Assessing the big picture
Scale and pricing power are qualities this Fidelity fund manager covets
The Canadian equity market has garnered more than its share of negativity in the past couple of years, primarily due to the downturn in energy prices and the apparent risks facing the domestic housing market.
Add to that concerns about potentially excessive valuations for dividend paying stocks as investors seek attractive yields in the persistently low interest rate environment, and you can see why Canadian stocks have underperformed in recent years.
But for Fidelity Investments portfolio manager Joe Overdevest, while many of these macro concerns are worth monitoring, it’s more important to take a step back and look at the long-term prospects of companies being affected.
The downturn in oil prices and the Canadian economy have put pressure on Canadian bank stocks of late, but high household debt levels have been a concern for investors in the sector for several years now.
Overdevest, who manages about $5 billion in assets as co-manager of the Fidelity Global Natural Resources Fund and lead manager of the Fidelity FIAM Canadian Focused Equity strategy, noted that Canadian banks have many of the attributes he looks for in an investment.
“They are strong businesses in terms of pricing power, and have a moat around the business, which is of course their large scale,” he said, noting that both Toronto-Dominion Bank (TD/TSX) and Royal Bank of Canada (RBC/TSX) are top 10 holdings in the Canadian equity mandate.
Overdevest also highlighted concerns that the banking sector has fallen behind in terms of technical innovation, and therefore faces risk from emerging competitors.
“Regulators may not want to give up access to Canadians’ lending and investing to a company in Silicon Valley,” he said.
“If all of a sudden we rely on them for credit and we hit a financial crisis, someone in the U.S. may decide not to lend to Canada anymore.”
Overdevest also noted that technology is allowing Canadian banks to be run more efficiently than in the past, and as more employees retire in the coming years, many may not need to be replaced, thereby saving a lot on costs.
When it comes to the energy sector, demand for oil was never much of an issue in recent years. What really drove the downturn of the past two years was a shift in supply.
Overdevest noted that the technical advances in drilling that drove more U.S. oil production initially caused a pullback in activity. However, production continued to rise due to the backlog of new projects coming on.
Today, the picture looks much different as banks around the world are beginning to cut off credit to energy companies, which is very positive for the supply outlook.
“It’s the first step in correcting the supply-demand imbalance,” Overdevest said.
As the oil and gas sector looks for ways to cut costs, and as many players look to add rigs if oil trades at US$50 to US$60 per barrel, companies like Schlumberger Ltd. (SLB/ NYSE) are being tapped to provide the technology to help them do so efficiently.
The world’s largest energy services company is a Top 10 holding in Overdevest’s natural resources portfolio, partly because its large scale and focus on technology generates a very high return on equity.
“The management team is very good at executing, the valuation is attractive, and they actually have free cash flow,” he said.
“That’s supported their dividend and even a share buyback, which is rare for an oil and gas company these days.”
As the oil price has become a major focus for the market, so have interest rates. Everyone seems to be a Fed watcher these days.
While low rates have produced strong returns for dividend-yielding companies, Overdevest noted that many Canadian stocks that fit this mould are still trading at attractive valuations.
“This is a very unique time in history, as many countries around the world have negative interest rates,” he said.
“The extent of this is unprecedented, so in this environment you may be surprised at how high valuations go on dividend yielding companies.”
Brookfield Asset Management Inc. (BAM.A/TSX) only pays a yield of about 1.55 per cent, but that, coupled with the high demand for infrastructure assets from pension funds and sovereign wealth funds, makes it an attractive opportunity for Overdevest.
“The returns are very strong, and in a low interest rate environment, the stock is very attractive for investors,” he said. “The management team also has a very strong track record, they own a large amount of stock themselves, and the valuation is attractive on a net asset value basis.”