When equity markets began to correct last spring the focus was on more speculative names with little or no earnings. Then central banks launched a campaign of rising interest rates to stem inflation – and it’s hit equities hard.
Meanwhile, uncertainty in the market has only worsened, observes Tim Johal, lead manager of the $2.6 billion 4-star bronze-rated Mackenzie Canadian Dividend F (also in Series D): “The narrative from the Federal Reserve was so aggressive in trying to get rates from zero to what is considered neutral, or close to 2.5%, that the market is expecting some probability of a recession, caused by the spike in interest rates, while demand for goods is falling as we come out of this pandemic.”
Recession's Still a Question of If and What
“There is uncertainty in the market as to how severe the slowdown will be. Will there be a recession, and if so, how significant will it be?” asks Johal, vice-president at Toronto-based Mackenzie Investments and a 24-year industry veteran who is based in Winnipeg and in 2017 joined Mackenzie, after a lengthy stint in North American equity investing for Investors Group. Working with North American equities team leader and senior vice-president, William Aldridge, Johal looks after approximately $7 billion in assets that are part of the Canadian dividend mandate.
Time to Broaden
Nevertheless, even as the gloom deepens, Johal argues that it could be time to take on more risk as some stocks are looking more attractive. “Last year we were overweight energy, banks and financials and other cyclical areas. Then about nine months ago we started to see a lot of our stocks approach or even surpass our estimates of fair value, so we began to de-risk the portfolio,” says Johal, adding that the portfolio has now broadened, which stands at about 140 names, of which about 50 are Canadian and account for about 80.4% of the fund (the balance of 90 names is held in U.S. and international stocks). “With the big correction that is healthy, we have started to see certain stocks look more attractive and we have added back to certain areas—and adding risk to certain areas.”
Compliance regulations prevent Johal from identifying the stocks he bought, but he does say they are not all value names, which his team has generally favoured. “When we deployed our valuation framework, many stocks that began to look attractive were the more traditional GARP [growth at a reasonable price] names. They’re in areas such as technology, industrials, and even some renewable power generation names that had corrected significantly, while more traditional utilities looked expensive. So we rotated into some of these more GARP-y areas,” adds Johal,“That’s how we’ve been shifting the portfolio. There has been a rotation because the markets have moved so quickly and corrected significantly from being almost over-priced coming into this year.”
Year-to-date (July 7) the fund has returned -2.35% versus -3.98% for the Canadian Dividend and Income Equity category. On a longer-term basis, the fund has also outperformed the category, as it had an annualized return of 8.06% over three years and 7.72% over five years. In contrast, the category had annualized return of 7.37% and 6.68% for the same periods.
Since Johal and his team of analysts, Dean Highmoor, who is also based in Winnipeg, and Scott Fletcher, in Toronto, are bottom-up value-oriented investors the sector allocations are a by-product of the stock selection process. The U.S. and international names in the fund are chosen by Darren McKiernan, who heads the Global Equity and Income team in Toronto and his team. On a sector basis, as of April 30, financials account for the largest sector at 35.94%, followed by 15.61% energy, 9.29% industrials, 7.59% communication services, and 6.95% consumer cyclical. With its focus on generating dividends, the fund has a running yield of 3.5%.
Risk-Reward’s Still Nearer to Neutral
Johal notes that his team is not fully risk-on, because of the uncertainty. “We do model a base case, a bear case and a bull case. There is still a downside to our bear case. That risk-reward [relationship] is closer to neutral than wanting to get very bullish right now. We do see opportunities in select stocks, so we are adding there, but we’re not super bullish.”
Two concerns underline Johal’s cautiousness. First, he does not know how aggressive central banks will deal with interest rates. “It’s very dependent on the stickiness of inflation.” Second, as a result of a slowing economy, there is the spectre of earnings revisions. “We are not looking for a decline in earnings right now. But we are certainly looking for a slowdown in growth.”
