Despite worries that the Canadian economy is weakening and on the brink of a recession, the Canadian equity market is still bullish and has returned 4.36% year-to-date (April 22). Seasoned investor and value-oriented stock picker Dave Jiles confirms that the market’s behaviour is hard to fathom, and attributes some of the bullishness to fiscal spending and central banks’ potential rate cuts.
“Go back to the fourth quarter of last year and all investors were in a deep funk,” recalls Jiles, managing principal and portfolio manager at Vancouver-based Leith Wheeler Investment Counsel. Jiles heads a team that oversees silver-medalist $4.6 billion Leith Wheeler Canadian Equity Series F. The fund is part of the $8 billion in Canadian equities managed by a 5-person team. “They were concerned that the Federal Reserve had gone too far and people were concerned about earnings growth. Then, of course, in late November-early December, the central bank pivoted and that triggered quite a relief rally. It’s extended into this year and it’s been coupled with the perception about the landing we might see. We will find out soon whether the perception is correct.”
The question is, will the economic landing be soft, or will there be no landing or even a delayed landing? The answer is very hard to predict.
Stronger Canadian and U.S. Economies Than Expected
“The biggest surprise that everyone is aware of is how resilient both the U.S. and Canadian economies have been despite the type of restrictive monetary actions that central banks have pursued,” observes Jiles, a 40-year industry veteran who joined Leith Wheeler in 1994, and has led the Canadian equity team since 2022. “But we are starting to see more signs that the consumer is feeling the impact of inflation in food and energy prices. So far, with the amount of fiscal spending in the U.S. and Canada, the economies have proven more resilient than everyone expected. And I suspect that even Jerome Powell, chair of the Fed, has been pleasantly surprised, too.”
Year-to-date (April 22) Leith Wheeler Canadian Equity F has returned 3.54%, while the Canadian Equity Fund category has returned 4.81%. On a longer-term basis, however, the fund has been in the second quartile and returned an annualized 8.23%, 8.98% and 6.65% over three, five and 10 years. In contrast, the category returned an annualized 7.46%, 7.92% and 6.36%, respectively.
Jiles argues that investors snatched up stocks in early winter because multiples were cheap and stocks were trading on average at 12 times earnings. Moreover, he maintains that markets have not been driven by earnings, but rather by people are willing to spend on the higher multiples. “Remember there is a battle that goes on between, ‘Do I put my money in a risk-free treasury bill or a 10-year note, or do I put it into the stock market?’ When people believed that central banks would be more accommodative, people took it as a signal to go out on the curve and buy stocks.” Those same stocks are now trading between 14 and 15 times earnings, thanks in part to a bounce in commodity prices and enthusiasm around how artificial intelligence may benefit parts of the economy.
Canadian and U.S. Stock On Separate Paths
Historically, Jiles adds, Canadian stocks have tracked their U.S. counterparts. Yet today, “We are seeing one of the biggest dispersions in the last 20 years and U.S. stocks are trading significantly higher than Canadian stocks. But it’s hard to make the argument that our markets are frothy,” says Jiles, noting that the TSX is trading at 15 times forward earnings, but U.S. stocks are trading at 21-22 times. “The U.S. has some amazing technology companies, which have helped to drive U.S. valuations. Still, last month, our market outperformed the U.S. Maybe investors are starting to see that Canada is a relative bargain to the U.S.”
That might suit the style of the firm, which was established in 1982 and has long followed a value-oriented focus to build portfolios. Currently, it oversees about $26 billion in assets under management. “We look for equities that have two characteristics: they are either overlooked or misunderstood and people have the wrong idea of what the future might bring,” says Jiles. “We try to look out three to five years and see what the company’s earnings power might be and then discount it back to the present. We try to decide if we are getting paid to take the risk in buying something that is out of favour.”
It has not been difficult to add new holdings, says Jiles, although the team has been extremely picky. “A new name has to be significantly better than what we currently hold,” says Jiles, noting that turnover is about 15% on average. “We take a long-term approach and get to understand a company’s economics. The bar is high in terms of selling companies we are familiar with.”
