Rather than try to forecast the future, the team managing Dynamic Canadian Value Class aims to avoid investment pitfalls and capitalize on growth by choosing holdings that can withstand a variety of challenging economic circumstances and prudently diversifying the portfolio.
The $125 million, gold-medalist fund has enjoyed a strong and smooth long-term climb, with the F Series showing a three-year average annual return as of May 15 of 15.5%, beating both its peer group in Morningstar’s Canadian Focused Equity Category and benchmark index. Longer term, the fund showed a 10-year average annual gain of 7.7%, beating the category return of 7.4% but slightly lagging the index’s return of 8.3%.
Low Volatility Made for Low Drawdowns
These gains have been achieved with relatively low volatility. For example, in 2022, a rough year for all portfolio managers, the fund fell by 4.3%, a significantly smaller drop than the 9.1% loss suffered by the category and the 5.5% hit experienced by the index.
“Low volatility is a consequence of being well-diversified,” says Don Simpson, vice president and portfolio manager at Toronto-based 1832 Asset Management LP and a member of the fund management team that also includes Eric Mencke and Rory Ronan, both vice presidents and portfolio managers. “We prefer to protect capital on the downside and get our fair share of the upside, rather than being the best performer in a bull market.”
He says investors don’t react well to volatility, they prefer a smoother ride. Fewer bumps help them to stay invested and reap better long-term returns, he says.
As in 2022, investors continue to fret about geopolitical tensions, rising inflation, interest rate hikes, and a possible recession. Central banks in Canada and the U.S. appear to be pausing -- at least temporarily -- on interest rate hikes after rapidly jacking them to levels not seen in 16 years. But while the inflation they are attempting to tame may have eased, it will not likely fade to previous lows as there is a variety of contributing causes at work, says Simpson.
Watch What Goes into Inflation
For example, some developed countries are cutting back on global outsourcing and relying more on domestic suppliers of goods, and often these goods are more expensive than imports from less developed regions.
In addition, the “greening” of the energy industry also incurs costs, and it will take time for the infrastructure to be put in place for such things as electric vehicles. As well, the COVID pandemic resulted in governments around the world flooding their economies with money, and the inflationary effects are still being mopped up, Simpson says.
“We will likely be in an inflationary environment for a while, and we want to make sure we own businesses with pricing power,” he says. “We analyze how a company could be affected if interest rates stay elevated or labour costs go higher. Rather than trying to be a predictor of macro trends, we want to be aware of what is happening and how that impacts companies.”
The focus of the fund is on durable businesses that have demonstrated superior long-term track records through a variety of cycles and are run by reliable management teams. Strong balance sheets are crucial.
Companies That Turn Problems into Opportunities
“Having been through down cycles, you learn to appreciate companies with strong balance sheets,” Simpson says. “They don’t get painted into a corner and they have the capacity to actually grow in times of distress. They can take out other businesses while the companies with weak balance sheets are going down.”
While he says a recession is possible, he isn’t bearish on the Canadian economy longer-term. The team will take advantage of lower stock prices during any market corrections to add to attractive holdings that can do well throughout the cycle.
For example, a handful of U.S. mid-size regional banks failed in the past couple of months as interest rates soared, due to spread mismatches between their cost of funds and income received from loans. These troubles depressed bank stocks across the board, including the relatively stable, better-managed, and better-capitalized Canadian banks.
Canadian Value Stocks
The Dynamic team took advantage of stock price drops to do some portfolio rearranging, adding to favourite banks and trimming elsewhere. The Royal Bank of Canada RY was recently the fund’s largest bank weighting, followed by Toronto-Dominion Bank TD.
Financial services are the largest sector weight in the fund at about 36% of assets. However, even within sectors the team aims to diversify by type of business. For example, in the financial services sector, in addition to the big banks, the fund holds Power Corp. of Canada POW and Onex Corp. ONEX Both firms are in the process of restructuring and streamlining and are among the top 10 holdings in the fund.
Simpson prefers to run a relatively concentrated portfolio and the number of holdings currently stands around 40. Most are large cap, established firms, but the team also looks for growth and will include some companies in the small to mid-cap range.
Supply is Key to Rental Apartment Stocks
During the pandemic when stock prices fell, the team made an investment in Boardwalk Real Estate Investment Trust BEI.UN. The firm is benefitting from being one of the largest rental apartment landlords in Canada at a time when the country is suffering a shortage of affordable housing stock and immigration is increasing, Simpson says.
While Boardwalk is affected by rising interest rates and its financing costs may go up, the more important factor is that housing supply is not keeping up with demand, and that bodes well for rental income, Simpson says. Boardwalk units were purchased in the fund well below their asset value, and have appreciated significantly in the past year.
The team uses the fund’s foreign content allowance to enhance diversification, and focuses on sectors that are not well represented in Canada, including technology and health care. Currently, 20% of fund assets are invested in U.S. stocks. Simpson expects a few European holdings to be added to foreign content, as the valuations and opportunities are relatively attractive.
