Canadian equities roundtable: Part 1

 Ian Hardacre, vice-president and head of Canadian equities at Invesco Canada Ltd. His mandates include the lead manager role in Trimark CanadianTrimark Select Balanced.

 Daniel Bubis, president and chief investment officer and founder of Winnipeg-based Tetrem Capital Management Ltd., which manages money for institutional and high-net-worth clients. Bubis manages a range of mutual funds for CI Investments Inc., including CI Canadian Investment   and CI Canadian Investment Corporate Class.

The managers spoke with Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and concludes on Friday.

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Q: The S&P/TSX Composite Index had a total negative return of 8.7% in 2011. Year to recent close, the total return was 3.7%. What is driving this?

Thomson: The Canadian equity market started 2011 with a robust view of the potential demand for commodities. As the year wore on, fear crept in. Problems in Europe came to the fore. China's economy was tied to this. Europe is a big export market for China. Investors started to worry and the more defensive areas of the market significantly outperformed in 2011. This has continued into 2012. Through the piece, Beutel Goodman has had a positive outlook on the Canadian equity market. We are finding good opportunities.

Daniel Bubis

Bubis: 2011 was a brutal year for the Canadian equity market. The year began with the optimism that the United States was past the worst of its financial crisis. Then there were Japan's natural disasters and nuclear meltdown, the re-emergence of concerns about Europe and in the summer of 2011, the U.S. political debacle and downgrade of its debt. You then started getting fears of a hard landing in China. Canada is seen as a derivative of what happens in China.

Q: You three are value managers. Are defensive stocks too expensive?

Bubis: Last year, at this time, defensive stocks were slightly more attractively valued than commodity-related stocks. This has reversed. Commodity-related stocks have become cheaper. Some of the more stable dividend-paying companies, which are viewed as less cyclical, such as utilities and telecom services stocks, are the most expensive relative to the rest of the market. They are also expensive on an absolute historical basis. Investors are paying up for this safety.

Hardacre: In the deemed safe sectors, it is harder to find value opportunities. The concerns about the commodity-related stocks reflect concerns about China. There are value opportunities in the commodity-related areas. China will be the economic power of the world longer-term. Will there be bumps along the way? Absolutely. It depends how big the pothole is.

Thomson: We have not talked about the fact that interest rates remain low and dividends are viewed favourably. It is only the safest dividends that have attracted a premium valuation. Companies like Enbridge Inc. ENB are expensive.

As you go down the safety continuum, some telecom stocks are fairly fully priced. But there are opportunities in the telecom/communications area. For example, we view Quebecor Inc. QBR.A and Rogers Communications Inc. RCI.B as reasonably valued. We also own Telus Corp. T, which is mainly a wireless business and is a strong cash-flow generator. With the telecoms, you have a fairly safe dividend, so they are trading at high valuation levels.

Mark Thomson

There are a lot of other great Canadian businesses that are reasonably valued. There are the Canadian retailers, the Canadian financial institutions, the railways, which are a little expensive, although Canadian National Railway Co. CNR is fair, but not great. These stocks are trading at valuations that will more than give us our minimum 50% return over the next three years. We are fully invested. The companies we like are strong free-cash-flow generators.

Bubis: Canadian telecom services stocks have performed well. We sold our telecom positions last year. They were at rich valuations. They have secular challenges. We have been slowly adding to our cable positions.

Q: Let's talk about dividend yields versus bond yields.

Thomson: The dividend yield on the S&P/TSX Composite Index relative to the yield on the 10-year Government of Canada bonds is at an all-time high.

Bubis: Also, most of the dividend paying companies will be raising their dividends. The coupon on the 10-year Government of Canada bond is fixed. Then there is the favourable tax treatment of Canadian dividends.

Hardacre: The majority of our companies pay dividends. We love dividend-paying stocks, but you have to be careful. The whole market is trying to do that now, so it could be a sign of a problem.

Bubis: Don't just go after dividends, because you could end up buying Enbridge and TransCanada Corp. TRP, which we don't think are cheap. Also, when interest rates go up, they are more interest-rate sensitive, as they are trading as a bond proxy. Dividends don't just have to come from utilities and telecom companies. There are other sectors, such as banks.

Q: Foreign content?

Hardacre: Some 30% of Trimark Canadian is invested outside Canada. Our model is to run between 40 and 45 names, with about 30 names in Canada and 15 outside of Canada.

We don't own any Canadian telecom. They are fairly fully priced. We used to be big holders of Telus. If you look at BCE Inc. BCE, Telus and Rogers, the companies are better managed than they have been in years. But they are fairly to fully valued. We have not owned a pipeline company in years, based on valuation. We can somewhat offset this in our foreign content, investing in consumer staples, for example.

We use our foreign content for businesses that are not available in Canada, including technology companies. Our Canadian content is skewed to energy and financials. We also have one-off names such as MacDonald Dettwiler and Associates Ltd. MDA and Toromont Industries Ltd. TIH. We have owned Toromont for more than 20 years. We have mid-cap names spread throughout the portfolio.

Ian Hardacre

Q: The U.S. equity market outperformed its Canadian counterpart in 2011. Are you finding opportunities south of the border?

Bubis: We are value investors and contrarian in execution. CI Canadian Investment has almost 30% in foreign content and some 38 names. Everyone had left U.S. equities for dead. The U.S. market looks super attractive right now. We have some 13% in the United States. We will be upping that a little and reducing our international holdings. Large-cap U.S. technology stocks are generally inexpensive. An example is Microsoft Corp. MSFT.

Hardacre: We have about 20% of Trimark Canadian in the United States. Our bias in the foreign content is to the United States. It is stock specific. We are value-oriented investors, not deep value investors. We have a three- to five-year time frame. We tend to be somewhat contrarian. You can find good ideas in Europe and the United States.

	Index	YTD*	2011	2010	2009	2008
	S&P/TSX Composite Total Return	3.7	-8.7	17.6	35.1	-33.0
	S&P 500 Total Return (C$)	10.6	4.4	9.3	8.1	-21.9
	Note: Year to date is as of the April 27 close Source: Morningstar

The U.S. equity market is not an expensive one and some of the mega-cap U.S. techs are reasonably valued. If you take out the tech companies' cash holdings, they are trading at single-digit earnings multiples and single-digit free-cash-flow multiples. We like Canada. The massive commodity bull run is probably over, but you can still make money in those stocks.

Thomson: We are primarily institutional investors. The Canadian model is limited to Canadian stocks. We have about 32 names in this portfolio. But Beutel Goodman Canadian Dividend can have foreign content, currently around 23%. We can find high-quality consumer and technology companies outside of Canada. I agree that U.S. technology stocks are cheap.

Photos: paullawrencephotography.com