Brian Madden, senior vice president and portfolio manager at Goodreid Investment Counsel
Focus: Canadian equities and fixed income
We know many investors are cautious, given the size and speed of the rally, but for context, the S&P 500 is up six per cent since the Nov. 8 election, which is in line with the seven per cent run markets took between Ronald Reagan’s election in 1980 and Inauguration Day, and actually pales in comparison to the nine per cent run markets took between the 1960 election of JFK and Inauguration Day (these two specifically were chosen because both were “upstart” candidates, and both won with narrow margins, but managed to take the House and Senate, as well). In our view, the equity rally since the U.S. election marks an important secular regime change wherein the baton of policy stimulus is being passed from the Federal Reserve to the government. The election and events leading up to it mark the end of nearly eight years of unconventional monetary policy via repeated rounds of quantitative easing and a mildly contractionary fiscal policy environment, with restrained deficit spending under a divided government. With Republicans now firmly in control, the odds are good that the U.S. will run a very expansionary fiscal program led by personal and corporate tax cuts, perhaps bolstered by a foreign profits repatriation tax holiday and rounded out by an aggressive infrastructure build campaign. The implications of this are broad and far reaching and fall broadly into three main categories: macroeconomics/fiscal and monetary policy, equity thematic opportunities and risks, and finally “everything else.” So, while our team has discussed, debated and considered numerous issues, six in particular, we believe, will have great impact on investment results in the coming year and beyond.
RISING INTEREST RATES
Bull markets don’t die of old age, but conversely, “trees don’t grow to the sky” either. Interest rates have been falling for 35 years and this has buoyed the performance of bonds tremendously. We believe this tailwind is coming to an end, and accordingly, prudence is the order of the day in managing bond portfolios. In practical terms, this means attempting to earn competitive yields by owning short-dated, high-quality Canadian corporate bonds and preferred shares and avoiding bond proxies in equity portfolios.
ACTIVE MANAGEMENT RENAISSANCE
Correlations between stocks have fallen to low levels, indicative of a marketplace where differentiating between good companies and bad companies, inexpensive and overvalued stocks, etc., is once again bearing fruit for active managers. We believe the macroeconomic and policy environment is supportive of this trend continuing in the stock market. In the bond market, investors have sought refuge from the supposed evil of high fees by investing in passive bond portfolios and ETFs. This could become a sad case of “penny wise, pound foolish” as in their attempt to minimize fees, these investors may have lost sight of the fact that passive bonds funds leave them fully exposed to rising rates at the very time when the skill and strategy of an active fund manager is most needed to squeeze out the requisite income whilst preserving capital in the face of a more hostile market environment. Minimizing fees is not, or at least ought not to be, a primary objective unto itself.
OPEC CARTEL RE-BOOTS THE ENERGY MARKETS
OPEC, after a two-year long failed experiment in mutually-assured destruction, has agreed to production cuts, which took effect Jan. 1 and which will pull 1.2 million barrels daily of OPEC oil production off the world market, and crucially has also secured commitments from key non-OPEC producers, including Russia, to take a further 600,000 barrels offline. The result, quite predictably, given that oil demand is extremely inelastic in the short- and medium-term and with two per cent of global supply being shut in, has been a sharp spike higher in prices (+18 per cent) since initial outlines of a deal emerged on Sept. 28. Admittedly, there is some well-deserved skepticism and investor grumbling about a history of the cartel cheating on quotas, but this misses the larger point, which is that cheating off of a lower base production level is better than the status quo, and moreover the OPEC cartel has historically been an incrementalist, such that if these production cuts fail to shore up the market, they are quite likely to follow them up with further cuts, as they did successfully three times in 2008-9, four times in 2001-2 and three times in 1998-9. Closer to home, the glow of the OPEC decision was followed promptly by the Trudeau government sanctioning two new export pipelines to carry Canadian crude oil to market, which should eventually narrow price differentials versus global benchmark pricing, further bolstering the case for owning Canadian energy producers.
REGULATION ROLLBACK … RED NECKTIES, NOT RED TAPE!
The President-elect has announced his intention to roll back the Dodd-Frank Act, which took effect in 2010 and has severely hampered the profitability of banks, including big Wall Street firms, by limiting their proprietary trading abilities, mandating higher capital levels, greater transparency for derivative investments, and greater safeguards on consumer credit products. The lifting or partial repeal of these restrictions has significant positive implications for large U.S. banks. Conversely, in Canada, the federal government, CMHC and at least one province are actively leaning into what amounts to a runaway bull market in housing prices in Vancouver and Toronto via tightening of credit through tax and administrative measures. Given that Canadian banks are extraordinary shareholder value creators over time, our approach is not to eschew the group altogether, but rather to emphasise the strongest and best diversified (by line of business and by geographic exposure) among them.
POPULISM, PROTECTIONISM AND ANTI-GLOBALIZATION
The new U.S. government is likely to usher in higher economic growth, but with it will likely come greater policy uncertainty, the occasional perplexing middle-of-the-night tweet and some of the uglier risks of nationalism and trade protectionism. Emphasizing domestically-oriented U.S. companies, rather than large multinationals, and limiting exposure to Canadian based manufacturers/exporters, should help insulate portfolios from the dual risks of trade wars and our expectation for continued strength in the U.S. dollar.