The ‘Wallet Test’ for Picking Stocks
In searching for companies, the team makes decisions as a group, as opposed to a single person pulling the trigger. It also uses the so-called wallet test. “When you are thinking about investing in a company, you are giving them your wallet. The idea is, how do they spend your capital? So we are very particular about the management teams that we use. Always keep in mind that we are stewards of other people’s capital.”
Jiles says the most important attribute of a stock is its price, followed by the economics of the business and the people who are involved in managing it. “We are optimistic investors and what we are looking for is an equity that is mispriced. That’s what gets people excited and doing the work. And the only way to find that out is doing the research and figuring out the economics of the business and what kind of returns the business is capable of generating over a longer period of time,” says Jiles. “That gets back to a very essential ingredient: is the management and the board properly focused on deploying capital and making the right investments over the longer term? You can manage the business on a short-term basis and make the results look good. But then you can suffer from a longer-term perspective.”
From a sector standpoint, the portfolio is dominated by a 30.1% weighting in financial services, followed by 19.3% in industrials, and 14.2% in information technology. 11.8% energy and smaller weights in areas such as utilities and consumer staples.
Cheap Canadian Stocks
Running a concentrated portfolio with 42 holdings, Jiles highlights two names that he notes are under-followed and under-appreciated. The first is Calgary-based Mullen Group Ltd. (MTL), a diversified firm with interests in trucking, warehousing, logistics and oil services. “It’s very well managed and has been in business for over 70 years and the insiders are managers-shareholders,” notes Jiles. “People are concerned about consumer spending because a lot of Mullen’s business is delivering packages, but when you read the Globe and Mail it doesn’t indicate how strong the Alberta economy is. In fact, its trucking business is less than 40% of its revenue. Mullen Group has been overlooked.”
Jiles also believes people are getting the investment case wrong because drilling activity in the energy patch in Alberta and British Columbia has picked up. “That will benefit Mullen’s oil services sector and it’s a buyer’s market for companies like Mullen, which has a good balance sheet. A lot of smaller companies have not been able to manage their costs, with respect to fuel, wages and insurance. This will provide Mullen with an opportunity to make cheap acquisitions going forward.”
Acquired in 2017, the stock is trading at C$14.90, or 10.3 times trailing earnings. The stock also pays a 4.82% dividend yield. Looking out three years, and expecting a recovery in the trucking segment, Jiles anticipates the stock will deliver a 14% annualized return.
Another favourite pick is Saputo Inc. (SAP), a Montreal-based leading manufacturer of dairy products, which Leith Wheeler acquired on the initial public offering in 1997. “The stock is out of favour today because of a whole series of issues, some of which were beyond their control and some of which were. Before Covid, for instance, there was a surplus of dairy products. The situation was starting to improve just as we hit Covid,” says Jiles. “During Covid, Saputo took some actions that were dramatically different from most companies. Basically, they paid all their employees, and didn’t take any government assistance.”
Saputo’s business suffered because a large part of its U.S. sales was in the food service business, which took a hit as travel and conventions came to a halt. Then inflation took its toll as the company delayed in raising its prices. Moreover, they spent a lot to re-tool their plants, to reduce their costs going forward. “Even if cheese prices remain depressed their earnings should recover quite nicely.”
Why is Jiles bullish about a recovery in the stock? “One of the things people are not paying attention to is a concept called a ‘milk bucket.’ Canada is a milk bucket, because it produces a lot of milk, as does California, Wisconsin, and a little bit in the U.K., Argentina and Australia. Milk production is directly related to how much farmers like to raise cows. With rising feed costs, and drought situations in a large part of the world, the amount of milk production has dropped quite a bit and continued to decline. My expectation is that the price for milk solids, like cheese, will start to inflect.”
So far, that has not happened. As a result, Jiles concedes that there is very little interest in the stock. “It’s trading at C$26.50, or 13 times next year’s earnings,” says Jiles, adding that the firm has a great management team and a solid balance sheet. “But three years out, the company can earn roughly $2.50 a share. Even if you kept the price-earnings multiple where it is now, you’d make an 11% compounded return over three years.”
