Now’s Not the Time to Chase Returns: Manager

With inflation still alive and kicking, the team managing the portfolio of $125 million Dynamic Canadian Value Class views the stock market surge of late 2023 and early 2024 as overly optimistic and somewhat premature and is therefore exercising caution.

“Markets have been reflecting the thought that the interest rate tightening cycle has ended, and the enthusiasm and excitement got a bit overdone,” says Don Simpson, vice president and portfolio manager at Toronto-based 1832 Asset Management LP.

The fund’s management team also includes Eric Mencke and Rory Ronan, both vice presidents and portfolio managers who have been with the fund for roughly six years. The team is also supported by Lauree Wheatley, portfolio analyst, and Peter Robic, associate portfolio manager.

Inflation Battle Far from Over

With the Consumer Price Index (CPI) rising at an annual pace of 3.4% in December, up from 3.1% a month earlier, investors are revising their expectations that interest rate cuts could be imminent, Simpson says. They’re realizing that wrestling inflation back to the Bank of Canada’s target of 2% may not be easily done and that rates could remain higher for longer.

“The market had previously been pricing in not only the end of the tightening cycle, but as many as six rate cuts this year,” Simpson says. “There’s been a lot of froth and with valuations going up so quickly we have become cautious.”

Finding the Pitfalls and Performers

While Simpson views Canada as a particularly good place to be invested, he says enticing opportunities are “not obvious” or easy to spot at this juncture. When the team members assess the risk/reward potential of a business they don’t assume everything will go wonderfully for the next five years, and instead assess what could go wrong.

Simpson’s preference is to protect capital on the downside and capture a reasonable share of the upside in dynamic markets. Rather than being top of the pack in a bull market, he’d prefer less volatility and less painful losses than market averages.

Volatility rankings indicate a smoother ride than the average fund. In the last 10 years the fund has had only three losing calendar years, 2015 when it lost 0.93%, 2018 when it lost 5.9%, and 2022 when it lost 4.3%. In all of these years the losses were much less than those suffered by the category and index. 

The gold-medalist Dynamic Canadian Value Class F Series, had a three-year average annual return at January 31, 2024, of 12.4%, beating both its peer group in Morningstar’s Canadian Focused Equity Category as well as the benchmark index. The fund’s 10-year average return of 7.0% beat the category return of 6.9% and slightly lagged the benchmark’s 7.6%.

Strong Stocks with Skilled Management

Simpson and the team differentiate the fund from the index by running a concentrated portfolio of 40 to 45 stocks and taking meaningful positions in each. They like durable businesses that have demonstrated resilience and management skills through a variety of cycles.

The team is also conscious of portfolio diversification -- as much by company focus as by TSX sector classification -- to ensure that companies have complementary strengths and weaknesses and won’t all react in a similar fashion to changing external circumstances. 

For example, the portfolio has exposure to gold through Franco-Nevada Corp. Gold FNV tends to go up when other things go down and therefore acts as a stabilizer, Simpson says. Franco-Nevada has been Simpson’s preferred gold company for several years, although it suffered a setback last year when its operations in Panama were shut down.

“We were disappointed but we still own the company and the Panama assets are now priced out of the stock,” he says. “It’s our main gold company, but we may diversify into a couple of others.”

He’s careful to avoid gold companies with properties in countries where the political situation is unstable and the risks are higher.  Gold stocks are typically a 2% to 3% weighting in the portfolio and never more than 5%.

Top Canadian Value Stocks

The largest sector weighting in the fund is financials at 33% of assets. Holdings include Royal Bank of Canada RY and Toronto-Dominion Bank TD, as well as non-bank financials such as Power Corp. of Canada POW, Onex Corp. ONEX and Intact Financial Corp IFC.

Simpson acknowledges that bank stocks are reflecting investor fears about how current high interest rates will negatively affect consumers renewing their mortgages, but he points out that less than 15% of residential mortgages are coming up for renewal this year. In addition, the salaries of consumers have risen in the past few years, which compensates for higher mortgage expenses.

Not Necessarily a Hard Landing Ahead

While he says Canada appears to be in a slight economic slowdown, he doesn’t foresee “a hard fall or a big shift downward.”

“I expect we will just plod along, and eventually get help from lower rates when they come through,” he says. “We don’t expect a lot of economic growth in the next year or two, and our portfolio is a reflection of that.”

Meanwhile Canadian immigration is strong and there will be continuing demand for housing and mortgages. 

“It’s a good time to put money to work in bank stocks if you have a longer time horizon,” Simpson says. “It could take a while and there is some caution warranted for the next few quarters, but we’re still getting a return in dividends.”

Bank stocks and others traditionally favoured for their dividends have been depressed by rising interest rates in the past year or so, as competing safe investments like money market securities and guaranteed investment certificates have offered juicy yields. However, the slump has created buying opportunities in traditional income-oriented securities such as Real Estate Investment Trusts and utilities.

Opportunities in Canadian Income Stocks

Examples include Boardwalk REIT BEI.UN and Enbridge ENB. Boardwalk is one of the largest rental apartment landlords in Canada with a focus on Alberta. It is benefitting from soaring demand for housing and rising rents.

Simpson describes Enbridge as a durable business with good quality assets. With the stock price down from previous highs, it has limited downside risk and a highly attractive dividend yield (7.6% at Jan. 31).