The vision of a stronger-than-expected economy with delayed rate cuts is shaping up on investor radar screens, but the ever-shifting outlook is keeping the portfolio management team at the $6.2 billion TD Canadian Equity Fund F (also available in Series D) on its toes.
While the stock market rebound in Canadian and U.S. markets at the end of 2023 and early 2024 was based on expectations of an imminent fall in interest rates, the end of rate hikes now appears to be postponed by six to nine months and markets are digesting the repercussions, says Michael O’Brien, managing director and portfolio manager at Toronto-based TD Asset Management Inc. and lead manager of TD Canadian Equity since February 2013.
“Investors were premature in terms of how fast they would get gratification from the Fed,” he says. “But it’s fair to conclude rates will be lower at the end of the year than today.”
Softer Canadian Economy Could See Rate Cuts First
He expects the Bank of Canada will likely cut rates sooner than the U.S. Federal Reserve, as the Canadian economy is somewhat softer than the U.S. About 11% of the fund is invested in U.S. stocks, with the rest in Canada. There is currently no exposure to Asian or European stocks in the 20% allowable foreign content portion as O’Brien’s comfort is higher in North America.
Under O’Brien’s leadership, the four-star TD Canadian Equity F Series, ranked silver by Morningstar, showed a 10-year average annual compound return of 7.5% at Feb. 15. It had a three-year average gain of 11.3% and a one-year gain of 4.5%.
“It’s amazing how fast the market’s collective mood seems to flip,” O’Brien says. “The market is of the mindset that it will be a soft-landing scenario and has been pricing for that. But as a portfolio manager, I like to hang on to a bit of humility. When you’re managing risk you need to consider different outcomes, and what might happen if things don’t go according to plan.”
Humility in the Face of Uncertainty
A soft landing scenario in the U.S. and Canada would be a case of “having your cake and eating it too,” he says, combining the positives of resilient growth and declining inflation. But he says a hard landing is not inconceivable. On the other hand, it’s also possible that the economy could accelerate and forestall rate cuts.
“It’s always possible that something goes bump in the night,” O’Brien says. “We don’t have 20/20 foresight so we try to have balance in the portfolio. It’s not just about sector diversification - as the classification of a business can be quite arbitrary. It’s about the type of businesses – whether they are steady-Eddy defensive names or non-commodity cyclicals – and how the mix of exposures lines up with our economic expectations.”
Although each company is assessed on individual merits, there is always some top-down analysis as well, O’Brien says. And the team is always looking for an opportunity to buy out-of-favour companies at attractive prices.
Canadian Bank Stock Favourites
For example, the team beefed up holdings in bank stocks, Royal Bank of Canada (RY), Toronto-Dominion Bank (TD) and Bank of Montreal (BMO) in the early part of 2023. These stocks had fallen out of favour as investors began to fear that they would be hurt by high interest rates and their impact on mortgage renewals, loan losses and commercial real estate values. Banks lagged as investors turned their attention to more exciting stories in such areas as artificial intelligence and technology.
However, in late 2023 the bank stocks rallied and rose quickly as investors switched to feeling fears were overdone. TD Canadian Equity was positioned to ride the turnaround with its overweight position.
“There’s often an element of patience required,” O’Brien says. “You have to stick to your point of view and not let the drumbeat of the market bully you out of a position. We have a process based on strong research. The market can sometimes try to tell you you’re wrong, but we’re not afraid to buck the market.”
He says the Canadian banks are high-quality stocks with great long-term track records and solid, supportable dividends.
Banking on Interest-Rate-Sensitive Stocks
“We were early on the banks but we held our position and waited for the market to come to our point of view,” O’Brien says. “The banks still have a tough slog ahead of them, but multiples have risen to more normal levels. We expect more measured returns going forward.”
Other interest-rate-sensitive stocks also presented buying opportunities as rates rose, particularly regulated utilities and communication services. The fund added to holdings in energy utility Emera Inc. (EMA) and in Rogers Communications Inc. (RCI.A) last fall. Holdings also include pipeline utility Enbridge Inc. (ENB)
Currently the fund holds about 50 companies, and the portfolio usually holds between 45 to 60 companies. The top 10 holdings make up roughly half the fund, and weights can be large. RBC for example has a weighting of close to 9%.
O’Brien says that with a $6 billion-plus portfolio, it’s important that the key holdings be highly liquid. Other criteria include stability and positive return potential.
Top Canadian Stock Picks
Top holdings include Canadian Pacific Kansas City Ltd. (CP) and Canadian National Railway Co. (CNR), transportation companies that O’Brien describes as a profitable “duopoly. “
Another favourite is Canadian Natural Resources Ltd. (CNQ), which O’Brien describes as a strong, mature company that has consistently grown dividends for more than 20 years. It will have easier access to world markets with the soon-to-be-completed expansion of the Trans Mountain Pipeline.
Outside of the top 10, smaller but still core positions include consumer stocks such as food companies Loblaw Cos. Ltd. (L) and Metro Inc. (MRU) and discount retailer Dollarama Inc. (DOL)
The foreign content allowance is used to provide exposure not available in the Canadian market and tends to focus on areas such as technology and health care. Non-Canadian names include Amazon.com Inc. (AMZN), Microsoft Corp. (MSFT), Google LLC (GOOG), Visa Inc. (V) and United Healthcare Inc., as well as consumer-oriented multinationals such as MacDonald’s Corp. (MCD) and PepsiCo Inc (PEP).