TO BUY OR TO BUILD? BETTER TO BUILD, WE THINK
Tying a number of these issues together, including the prospects for higher interest rates, the expectation that a policy regime change in the U.S. will propel the economy towards a higher growth path, the rise of protectionism, and adding the further observation that tax reform initiatives may include some sort of foreign profits repatriation tax holiday, we expect outbound merger and acquisition activity to cool off somewhat. Further, under Trump, one might reasonably expect that a tax holiday for foreign profit repatriation could come with strings attached, namely the obligation to reinvest in facilities and domestic expansion. Accordingly, the tax- (recall the multitude of “inversions” where American companies orchestrated reverse takeovers into low-tax jurisdictions like Ireland, Barbados, etc.) and cheap-financing-driven merger and acquisition bonanza we have experienced over the last several years may have seen its best days as cash is incentivized back to work in the real economy rather than incentivized into financial engineering initiatives like share buybacks and acquisitions. The implication is that companies with compelling organic growth prospects should re-take the spotlight from serial acquirers over time.
ALIMENTATION COUCHE-TARD (ATDb.TO) – Last purchased on January 6, 2017 at $60.54
Alimentation Couche-Tard is the largest convenience store operator in North America. The company has a 20-year+ record of growing earnings and enjoys high and rising profitability as measured by return on shareholders’ equity. Their increasing size and scale is driving procurement advantages relative to rivals, so they can price sharply on fuel to draw traffic. Shoppers are then enticed into attractive, modern and well-merchandised stores to buy chocolate bars, coffee, cigarettes, prepared foods, etc., which carry 34 per cent gross margins versus the five-to-six-per-cent margins on gasoline. Management consists of extremely capable acquirers and integrators of businesses, which is important in this still-fragmented industry where there are more motivated sellers than qualified buyers. The company is in the process of acquiring CST Brands in their largest deal yet for $4.4 billion, which should be about 15 per cent accretive to earnings. The stock trades at 17x earnings versus the TSX Composite, which trades at a multiple of 16.5x. The company grows consistently faster than the TSX, so we expect it to re-rate higher, and cannot rule out the prospect of further large-scale, financially-accretive M&A later in the year, with large assets from the likes of Marathon Petroleum and Suncor still thought to be up for eventual sale.
SHOPIFY INC (SHOP.TO) – Last purchased on January 4, 2017 at $58.72
Shopify is Canada’s largest e-commerce enablement company, and is growing at a torrid pace with sales up 89 per cent compared to the prior year in their latest quarter. While not yet profitable, this company, which went public in 2015, expects to hit the breakeven mark later this year. We are drawn to their comprehensive “retailer/e-tailer-in-a-box” open platform solutions for small and mid-sized businesses with functionality spanning sales promotion management, inventory management, shipping and order management, point-of-sale solutions/retail hardware, payments, and receivables financing. Shopify offers connectivity to all major sales channels and payment methodologies whether they are web-based (Amazon), mobile (Apple Pay), social-media based (Facebook) or bricks-and-mortar. The company is investing back into enriching their user experience and their platform functionality, creating high switching costs via greater integration into all aspects of their clients’ businesses. This has been restraining short-term profitability, but in our view is cementing loyalty, which should lead to higher lifetime revenue and, ultimately, profit per client.
MANULIFE FINANCIAL (MFC.TO) – Last purchased on December 15, 2016 at $24.93
Manulife is Canada’s largest life insurance company. The business is well balanced geographically, with Canada, the U.S. and Asia each contributing to roughly one-third of revenues. The stock yields 3.5 per cent and trades at 1.1x book value, which is discounted both versus other Canadian life insurers and relative to U.S. peers. Manulife offers a 10-per-cent-and-rising return on shareholders’ equity. Life insurer balance sheets are heavily exposed to fixed income securities via investments in mortgages, bonds and private loans, and thus the company has favourable exposure to a rising interest rate environment, which will produce more portfolio income in their general funds.
PAST PICKS: AUGUST 29, 2016
ALIMENTATION COUCHE-TARD (ATDb.TO)
- Then: $67.63
- Now: $60.10
- Return: -11.13%
- TR: -10.90%
MAGNA INTERNATIONAL (MG.TO)
- Then: $52.29
- Now: $60.08
- Return: +14.24%
- TR: +14.93%
CCL INDUSTRIES (CCLb.TO)
- Then: $240.35
- Now: $259.00
- Return: +7.75%
- TR: +8.21%
TOTAL RETURN AVERAGE: +4.08%
FUND PROFILE: GOODREID NORTH AMERICAN BALANCED
PERFORMANCE AS OF DECEMBER 30, 2016:
- 1 year: Fund 7.3%, Index* 10.2%
- 3 years: Fund 8.1%, Index* 5.5%
- 5 years: Fund 10.3%, Index* 7.1%
* Index: Globe Canadian Equity balanced peer average
* Net of fees
TOP HOLDINGS AND WEIGHTINGS
- Canadian equities: 34%
- U.S. equities: 37%
- Canadian fixed income: 24%
- Cash: 5%