To protect capital in any market cycle, the investment team at EdgePoint Investment Management Inc. uses “proprietary insights” to assess diverse businesses, says Frank Mullen, a portfolio manager for the gold-rated EdgePoint Canadian Growth and Income mandate.
“We think of ourselves as business owners,” says Mullen, “using a stock market to purchase a fraction of ownership of a business. So we look at the long-term competitive advantages of a business over the next three to five years. We think about what’s our edge from that perspective when making an investment. What do we see that the market doesn’t see?”
What is also imperative for the team of 10 partners, based in Toronto, is to build a portfolio that is diversified by business ideas that are not correlated to each other. “We are going to make mistakes,” says Mullen, “the nature of investing is you’re not going to bat 100%. So you’ve got to make sure that the driver of a business isn’t highly correlated to the driver of all your other businesses.”
Based on a bottom-up approach, that strategy is evident in the approximate 11% weighting in “diversified” financials. For example, “over the next five years,” says Mullen, “the drivers of Onex Corp. (ONEX), a U.S. private equity firm among the top 10 holdings, have very little in common with the drivers of the Fairfax Financial Holdings Ltd.” (FFH) holding, a property casualty insurance business, or Manulife Financial Corp. (MFC), among the top 10 positions. According to Mullen, Manulife has a large Asian presence in the wealth management business and is not really correlated to what happens to Onex or Fairfax.
Diversifying by business idea rather than using traditional sector allocations is further reflected in the low weighting of 3.7% in the bank area, with two Canadian bank holdings, The Toronto-Dominion Bank (TD) and The Bank of Nova Scotia (BNS). “I think we’re also conscious of where we are in the cycle,” says Mullen. “We think the Canadian banks are great businesses, with great competitive positioning and very attractive returns on capital, but we reckon that we’re 10 years into a cycle and these are cyclical businesses.”
Less discretionary, more champions
For some time, Mullen says they have had some concerns about the fact that the average Canadian consumer has a little more leverage than they should. Other concerns or “cautions” include worries about very low interest rates and the effect on behaviour, among others. “So you’ll find,” says Mullen, “that in positioning the portfolio, we tend not to own a lot of businesses directly tied to the health of Canadian consumers. So you don’t see a lot of discretionary businesses that are dependent on consumer spending. Instead, you’ll find a lot of what we call the local champions that happen to be headquartered in Canada, such as Constellation Software Inc. (W9C), and Onex, that are global companies.”
The emphasis on sharing “deep-dive” original research often results in generating ideas in both the equity and fixed income side of a company. Ideas like Element Fleet Management Corp. (ELEEF) last year, for example. “The company’s convertible bonds became one of the largest fixed income positions last year,” says Mullen, “and is now currently the largest equity weight in the mandate. I think that valuable proprietary insight across the capital structure is something that sets us apart.”
The current asset mix of approximately 34% in corporate bonds across 86 issuers and 64% equities across 73 holdings is characteristic of the portfolio. Over the last decade, the fixed income component has ranged between 30% to 35% of the overall fund, with room for flexibility according to market opportunities.
Low-duration, high-yield fixed income
The fixed income side of the portfolio right now is set up to have an extremely low duration with a large number of bonds that are maturing within 18 months. Also characteristic is a relatively strong concentration in high-yield bonds. According to Mullen, high-yield bonds among the fixed income sleeve (about 35% of the fixed income weighting), have played a very material role from both the return and the positioning of the portfolio since inception. “We’re trying to be just as active on the fixed income side as on the equity side,” says Mullen, “and are willing to take more credit risk because our skills set have analyzed that credit risk.”
The managers fundamentally think of Canada as a narrow universe. “It’s a small pond to fish in,” says Mullen, “and it’s our intention to maintain flexibility across the market cap spectrum. Favoured equity holdings focus on quality businesses with strong competitive edges, long-term growth potential and competent management teams. “I think the hallmark of the type of business that we own,” says Mullen, “is we want it to be free-cash generative. We also want to see capital allocation from the management team that is defined and has a track record of generating positive returns.”
In positioning the portfolio, “it is very important that we’re aligned with our clients,” says Mullen. “Everyone at EdgePoint is invested in the EdgePoint products, and specifically anyone on the investment team is mandated to own a certain percentage of the products which they are managing. We have over $260 million of our own capital invested right alongside the portfolios our clients can purchase. So I think that’s a pretty strong alignment of interest.”
