Editor's note: This week's Morningstar roundtable on equity-income investing in Canada continues today with the managers explaining what they look for when building their portfolios, and talking about the prospects for banks and real estate investment trusts.
Our panellists: Jason Gibbs, vice-president and portfolio manager at Goodman & Co. Investment Counsel Ltd., which manages the Dynamic stable of mutual funds; Michael Lough, vice-president and director, TD Asset Management Inc.; and Michele Robitaille, senior portfolio manager at Guardian Capital LP, a sub-adviser to the BMO Guardian family of funds.
The discussion was moderated by Morningstar columnist Sonita Horvitch, whose three-part series began on Monday and concludes on Friday.
Q: Time to talk about investment styles in your equity-income portfolios.
Robitaille: We have a buy and hold strategy. We run a high-conviction, fairly concentrated portfolio. We look for companies that have sustainable cash flow and the ability to grow that. We look at a number of other factors such as the business model and the outlook for the business, market share, quality of management and the balance sheet. The (dividend/distribution) payout ratio in the context of the business model is important. A stable business can withstand a higher ratio, but, for example, with oil and gas, you like to see a slightly lower payout ratio, probably in the 40% to 60% range. We look at the valuation relative to its peers and on a historic basis.
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| Jason Gibbs | |
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Lough: Our approach is similar to Michele's. We like stocks that pay a good dividend and are able to grow that over time. The companies must at least be able to grow with the growth rate of the economy, currently at 2% or 3% a year. We look for companies that have a higher-than-average return on equity. Typically, these companies can grow their businesses, even if they only retain a small amount of their cash flow.
Gibbs: We like companies with reasonable pricing power, high margins and staying power. We like management teams that treat their capital as precious, showing restraint in making acquisitions and share issues. It is always important, as we all do round this table, to have a sense of what the company is worth. In the case of companies such as real estate and infrastructure, it is important to know what the private market would pay for those assets.
Q: Michael and Jason, please discuss briefly the asset allocation in your balanced funds.
Lough: In TD Diversified Monthly Income we have 57% in Canadian equities and 33% in corporate bonds. We have a small component in U.S. and international stocks, mainly in blue-chip consumer product stocks. We have very little in cash. We tend to be fully invested in the portfolios we manage.
Gibbs: In our Dynamic Strategic Yield, we have 55% in equities and about 33% in corporate bonds, including high-yield bonds. We have a reasonable cash component. We do use cash strategically in the portfolios we manage.
Q: Let's look at the major dividend-paying sectors of the Canadian equity market. First, the financials, which includes real estate. Michael, please start the discussion on banks.
Lough: We are well overweight banks in TD Diversified Monthly Income and have been for the past decade. Over that time, they have outperformed. We don't expect them to deliver the same outperformance that we've seen in the past decade. As equity-income stocks, the banks have high returns on equity and pay good dividends. They've been strong dividend growers over the past decade.
In terms of their business growth prospects, the Canadian market is getting pretty saturated. In terms of their asset growth, financial assets do grow faster than the GDP of the country, so that they should be able to grow by 4% or 5% per annum. If you add that prospect to their dividend yield, it's a good, solid total return. The Canadian banks have been expanding the number of businesses that they're in, for example wealth management. Modestly rising interest rates will be a tailwind for them.
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| Michele Robitaille & Michael Lough | |
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Gibbs: We hold Canadian banks in Dynamic Equity Income, but are underweight them. The stocks aren't going to be as good as they were, because the low-interest-rate environment is causing some margin pressure. Still, you can get a 4% dividend yield and 5% capital growth.
Robitaille: We are underweight the banks in BMO Guardian Monthly High Income II. A lot of our financial-sector exposure in this fund is through REITs. We like the banks. We have been putting a little money to work there. They are good holdings in a dividend-oriented fund and currently represent good value long-term.
Q: Life insurers?
Gibbs: We haven't owned these stocks for a long time. It's hard to forecast their earnings. Their accounting is so complex.
Lough: We do own some life insurance companies, but we are underweight them. They remain good organizations. The current low-interest-rate environment is poor for them. But their longer-term prospects are positive.
Robitaille: We are very underweight the insurers. The poor macro environment, given their interest-rate sensitivity and their capital-market sensitivity, is weighing heavily on them.
Q: REITs?
Gibbs: You want to own real estate in this interest-rate environment. The Canadian REITs are a pretty safe place to be, if you own the right ones. They are still tax advantaged. They are trading at around net asset value to a premium to NAV, depending on the REIT. They are not amazingly cheap, but offer fair value. When they trade at a 15% to 20% premium to NAV, they get very expensive. If they trade at a discount to NAV, you want to buy them. They are simple businesses. You can understand them and they offer modest growth. You can get distribution yields above that of the S&P/TSX Composite Index.
Robitaille: We have a weighting just under 22% in REITs in BMO Guardian Monthly High Income II. REITs are a great long-term investment for an income-oriented portfolio. The dividend yield is 5.6% on average for the REIT Index. REITs have high-quality real estate, primarily in Canada, and strong management teams. They have low leverage, looking at their debt relative to gross book value. The fundamentals for the underlying portfolios are good. There is a lot of discipline in Canada in bringing new properties to the market. I agree with Jason that the valuations are pretty fair right now. The long-term average valuation is about a 4% or 5% premium to net asset value and they are in line with that average now.
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| Michael Lough | |
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Q: Any names, Michele?
Robitaille: I view Canadian Real Estate Investment Trust REF.UN, in particular, as one of the most defensive REITs. This diversified REIT is conservatively managed in terms of its payout ratio and leverage. In this environment, apartment REITs tend to be quite defensive. Boardwalk REIT BEI.UN and Canadian Apartment Properties REIT CAR.UN are examples. Housing has become more expensive, and this bodes well for demand for rental housing. Both of these REITs are well managed.
Lough: REITs are not a big weight in TD Diversified Monthly Income. I own RioCan REIT REI.UN. The REITs are fairly valued. They are more defensive. We don't expect great unit price advances from them. RioCan and Calloway REIT CWT.UN are the two biggest holdings. We like the retail REITs. There are a number of U.S. retailers coming to Canada that want space. This has helped to keep lease rates at favourable levels.
Gibbs: Calloway is one of the biggest holdings in Dynamic Equity Income. REITs are 17% of this fund. Calloway has great real estate. Wal-Mart is a key tenant. The yield is attractive. It's not going to grow a lot. You buy it for its stability and its yield. H&R REIT HR.UN is a big holding, a diversified REIT. Its distribution will grow over time.
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