Canadian equity roundtable: Part 3

Ian Hardacre, vice-president and head of Canadian equities at Trimark Investments, a division of Toronto-based Invesco Canada Ltd. His mandates include the flagship Trimark Canadian.

Daniel Bubis, president and CEO of Winnipeg-based Tetrem Capital Management Ltd. Bubis and his team manage a range of mutual funds for CI Investments Inc., including CI Canadian Investment and CI Canadian Investment Corporate Class.

Michael O'Brien, managing director and head of the core Canadian equity team at TD Asset Management Inc. His mandates include that of lead manager of TD Canadian Equity, TD Canadian Blue Chip Equity and TD Balanced Income.

Morningstar columnist Sonita Horvitch convened and moderated the roundtable. Her three-part series began on Monday and continued on Wednesday.

Q: Time to talk about the Canadian banks.

Thomson: Since the '90s, their fees have gone from about 30% of the bottom line to in excess of 50%. Also, government-guaranteed mortgages have gone from around 30% to 50% of their loan book. So their net exposure to lending has dropped significantly.  Toronto-Dominion Bank (TD) is a major holding in Beutel Goodman Canadian Equity and it has one of the largest short positions on the TSX. So you put those two facts together. For us this means that one of the better businesses in Canada is out of favour.

We have almost 9% of the portfolio in TD and almost 9% in  Royal Bank of Canada (RY). We have added to both these holdings in the last few months. These two banks have the best position in Canadian retail banking, which is the best business of the banks. Between the two of them, they have about a 50% share of the Canadian market. A lot of good things come out of their market share, including operating leverage. We're very comfortable with these two banks' management.

	Daniel Bubis

Some of the other players, because of their market share, are disadvantaged relative to Royal and TD. These two banks have grown their dividends close to 10% per annum for the last five years.  Bank of Nova Scotia (BNS) has grown its dividends at 5% to 7% per annum.  Canadian Imperial Bank of Commerce (CM) and  Bank of Montreal (BMO) have dividend growth in the low single digits. Having said this, we still think Scotiabank and Commerce are attractive businesses with high returns on equity and the ability to generate excess capital.

O'Brien: When it comes to valuation, Scotiabank is the outlier, at present, in terms of where it trades versus the rest of the banks compared with its historic valuation relationship. It has been de-rated. It speaks a lot to the view as to how the global macroeconomic backdrop is going to play out. Scotiabank is most exposed to that global growth theme. Its valuation multiple has suffered over the last year or two because of that. If there is one potential for a multiple rerating, it is Scotiabank.

Bubis: Why did Scotiabank opt for that diversification into Central America and Latin America? Banking is under-penetrated there. The growth will be higher there, assuming Scotiabank has the right franchises.

O'Brien: The valuation on the stock is compelling, if you want to bend against the wind here and have a three-year investment horizon.

	Bank of Nova Scotia	Canadian Imperial Bank of Commerce	Royal Bank of Canada	Toronto-Dominion Bank
Nov. 11 close	$60.90	$99.75	$75.98	$54.72
52-week high/low	$71.17-$52.60	$107.32-$83.10	$83.87-$68.05	$57.89-$47.75
Market cap	$72.7 billion	$39.2 billion	$108.5 billion	$100.6 billion
Total % return 1Y*	-7.0	0.5	-3.3	0.5
Total % return 3Y*	8.4	12.6	14.8	14.6
Total % return 5Y*	6.2	9.1	10.6	11.4
*As of Nov. 11, 2015 Source: Morningstar

Hardacre: Trimark Canadian has about 6% in TD and 5% in Scotiabank. We also own Royal. The only bank that we added to early in the year was Scotia.

Bubis: CI Canadian Investment has significant holdings in TD, Royal, Scotiabank and Commerce. The biggest holdings are TD and Royal. We have been building out our position in Scotia this year.

Q: A summary on the Canadian banks?

Thomson: They are decent businesses and valuations are attractive. The S&P/TSX Composite Index has a dividend yield of 3.1% and the dividend yields on bank stocks are between 3.8% and 4.5%.

Q: What about industrials, specifically the rails?

