TUR­BU­LENCE

Cana­dian eq­uity in­come funds face both head­winds and tail­winds as in­ter­est rates rise amid strong eco­nomic growth

Investment Executive - - FRONT PAGE - BY JADE HE­MEON

Cana­dian eq­uity div­i­dend and in­come funds face head­winds and tail­winds.

port­fo­lio man­agers of mu­tual funds that fall within Morn­ingstar Canada’s “Cana­dian div­i­dend and in­come eq­uity” cat­e­gory have been find­ing more op­por­tu­ni­ties since sharp de­clines in global and Cana­dian stock mar­kets tripped up the long-run­ning bull last month. How­ever, these port­fo­lio man­agers are tread­ing care­fully and ex­pect a lot of buck­ing and swerv­ing as in­vestors at­tempt to sort out the ef­fects of con­flict­ing mar­ket in­flu­ences.

“There are both head­winds and tail­winds,” says Pa­trick Reddy, port­fo­lio man­ager with Van­cou­ver-based Leith Wheeler In­vest­ment Coun­sel Ltd. who over­sees Leith Wheeler Cana­dian Div­i­dend Fund. “In­ter­est rates have gone up slightly and could go up more, but the tail­winds come from strong eco­nomic growth and wage in­creases.”

Global eq­ui­ties mar­kets have turned volatile, end­ing a mul­ti­year pe­riod of steadily ris­ing stock prices com­bined with an ab­sence of the er­ratic fluc­tu­a­tions that typ­i­cally char­ac­ter­ize eq­ui­ties.

Af­ter the key Dow Jones in­dus­trial av­er­age (DJIA) in the U.S. surged by 25% in 2017, that in­dex ex­pe­ri­enced a 10% pull­back from Jan­uary highs within a few days in early Fe­bru­ary. That put the DJIA into of­fi­cial “cor­rec­tion” ter­ri­tory be­fore re­cov­er­ing some ground. At the same time, the bell­wether 10-year U.S. trea­sury bond saw its yield jump to a four-year high of 2.8%, in­creas­ing the at­trac­tive­ness of bonds for in­come-seek­ing in­vestors and spark­ing fears of higher bor­row­ing rates.

In­vestors are ner­vous about in­fla­tion and in­ter­est rate in­creases. How­ever, the good news is that eco­nomic growth and job cre­ation have been strong in the U.S., and that trend spills over into de­mand for Cana­dian goods. Canada had a dis­ap­point­ing jobs re­port in Jan­uary, but statis­tics from the U.S. Bureau of La­bor showed U.S. non-farm pay­rolls rose by 200,000 in Jan­uary, beat­ing ex­pec­ta­tions of 180,000 new jobs. U.S. un­em­ploy­ment is at a low level of 4.1%, and job­less claims are at the low­est level in 45 years. Av­er­age an­nual earn­ings grew at an an­nu­al­ized pace of 2.9% in Jan­uary, the best gain since the early stage of the re­cov­ery in 2009.

“The job num­bers have a lot of peo­ple con­cerned that in­ter­est rates will rise faster than ex­pected,” Reddy says. “And there has been a re­cal­i­bra­tion in fi­nan­cial mar­kets.”

The pace of real gross do­mes­tic prod­uct growth in the U.S. came in at a healthy 2.6% in 2017 and could ac­cel­er­ate. Eco­nomic ac­tiv­ity also is pick­ing up i n other parts of the world, such as Eu­rope, Ja­pan and Canada, which usu­ally bodes well for cor­po­rate earn­ings and div­i­dends.

In look­ing for com­pa­nies that can grow div­i­dends, Reddy’s team fo­cuses on what may af­fect a com­pany at least three years out. Even prior to the re­cent mar­ket gy­ra­tions, the team had been fo­cus­ing on com­pa­nies that could weather an up­turn in in­fla­tion and in­ter­est rates by hav­ing the abil­ity to grow earn­ings via prod­uct price in­creases or busi­ness ex­pan­sion.

