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