Michael O'Brien and Mark Thomson

O'Brien: In the Morningstar roundtable a year ago, we agreed that the rails were good businesses and that the stocks had had a good run and were no longer cheap. The stocks came off earlier this year. The economy has been soft, crude-by-rail declined and there was not as big a grain crop. Valuations on rail stocks came back to something more reasonable. We were able to pick away at  Canadian National Railway Co. (CNR) in the late summer/early fall. The stock has done well into the fall. It is among the top 10 holdings in TD Canadian Equity.

Thomson: We own both CN and  Canadian Pacific Railway Ltd. (CP) in Beutel Goodman Canadian Equity. Over the last five/six years, we did repeated sells on them, as they hit our targets. We were also buyers of these stocks this year.

Bubis: We own CN; we added to it in the summer. It's among the top-10 holdings in CI Canadian Investment.

Hardacre: Two big industrial holdings in Trimark Canadian are Toromont Industries Ltd. (TIH) and MacDonald, Dettwiler and Associates Ltd. (MDA). The latter is the largest satellite maker in the world and really is a technology company. We have owned it for about a decade and it has provided a good return over time. This year, there has been a slowdown in satellite orders, so the stock is off. But this doesn't change the long-term view. It's one of the best-managed companies in Canada, as is Toromont, which we have owned for north of 20 years. It's a simple business. It's a Caterpillar dealership in Eastern Canada.

Thomson: Finning International Inc. (FTT) is in Beutel Goodman Canadian Equity. This is an excellent business, with a high return on capital. The company is exposed to the energy business. The stock is heavily discounted because of this, but Finning can manage downturns effectively. The stock will provide a good return even if oil prices don't recover, and an excellent return if they do.

O'Brien: Back in January, we eliminated Finning from the portfolio because we had a fair amount of cyclicality throughout the portfolio. It was a defensive move.

Q: Consumer-discretionary stocks? The Composite's consumer-discretionary sector (7.2% of the index) had a total return of 18.5% in the 12 months to the end of September versus the index's negative total return of 8.4%. Three of you own auto-parts manufacturer  Magna International Inc. (MG).

O'Brien: Magna has done a great job. It was a top-10 holding for us last year and we have been selling it down. It's still a good weight in the portfolio. The question is how much is left in the auto cycle? Magna is an early-cyclical stock. The company has seen an enormous rebound in auto sales in North America. The stock is still inexpensive and the company has prospects for decent earnings growth.

Thomson: We own a big position in the stock. I concur.

Bubis: We still own Magna. It's a superior supplier to the auto industry. There are concerns about the U.S. cycle, which is a big part of what Magna does. The European cycle is at an earlier stage. Magna has exposure there. The stock trades at a discount to its U.S. peers.

Thomson: Magna's management is excellent.

Q: Consumer staples? This sector (4.4% of the index) produced a total return of 34% in the 12 months to September.

Thomson: The grocers are fully priced. Metro Inc. (MRU) is well managed. It understands capital allocation and what matters in running its business. The Street recognizes that and the valuation is getting up there. We have been consistently taking some money off the table in this stock. We also own Loblaw Cos Ltd. (L).

	Ian Hardacre

Bubis: In this group, Loblaw is not that expensive on a relative basis and you do have the return of capital. There is a ramp-up in its cash flow and it is committed to increasing its dividend.

Thomson: Loblaw is catching up, whereas Metro has been extremely well managed all along.

Bubis: It's a reversion-to-the-mean opportunity. We all agree that the consumer-staples sector is generally expensive.

Q: Summing up?

Hardacre: There is consensus that the banks are excellent businesses and represent good value. In the case of energy, there are excellent opportunities and it's a question of timing.

O'Brien: The degree of enthusiasm for the Canadian equity market is directly correlated with your investment horizon. The longer that we look out, the more confident we feel about some of the big sectors.

Thomson: The Canadian financial-services sector has a 37% weighting in the Composite and accounts for 61% of the index's earnings. The Canadian equity market provides good opportunity over the next three to five years.

Bubis: Four bottom-up money managers are optimistic about the Canadian equity market. If this were a discussion among top-down macro managers, it would be a lot different. This is what is creating this opportunity.

Photos: paullawrencephotography.com