This strat­egy has kept the Leith Wheeler fund away from tra­di­tional low-growth util­i­ties and pipe­lines, which Reddy be­lieves were over­val­ued dur­ing the past few years. How­ever, the fund’s as­sets un­der man­age­ment (AUM) is in­vested in a few ex­cep­tional firms in the util­i­ties sec­tor with growth po­ten­tial, in­clud­ing Brook­field In­fra­struc­ture Part­ners LP, Su­pe­rior Plus Corp. and Hy­dro One Ltd.

The Leith Wheeler fund also holds some real es­tate in­vest­ment trusts (REITs) that will be able to keep up with in­fla­tion through rent in­creases, in­clud­ing Cana­dian Real Es­tate In­vest­ment Trust Ltd. and First Cap­i­tal Realty Inc.

“We look for com­pa­nies with re­silience to neg­a­tive shocks, that can growth their div­i­dends over time and have rea­son­able div­i­dend pay­out ra­tios,” Reddy says.

The Leith Wheeler fund fo­cuses solely on Cana­dian stocks. A key hold­ing is Cana­dian Na­tional Rail­way Co. (CNR), which has a his­tory of dou­ble-digit earn­ings growth and a strong bal­ance sheet, Reddy says, and will con­tinue to ben­e­fit from eco­nomic growth in the 2%-3% range.

“In­ter­est rates may have gone up, but they’re not high, and the av­er­age cost of cap­i­tal still is at­trac­tive,” he says. “There may be some pickup in in­fla­tion, but that can be a healthy sign of a grow­ing econ­omy. In­fla­tion has been ab­nor­mally low for the past few years.”

Fi­nan­cials are the big­gest weight­ing in the Leith Wheeler fund, at 45%. Reddy likes the big Cana­dian banks, but the fund also has key hold­ings in in­surance com­pa­nies Great-West Lifeco Inc. and Man­ulife Fi­nan­cial Corp., and in fund-man­age­ment gi­ant CI Fi­nan­cial Corp.

In­dus­tri­als are the fund’s sec­ond-largest sec­tor, at 12%. Within that sec­tor, Reddy likes com­pa­nies that will ride the wave of an im­prov­ing econ­omy, a po­ten­tial pickup in re­sources stock prices and ris­ing in­fra­struc­ture spend­ing. Hold­ings in this sec­tor in­clude Cater­pil­lar ma­chin­ery deal­ers Fin­ning In­ter­na­tional Inc. and Toromont In­dus­tries Ltd.

Re­sources com­pa­nies may be be­gin­ning to stir, Reddy says, given some com­modi­ties price im­prove­ment i n 2017. The Leith Wheeler fund holds a large po­si­tion in en­ergy firm Cana­dian Nat­u­ral Re­sources Ltd. and in Mullen Group Ltd., a truck­ing and en­ergy ser­vice firm.

A name added more re­cently to the Leith Wheeler fund is Nutrien Ltd., a com­pany cre­ated by the re­cent merger of fer­til­izer firms Agrium Inc. and Potash Corp. of Saskatchewan.

“We look for com­pa­nies with re­silience to neg­a­tive shocks”

“THE STOCK MAR­KET PULL­BACK in Fe­bru­ary was not a sur­prise, al­though the mag­ni­tude was a bit sur­pris­ing,” says Stephen Duench, vice pres­i­dent in Lon­don, Ont., with High­street As­set Man­age­ment Inc. and port­fo­lio man­ager of AGF Div­i­dend In­come Fund. “How­ever, the cor­rec­tion has been noth­ing close to the 2008 credit cri­sis, and we’re search­ing

for the best buy­ing op­por­tu­ni­ties. We’re not shy to add when op­por­tu­nity presents it­self, but our fo­cus is very com­pany-spe­cific. We look for com­pa­nies for which fun­da­men­tals are still strong and the val­u­a­tions are at­trac­tive.”