Not the Ingredients for a Severe Recession
In comparison to previous bear markets, this one differs. The technology-telecommunications bubble that burst in 2002 was prompted by financial excesses in the form of huge capital outlays and debt financings. The 2009 bear market began with an implosion in the U.S. subprime residential mortgage market. “This time you haven’t seen the financial excesses built up. The consumer is in great shape. In Canada, people still have a lot of equity in their homes and there has not been a loosening in lending standards. If you look across North America, there has not been a build-up in excesses in financial markets. If there is a slowdown in demand that would cause a recession, we don’t believe it will be long and deep. It will be a ‘technical’ recession,” says Johal, adding that he expects inflation will subside, although it depends on how energy prices evolve over the next while.
Capital Allocation is Key
In selecting stocks, Johal says his team focuses on quality, value, and dividends. “We want to buy stocks with a margin of safety and we consider the risks that we take in building a position,” says Johal, adding that his team’s main method of valuing companies is discount cash flow analysis that goes out 10 years. “We try to focus on quality companies which help us to manage risk. They are more predictable and less volatile. They have management teams that have built value over time. We constantly assess their strategy and their execution of that strategy. The key determinant, in terms of quality, is: how does management allocate capital?”
Whether the company reinvests profits in the company, makes acquisitions that produce higher earnings, or returns them in the form of dividends, are key factors in making it into the portfolio “We focus on the sustainability of dividends and the growth of dividends,” says Johal. “We think about companies and their willingness to return capital to their shareholders. It’s been proven in the Canadian market that dividend growers outperform over time and do so with less volatility. That’s what we are focused on doing.” Johal notes that for the 25 years ended October 2021, an equally-weighted index of Canadian dividend-growing stocks had a compound annual growth rate of 11.1%, versus 9.4% for an equally-weighted index of dividend-paying companies, according to a study by RBC Capital Markets Quantitative Research.
Top Stock Picks
One of the top names in the portfolio that are representative of the team’s approach is Intact Financial Corp. (IFC), a leading Canadian property and casualty insurer. “This is a world-class operator with a strong management team. In terms of ranking CEOs in Canada, Intact’s Charles Brindamour is among the top three,” says Johal. “They had previously exclusively focused on Canada, but have allocated capital to growth in the U.S. and added quite significantly to their earnings growth over the last few years.”
Last year, Intact acquired RSA Insurance Group PLC, which operates in Canada. “It complements the business they have in North America. And they have made a foray into Europe with that acquisition. They are very disciplined in their underwriting and risk management. This will be the next leg of growth and profitability for the company.” Because the RSA acquisition has diluted the return on equity from 16% to 14%, the price-to-book-value multiple has fallen to 2.2 times. “But through synergies and strong execution, we think they will get the ROE back up to the high teens. We expect to see a re-rating of the stock.” The current dividend yield is 2.2%
Another favourite is Telus Corp. (T), a leading Canadian telecom provider. “It’s another example of a strong compound growth company led by a very strong CEO, Darren Entwistle. He’s been very successful and continues to make great strategic decisions,” says Johal.
The firm, he argues, is well-positioned to take market share in both the so-called wireline (cable TV and Internet) and wireless business segments. “They are a leader in customer service and it’s resulted in better profitability and lower ‘churn’ [customer turnover] across their networks,” says Johal, adding that two new divisions, Telus Health, which provides healthcare data for professionals and patients and Telus International, which builds digital solutions for major companies, have also done extremely well.
“They have seen dividend growth every year since 2005, and it’s all due to Darren Entwistle’s doing. This year, they committed to another three years of 7-10% dividend growth,” says Johal, noting that Telus’s dividend yield is 4.8%. “They are paying out about 100% of free cash flow as dividends. But in 2023-24, we see some of the heavy capital expenditure come off and you’ll see a bump up in free cash flow.” The stock is trading at 8.8 times enterprise value to earnings before interest, taxes, depreciation and amortization. “That is in line with BCE Inc. [BCE] and its peers. But we think Telus should trade at a premium because it has a better growth profile and it’s investing heavily in fibre and other technologies. It also has levers in the form of Telus International that the peers don’t have.”
