Even though Canadian and U.S. markets delivered strong results in 2023, veteran equity manager Jennifer McClelland saw it as an extremely challenging year. Rapid moves in interest rates hit many of the dividend-paying stocks she favours.
Moreover, this year, with 50/50 odds of a recession or a soft landing, McClelland argues that the forecast appears to be cloudy.
“Predicting the future is futile, as I’ve found out over the last 30 years,” says McClelland, lead manager of the 4-star rated gold medalist $3.1 billion RBC Canadian Equity Income F (also available in Series D) and vice-president and senior portfolio manager, North American equities, at Toronto-based RBC Global Asset Management Inc. A 1993 graduate with a BA in economics from the University of Western Ontario, McClelland oversees about $10 billion in assets in a variety of funds. “But if we start to see more negative economic impacts from higher interest rates then the market will start reflecting lower rates in 2025, and a scenario of more ‘normal’ times. This year will be pretty volatile and we are all watching for individual pieces of data. It won’t be easy. But it may be more constructive by the end of the year.”
Stock Market Clouds Should Clear by End of Year
The market will start to look forward by the year’s end and price in better times ahead, argues McClelland, who shares duties with Brahm Spilfogel, vice president. “With the banks, for example, we are all trying to figure out what the loan losses will look like and what the peak will be. Once we know we get a better feel for what they look like, there will be more confidence that we can get a better handle on what next year will look like. There will be more rational markets.”
Needless to say, there are a lot of macro-economic issues to worry about. These include geo-political tensions, such as those emanating from the Israel-Hamas war, and a U.S. presidential election that could spring a few surprises. “If some of these geo-political conflicts escalate it will impact everyone, especially consumer activity. There are a lot of second and third-tier impacts that will be difficult to figure out. There will be a lot of volatility. That’s my biggest worry,” says McClelland, noting that shipping costs have escalated as Far East freighters are being diverted from the Suez Canal. As for the U.S. presidential election, McClelland maintains that the probability of a Trump victory is moving higher. “How that directly impacts financial markets we are not really sure yet, because we don’t know exactly what policies Trump will focus on. That uncertainty is something we worry about.”
Light Shining Through in Capital Markets and Private-Public Projects
On the other hand, McClelland argues there are some reasons for optimism. First, she observes there has been a pick-up in financial transactions. “Last week, we saw the take-over by U.S.-based Blackstone Inc. BX, of Canadian residential developer Tricon Residential Inc TCN. By taking Tricon private, it’s showing value in Tricon’s stock that was not shown in the public market. To me, that’s an optimistic sign. There are a lot of things that need to happen, which really stalled last year. We need to see a pick-up in capital markets activity, to know what things are worth.”
Second, there are more signs of private and public sector cooperation. In particular, McClelland points to oil and gas companies and governments negotiating over deals to handle large carbon capture projects. “Companies are saying that conversations are getting more constructive and there is more ‘meeting of the minds’ on various issues, such as the carbon tax and what the government can do to support more renewable energy projects. There is more cooperation taking place.” In a similar vein, real estate companies that specialize in apartment construction are discussing issues surrounding the lack of housing supply. “There is too much immigration and the federal government is starting to make moves to address that as well. Again, they are having more productive conversations.”
Interest Rates Outweighing Fundamentals
McClelland acknowledges that she and her team use a blend of top-down and bottom-up analyses to determine the sector and individual stock holdings. “The direction of interest rates is a very big factor on how out companies are valued. In the last year, the macro environment has really impacted how the stock market has behaved. It’s been more of a factor than the fundamentals of individual companies. So it pays to look at both sides, for sure.”
From a performance standpoint, RBC Canadian Equity Income F has returned 0.14% for the year-to-date (Jan. 25), versus 0.86% for the Canadian Dividend and Income Equity category. On a longer-term basis, the fund has been an out-performer. Over the last 5-, 10- and 15-year periods, the fund has returned an annualized 9.34%, 7.71% and 12.76%. In contrast, the category returned an annualized 7.98%, 6.40% and 8.83%, respectively.