Al­though 77% of the AGF fund’s AUM is held in Canada (a top hold­ing in this fund is CNR and, no­tably, a stock the Leith Wheeler fund also holds), Duench says, re­search has f ound the op­ti­mal range for U.S. ex­po­sure to be 15%-25%. Af­ter tak­ing prof­its when mar­kets soared in Jan­uary, the AGF fund’s U.S. ex­po­sure is about 20%, leav­ing room for buy­ing in stocks of in­ter­est, such as John­son & John­son Ltd. and Pfizer Inc., both of which have a long his­tory of in­creas­ing div­i­dends.

“We are cir­cling the wag­ons, and have been adding on [stock price] weak­ness,” Duench says.

Among U.S. stocks, he also likes 3M Co., a multi­na­tional con­glom­er­ate that makes more than 55,000 prod­ucts, in­clud­ing ad­he­sives, abra­sives, lam­i­nates and car-care prod­ucts.

Fears of in­ter­est rate in­creases re­cently sent many U.S. and Cana­dian in­ter­est-sen­si­tive stocks (a.k.a. “bond prox­ies”), such as pipe­lines, util­i­ties, tele­coms and REITs, into a down­ward spin fol­low­ing sev­eral years of pop­u­lar­ity and es­ca­lat­ing val­u­a­tions. But, Duench says, the sell­off may have been over­done and some com­pa­nies in these sec­tors have the abil­ity to grow prof­its and raise div­i­dends, even in a ris­ing in­ter­est rate en­vi­ron­ment.

“Val­u­a­tion op­por­tu­ni­ties are be­gin­ning to ap­pear in the in­ter­est rate-sen­si­tive and de­fen­sive sec­tors,” he says. “And, as bot­tom-up in­vestors, we can’t be blind to that.”

For ex­am­ple, Duench is par­tial to some mid-cap com­pa­nies, such as Pem­bina Pipe­line Corp. and Algon­quin Power & Util­i­ties Corp. The AGF fund also has a healthy hold­ing in En­bridge Inc., for which the div­i­dend yield is in ex­cess of 6% af­ter a re­cent price drop.

The AGF fund’s port­fo­lio is rel­a­tively con­cen­trated with about 40 names, and Duench likes to have more than just in­vest­ment strat­egy. He and his team look for well-priced growth stocks that have fallen into the team’s buy­ing range, in­clud­ing in­dus­tri­als, tech­nol­ogy and con­sumer dis­cre­tionary stocks.

The AGF fund is un­der­weighted in the en­ergy sec­tor, a value play that has been out of favour re­cently. Says Duench: “Some en­ergy stocks have cleaned up their op­er­a­tions, but oth­ers have not. And stock se­lec­tion in the en­ergy sec­tor has never been as im­por­tant as it is to­day.”

Fi­nan­cials are the AGF fund’s big­gest weight­ing, at 36%, and Duench con­tin­ues to favour Cana­dian banks, with the Big Five rep­re­sented among the fund’s top 10 hold­ings. From a fun­da­men­tals point of view, he says, Toron­toDo­min­ion Bank is his fa­vorite be­cause its U.S. op­er­a­tions’ po­ten­tial has not been fully rec­og­nized.

An­other large hold­ing is Power Fi­nan­cial Corp., which has ex­po­sure to the in­surance busi­ness but tends to be less volatile than pure in­surance com­pa­nies, Duench says, and is di­ver­si­fied in other fi­nan­cial ser­vices busi­nesses.

Un­cer­tain­ties sur­round­ing the North Amer­i­can Free Trade Agree­ment have cre­ated op­por­tu­ni­ties in some Cana­dian mid­size in­dus­trial names, Duench says. Specif­i­cally, he likes New Flyer In­dus­tries Inc. (a bus man­u­fac­turer) and WSP Global Inc. (an en­gi­neer­ing and con­sult­ing firm). At 17% of AUM, the AGF port­fo­lio is over­weighted in in­dus­tri­als.

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