Michael O' Brien, managing director and head of the core Canadian-equity team at TD Asset Management Inc., says that key macroeconomic headwinds combined with higher equity-market valuations suggest that investors in equities need to be even more strategic and disciplined in their stock selections and sales.
"The Canadian-equity bigger-cap market -- as represented by both the S&P/TSX 60 Index and the S&P/TSX Composite Index -- has been essentially flat since the beginning of 2015, as well as over the past 12 months to recent close."
O' Brien's comprehensive statistics show that energy, a heavy weighting in both Canadian indexes, has produced negative returns over both time frames and has been among the poorest performing sectors. Meanwhile, the financial-services sector -- which is another big weighting -- has delivered flat to low-key returns.
The recent showing of the two leading Canadian equity indexes, says O'Brien, is in sharp contrast to their robust performance in calendar years 2013 and 2014. In 2013, the S&P/TSX 60 Index and the composite both produced a total return of 13%. In 2014, the S&P/TSX 60 had a total return of 12% and the composite 11%.
At this stage, says O'Brien, it is important for investors to modify their return expectations from not only equities, but also from bonds. "Both have delivered solid double-digit annual returns over the last six years, following the global financial crisis and the worst recession in 70 years. But he cautions that the circumstances that helped to propel this six-year bull market in financial assets have changed.
Following the financial crisis, central bankers adopted an "aggressive monetary stimulus" to combat the weakness in the financial system and the underlying economy. While Japan and Europe's central banks are still pumping money into their economies, says O' Brien, the U.S. Federal Reserve Board is no longer in all-out stimulus mode. "The Fed is looking to begin to normalize its policy rate, as the U.S. economy gathers strength."
Furthermore, says O' Brien, the Canadian equity market is no longer cheap. Price/earnings multiples have risen from the extremely low levels experienced during the financial crisis to the point where "the equity market is now fair to fully valued." In the last few months, TD Asset Management's asset-allocation team, says O'Brien, has reduced the equity weighting in the firm's balanced portfolios.
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| Michael O'Brien | |
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At TD Asset Management, O' Brien is responsible for some $7 billion in assets. His mandates include that of lead manager of TD Canadian Equity, TD Canadian Blue Chip Equity and TD Balanced Income.
TD Canadian Blue Chip Equity, with assets of $1.6 billion and 44 names, is benchmarked against the S&P/TSX 60 Index. "It is a conservative fund and I have become more valuation-sensitive in the past six to 12 months than I was in the earlier stages of the equity bull market," says O'Brien, who is a growth-at-a-reasonable-price (GARP) manager.
He has, he says, become "even more disciplined in taking profits in stocks," where he considers that valuations have exceeded the fundamentals. He has also allowed the cash component of the fund to modestly rise to 3% to 5%, versus the more typical 1% or less.
An example of a recent trim in this big-cap Canadian portfolio is the grocery chain 
Metro Inc. (MRU). This consumer-staple stock has been a strong performer and is now "trading at a price/earnings multiple of 18-plus times." This multiple is high by the stock's historic norm of 10 to 12 times and "is difficult to justify by the fundamentals in the Canadian grocery trade," says O'Brien. The portfolio is modestly overweight in the consumer-staples sector at 5.5% versus 4.2% in the S&P/TSX Composite Index.
In addition to taking profits where appropriate, O'Brien says he has also been "reducing the cyclicality and, therefore, volatility in the portfolio." For example, he sold the fund's holding in Finning International Inc. (FTT), which is in the industrial sector. Industrial stocks represent 6.6% of the portfolio versus 7.4% in the index.
A major Caterpillar dealer, Finning operates in some of the most resource-rich territories in the world. "Finning is a deep cyclical and I used the proceeds to focus on stocks that are less volatile and have a good dividend yield."
An example of a purchase that fits these criteria, he says, is BCE Inc. (BCE). This major Canadian telecommunications player is increasing its market share in both the Canadian wire-line and wireless business, he says. "The company is being well managed by CEO George Cope."
Both BCE and Telus Corp. (T), a top-10 holding in TD Canadian Blue Chip, are taking market share away from Rogers Communications Inc. (RCI.B), says O' Brien. BCE and Telus have a lower customer-turnover rate, he says. "Telus's management is excellent and the company's operations are ahead of those of its peers."
BCE, says O'Brien, is currently trading at 16 times EPS estimates for 2015 and 15.3 times 2016 EPS estimates. Telus trades at 16.5 times 2015 estimates and 15.2 times 2016 estimates, he says. "Both stocks have an enterprise value (EV) relative to EBITDA (earnings before interest, taxation, depreciation and amortization) of eight times."
The P/E multiples on both BCE and Telus are in line with that of the market, says O'Brien. "The two stocks have high dividend yields and the dividends are well supported." The companies, he adds, are good at converting earnings into free cash flow and giving money back to shareholders. In all, he says, these stocks offer attractive total-return profiles in a market that is likely to produce single-digit returns." Telecommunications services represent 5.9% of the portfolio versus 6.1% of its benchmark.
| BCE Inc. | Rogers Communications Inc. | Telus Corp. | |
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| June 29 close | $52.98 | $43.55 | $42.45 |
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| 52-week high/low | $60.20-$46.43 | $47.50-$40.72 | $45.14-$37.13 |
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| Market cap | $44.6 billion | $22.5 billion | $25.7 billion |
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| Total % return 1Y* | 14.3 | 5.9 | 10.2 |
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| Total % return 3Y* | 12.8 | 9.8 | 16.2 |
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| Total % return 5Y* | 16.1 | 8.1 | 20.6 |
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| *As of June 29, 2015 Source: Morningstar |
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Financial services are 39% of TD Canadian Blue Chip Equity's holdings versus 36.7% in the S&P/TSX 60 Index. Canadian bank stocks represent 29% of the fund and 27.9% of the index. O'Brien reports that he has continued to add to the major Canadian life insurers such as Manulife Financial Corp. (MFC), which is a top-10 holding, and Great-West Lifeco Inc. (GWO).
"The life insurers have good risk-return profiles." But O'Brien has taken some profits in property and casualty insurer Intact Financial Corp. (IFC). "The property and casualty companies have different cycles to those of the life companies." He continues to like the banks. "Their valuations are reasonable by historic standards."
Energy is another overweight position in the portfolio at 23.2% versus 19.8% in the Canadian big-cap benchmark. O'Brien says that he initially trimmed his holdings in energy at the beginning of the year. "I reduced the fund's holdings in major energy producers Suncor Energy Inc. (SU) and Canadian Natural Resources Ltd. (CNQ)." There was concern, he says, about global economic growth and its impact on energy prices. "This was a risk-mitigation move."
After the NDP election win in Alberta in early May, O'Brien took some more money off the table in the energy sector -- "predominantly in oil-sands and Alberta-centric names." There is uncertainty, he notes, about the outcome of the new provincial government's royalty reviews and its future carbon-tax levies.
His strategy was to further trim "flagship names like Suncor and CNQ" and redirect the money into intermediate producers such as ARC Resources Ltd. (ARX) and Crescent Point Energy Corp. (CPG). These two companies, he says, have no oil-sands exposure and limited production in Alberta.
O'Brien explains that he remains overweight in the energy sector because he considers that the oil demand/supply equation is "moving in the right direction." Also, he adds, there could be good upside potential in the stocks over the medium term, as they now represent good value. "But investors have to have patience and it could be a fairly bumpy ride."