The fund, which has a running yield of 3.6%, before fees, depends on a dividend stream from a slew of financial services, energy and real estate firms. Currently, 34% of the portfolio is in a mix of banks (23.7%), insurers (6.4%), as well as 3.9% in other financial service firms such as capital market players. “The weighting reflects our customized benchmark, which includes the S&P/TSX Capped Composite Return Index. On top of that, banks are strong dividend payers. We believe the safety of the dividend stream is there. Within financials, you can earn dividends plus benefit from the opportunity for capital appreciation. They make a lot of sense within an income-oriented portfolio.”
Top Canadian Stock Picks
There is also 17% in energy players, divided between 6% producers such as Canadian Natural Resources Ltd. CNQ and 11% in pipelines and storage firms, such as Enbridge Inc. ENB. “Enbridge has a yield of 6.8% and the large producers have a very good cash flow stream to pay dividends. For example, CNQ is the largest energy producer in Canada and has a 4.6% dividend yield. It comes from the cash flow they earn on their production. These companies have done a really good job over the last decade, addressing the concerns investors have had, instead of reinvesting cash in marginally profitable growth projects. The producers make sure they have healthy balance sheets, no matter what oil prices happen to be.”
Meanwhile, the real estate weighting is 8% and includes only one office-oriented player, Allied Properties Real Estate Investment Trust APYRF. “As bond yields went higher and higher last year, the sector sold off, probably more than it needed to,” says McClelland, adding that the fund holds a mix of retail, residential, and industrial names. “As a group, these stocks are now very cheap, versus the value of the assets that these companies own. But they are all enjoying robust rent growth.” The other sector weightings include 9.7% industrials, 9.4% utilities, 8.2% materials and 4.6% communication services.
In searching for attractive stocks, McClelland looks at key attributes such as visibility and predictability of cash flow, a defensible moat for the firm’s business, and a management team that is conservative and yet also growth-oriented at the same time.
Running a 91-name portfolio, McClelland highlights RioCan Real Estate Investment Trust RIOCF, a leading owner and operator of indoor and outdoor shopping malls. “We believe RioCan’s rental stream is very resilient. When companies want to make a decision on where to open a store, they go to RioCan first. They have really good relationships with retailers,” says McClelland. “And because of our growing population, more retailers want to come to Canada to take advantage of that. But there’s been very new supply. It’s come to a halt. So the supply-demand balance is very positive [in RioCan’s favor].”
The REIT, which is trading at about a 20% discount to its net asset value (NAV), pays a 5.8% dividend.
Another favourite name is Boralex Inc. BLX, a Quebec-based firm with a market capitalization of $2.9 billion which has built renewable energy projects in Canada, France and the U.S. As part of the ESG (environment, social and governance) sector that once was high-flying, the stock has been hit by the market doing an about-face. “The ESG sector was over-bought and now it’s reversed in spades and a lot of money has come out of ESG funds,” says McClelland. “Some very large companies have had to write down their portfolios. This company has not had the issues of some others. But it is trading as if it is. They have been very conservative in their growth strategy and manage their cash flow in a conservative way.”
Although the stock is trading at $33, McClelland’s team estimates the intrinsic value is $41. The dividend yield is 2.3%.
As a 30-year industry veteran, McClelland acknowledges this is one of the trickier investment cycles that she has seen. “Because the market has so many more funds that are not managed by individuals—such as exchanged traded funds--there are a lot more irrational moves in the market. The swings are more extreme now, because there are fewer individuals looking at stocks, and they are saying, ‘That’s not reasonable,’” says McClelland, adding that the effects of the Covid-19 pandemic on consumer behavior and macro-economic developments are still being felt. “The stock market is not pinpointing value accurately because the make-up of market is a lot of trickier to navigate.”
Optimism About 2025 Should Overshadow Uncertainty
Accordingly, when McClelland looks at 2024, she expects it to be a tepid bull market. “There are a lot of companies that are reflecting negative scenarios. But once we get to the other side, there will be a better tone in our market. More capital markets transactions could be a catalyst for our equity markets,” says McClelland. “We have been anticipating a slowdown for so very long. Once we get in the middle of it, people may start to see how things will look better in 2025.”
