Large-caps that a value investor can bank on

Banks and telecoms are prime hunting ground for Beutel Goodman's Mark Thomson.

Sonita Horvitch 14 August, 2013 | 6:00PM

 Mark Thomson, managing director, equities at Toronto-based Beutel Goodman & Co. Ltd., says that there are significant opportunities in the Canadian equity market to invest in companies that are strong free cash-flow generators, good dividend growers and disciplined capital allocators, and that trade at reasonable valuations. "Prime hunting ground," he says, "is among the major Canadian chartered banks and the leading Canadian telecom-services providers."

Thomson is cautious about Canadian energy and materials producers in general. Many are saddled with high costs and operational hiccups plus, in some cases, there is the challenge of commodity-price headwinds, he says. "There is a need to pick your spots."

Finally, Thomson says he is eschewing utilities and pipeline stocks, as well as real estate investment trusts. "Even though they're solid cash-flow producers, they're simply too expensive."

Beutel Goodman, which manages assets of $35 billion, is a traditional value manager. Thomson and his team manage some $13.5 billion in Canadian equities including Beutel Goodman Canadian Equity, which had assets of $3.7 billion at the end of June.

The fund, with 33 names, is predominantly a large-cap fund, with the holdings in the large-cap component averaging a market float of $30.9 billion. The fund also has a small-cap component, which was 6.6% at the end of June.

Adding in the small-cap names in the different sectors, the fund had 36% in financials, 13.8% in consumer-discretionary stocks (including some companies with telecom-services characteristics), 8% in telecom-services companies and 10% in industrials, at the end of June. All these are overweight positions relative to the S&P/TSX Composite Index, the fund's benchmark. Cash constituted some 2.5% of the fund at the end of June. "We are essentially fully invested," says Thomson.

Beutel Goodman Canadian Equity has for some time favoured telecom-services stocks. "They are strong, sustainable free-cash-flow generators," says Thomson. Furthermore, he says, over the past three to four years, these companies have become more disciplined allocators of capital and returned significant amounts of capital to shareholders.

Thomson's current favourite in this sector is Rogers Communications Inc. RCI.B. "It boils down to valuation." The stock is cheaper than the fund's other major telecom-services holding, Telus Corp. T, he says.

 
Mark Thomson

Rogers, he notes, has reduced its common shares outstanding by 20% over the past five years through share buybacks and has raised its dividend substantially over that period.

The stock, says Thomson, is capable of generating a return of at least 50% over the next three years. This is despite, he says, the potential entry of U.S telecom giant Verizon Communications Inc. VZ into the Canadian market. "This possible entry is still very much up in the air."

A long-time proponent of Canadian bank stocks, Thomson says that these are currently cheap by historic standards and offer a dividend yield close to 4%. "This is comfortably above that of the Canadian equity market as a whole," he says.

The Canadian banks, he notes, are now almost at the end of the period of the regulatory demands on them to boost capital. "This will free up capital in an industry that generates significant excess capital."

Furthermore, he says, the banks have been raising their dividend-payout ratios and this, combined with rising bank earnings per share, has resulted in dividend increases. Also, he says, some of the banks, notably Canadian Imperial Bank of Commerce CM and Royal Bank of Canada RY, have been buying back shares.

Among the banks, Thomson favours Toronto-Dominion Bank TD, which continues to be the fund's largest holding (7.7% at the end of June), and Royal (5.9%), which is also in the top 10. "TD and Royal have dominant market shares in Canada retail banking," he says. "This translates into enhanced returns on capital over time." These two banks should also continue to make market share gains, he adds. In all, he considers that "these high-quality stocks" are capable of meeting Beutel Goodman's threshold return requirement of 50% over the next three years.

Rogers Communications Inc. Royal Bank of Canada Toronto-Dominion Bank
Aug. 12 close $40.35 $63.33 $86.41
52-week high/low $52.75-$39.10 $65.66-$50.53 $89.11-$78.05
Market cap $21.0 billion $92.5 billion $80.4 billion
Total % return 1Y* 4.2 28.6 12.9
Total % return 3Y* 6.9 10.9 10.3
Total % return 5Y* 5.6 9.5 9.7
*As of Aug 12, 2012
Source: Morningstar

In the industrial sector, Thomson is enthusiastic about the global engineering and construction giant SNC Lavalin Group Inc. SNC. It is a "controversial story," given the company's high-profile missteps, he says. "But the investment case is fairly straightforward," based on valuation. The stock is cheap, he says, considering the company's assets and potential to improve its construction earnings.

Thomson notes that SNC's recent share price was $41. From this he "deducts some $28 a share for the company's investments." These include its stake in the Highway 407 toll road in Ontario.

In addition, he says, SNC has surplus cash on its balance sheet of $4 per share. This means, he says, that you are paying around $9 a share for the construction business, which makes for a P/E multiple of nine times on "currently depressed earnings." SNC, says Thomson, is "winning prestigious contracts, including one for the extension of Highway 407, so its construction earnings should rebound."

Turning to resources stocks, Beutel Goodman Canadian Equity remains substantially underweight in both the energy and materials sectors. Of the major Canadian energy players, Thomson considers that "many are high-cost producers that have an abysmal return on capital."

The better players, he says, include Canadian Natural Resources Ltd. CNQ, a top-10 holding in the fund. "The company has good, low-cost assets in Western Canada and excellent management."

Prominent oil-patch investor Murray Edwards, who has a significant stake in CNQ, is chairman of its board, Thomson notes. "The stock trades at a discount to the company's net asset value per share and should give us our minimum return of 50% over the next three years."

Thomson has sold the bulk of the fund's holding in Talisman Energy Inc. TLM. "Talisman has a mixed bag of assets generating disappointing returns."

In the materials sector, the fund still has no holdings in gold stocks, says Thomson. "Despite their sharp declines, these stocks continue to be expensive by traditional valuation standards."

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Sonita Horvitch

Sonita Horvitch