Canadian equities roundtable: Part 1

More than just a resources market

Sonita Horvitch 18 April, 2011 | 6:00PM
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When measured by market capitalization, resources companies now make up slightly more than half of Canada's equity market, and to a large degree have overshadowed other sectors. In this week's Canadian equities roundtable, we asked our panel of value managers to look beyond the rocks, trees and oilfields for attractively priced non-resources stocks.

Our panellists:

 Kim Shannon, president and CEO of Toronto-based Sionna Investment Managers Inc. A value manager, Sionna offers mutual funds in conjunction with Brandes Investment Partners & Co., including Brandes Sionna Canadian Equity   and Brandes Sionna Canadian Balanced.

 Mark Thomson, managing director and head of research at the value manager Beutel Goodman & Co. Ltd. Thomson and his team have a number of mandates including Beutel Goodman Canadian Equity  Beutel Goodman Canadian Dividend   and Beutel Goodman Balanced  .

 Ian Hardacre, vice-president and head of Canadian equities at Invesco Trimark Ltd. A value manager, Hardacre's mandates include lead-manager roles for Trimark Canadian and Trimark Select Balanced.

They spoke with Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and Thursday.

Q: This Canadian equity roundtable will focus on some of the non-resource sectors in the S&P/TSX Composite Index. In all, these sectors comprise roughly 49% of the index. There has been much investor interest in energy and materials, which are collectively roughly 51% of the index. This has overshadowed other sectors.

Thomson: There is significant bifurcation in the Canadian market. The natural-resource sector, including both energy and materials, is fully priced. That leaves a significant portion of the market trading at reasonable valuations. Investors are ignoring a lot of good long-term opportunities, such as in the financials, telecoms, consumer staples and also some consumer-discretionary stocks. The bulk of these stocks are reasonably valued and have the potential to produce 50%-plus total returns over the next three years. These companies are often strong cash-flow generators and dividend payers. Dividends have historically accounted for a large portion of total returns. There is an opportunity, at this stage, to produce a high-quality portfolio with lower risk and good returns.

Ian Hardacre, Kim Shannon and Mark Thomson

Shannon: I agree on the bifurcation of the market. The Canadian equity market as a whole is getting pricey. You have a trailing price/earnings multiple on the Canadian equity market north of 20 times. The stock price to book value is currently 2.2 times. This is expensive, and history suggests that the following decade could see subpar returns. We tell investors to learn to love an average return of 6% per annum. The bulk of this comes from dividends. Active managers can improve on the subpar returns. The Canadian equity market looks a little vulnerable at this stage.

What is interesting in this market is that there are some high-quality large-cap stocks trading below book value. We have not had that happen often in the last decade. We are in a sideways market after the tech mania of 2000. Such markets are volatile and generally last for a minimum of 15 years. We are in year 11, so there is more volatility to come. They end when the market is down to single-digit P/E multiples, because earnings have caught up.

Hardacre: What is being ignored is also stock-specific. For example, Thomson Reuters Corp. TRI, in the consumer-discretionary sector, is being overlooked. We increased our holding in this stock to a big weighting. We are having trouble finding new names in Canada. We look for stocks that we consider better than those that we already have. We made changes to the weightings of the existing holdings in our portfolio. We have been net sellers for the last six months and have been raising cash. A lot of the sales have come from the energy sector. We don't have a lot of basic materials. We are cautious, particularly on the resource stocks, especially basic materials. At the margin, I am more bearish than optimistic.

Thomson: We are fully invested, we are very bullish longer-term.

Hardacre: I differ from Mark in that I don't see bank stocks as being incredibly cheap. We have core positions in two of them, Toronto-Dominion Bank TD and Bank of Nova Scotia BNS, which we have had for a number of years, and wait for opportunities in others. We own Royal Bank of Canada RY in our balanced fund.

Q: The financial services sector, at 28% of the S&P/TSX Composite Index, is neck and neck with energy as the biggest sector. The Canadian banks account for a hefty 19% of the index.

Mark Thomson

Hardacre: Banks are good businesses. In some ways they have a licence to print money. Even when they make mistakes, they remain resilient. I find it difficult to put new money into banks.

Shannon: So do I. I am underweight the banks. My main holdings are Scotiabank, RBC and TD Bank. Scotiabank is the quality name in banking. It has good growth through its emerging-market exposure. It has been doing this for more than a century.

Hardacre: We have a big weighting in the financial-services sector in Trimark Canadian, but it is spread among a variety of companies including international stocks. I have 25% of the portfolio outside Canada. Our bank exposure is definitely underweight.

Thomson: The banks are dividend payers. Unlike Ian and Kim, my portfolio is all- Canadian. I have 25% in the banks, which is an overweight position. The main holdings are TD, which has a dividend yield of 3.19%, Canadian Imperial Bank of Commerce CM with a yield of 4.18%, Royal, with a yield of 3.34% and Scotiabank with a yield of 3.62%, on recent closes. The dividend yields on bank stocks are the highest they have been relative to the 10-year Government of Canada bonds for many years. Would we buy banks at this stage? We already have a full overweight position.

Shannon: We try to keep our sector weightings at plus or minus 5%. For financial services, we are in that range and underweight banks.

Thomson: We can be zero weight a sector as we are in information technology, health care and utilities. Back to the banks, the banks as a scale business in Canada are the best businesses we have. Canadian retail banking has returns on equity of 30% to 35%.

Shannon: The banks have an oligopoly in Canada. The problem is when they diversify. They are not always that good at capital allocation.

Thomson: Some of them are poor allocators of capital. Royal Bank of Canada spent $6 to $7 billion in the United States. Now it is getting out of its U.S. operations at probably half that price if it sells it.

Kim Shannon and Mark Thomson

Hardacre: The banks sit there with excess capital. Their boards and their management feel that they need to do something with this. Greater than 50% of the time, the money is invested on a negative-return basis.

Thomson: It is the siren call of growth. The banks are able to achieve huge excess-capital generation largely from operations. They are great cash-flow generators and they have the opportunity to raise their dividends. Their payout ratios are going up, as they should be. The stocks currently trade at valuations that we think are attractive.

Shannon: To us, bank valuations are rich relative to their history and to other opportunities in Canada. There are depressants on their returns on equity (ROE). One of their most stable profit centres has been in mortgages. We do not think that the growth in this business can continue. The banks are trying to replace mortgages with commercial loans, which tend to be riskier and less profitable. The regulatory pressure of increasing capital and increasing quality of capital will depress banks' ROEs. Also, bank tax rates could go up.

Thomson: Scotia on the whole has made good acquisitions.

Shannon: Yes.

Thomson: TD has made good acquisitions. You have to go back a ways. Its purchase of Waterhouse was good. It improved the bank's stock-market valuation and helped it to buy Canada Trust, which substantially boosted its clout in Canadian retail banking. It has TD Ameritrade Holding Corp. AMTD, which is a good stable business. The return on capital on its U.S. banking operations, TD Banknorth and Commerce Bank, is low. That is what happens when you go to someone else's market. This will work itself out over time.

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Sonita Horvitch

Sonita Horvitch  

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