratner

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 outperform­ance 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 onetime 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.

 ?? Michele Siu for National Post ?? Brandon Snow, principal and portfolio manager at Cambridge Advisors, says the highest dividend paying stocks in the S & P 500
have seen valuations stretched to the point where they are trading almost in line with the index itself.
Michele Siu for National Post Brandon Snow, principal and portfolio manager at Cambridge Advisors, says the highest dividend paying stocks in the S & P 500 have seen valuations stretched to the point where they are trading almost in line with the index itself.

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