William Dye, chief investment officer at Leith Wheeler Investment Counsel Ltd., is looking for the firm's Canadian equity portfolio to produce compound annual total returns of 10% over the next three years.
"It has been a challenging year in the Canadian equity market," says Dye. The extreme volatility of the market so far this year has resulted in a higher than average turnover in the portfolio, he says. "There were opportunistic purchases in the first half of the year and subsequent sales or trims to take advantage of the market surge."
In selecting Canadian equities, Dye and other members of the Canadian equity team assess a company's prospects over a three-year term horizon. They estimate the earnings growth potential of a company three years out, establish a target price for the stock and then calculate the expected compound annual total return over the three-year period. Qualitatively, the Canadian equity team seeks to invest in companies with a commanding business franchise and solid management.
Vancouver-based Leith Wheeler manages $10 billion in assets. The Canadian equity team manages $4 billion, which includes the Morningstar 4-star ratedLeith Wheeler Canadian Equity Series B 
, a top-quartile performer in its peer group over the past 10 years. This fund returned 17.7% in the year to date to the end of October. The portfolio is market capitalization "agnostic" and currently has 39 names.
The big-cap wireless-device manufacturer Research in Motion Ltd. ( RIM) was added to the portfolio earlier this year. "We had been watching RIM, which has such a strong franchise, for many years, but we resisted buying the stock as we considered it to be too expensive," Dye says.
RIM's historic price-earnings multiples were in the range of 25 to 40 times, he notes. At recent close, the stock traded at a significantly lower P/E of 16.9 times trailing 12-month earnings and 13.8 times forward 12-month earnings estimates. "It has become a value stock," Dye concludes.
| Research in Motion Ltd. (RIM/TSX) | |||
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| Nov. 17 close | $64.53 | ||
| 52-week high/low | $95.00-$44.23 | ||
| Market cap | $36.5 billion | ||
| Total return 3Y | 8.0%* | ||
| Total return 5Y | 14.5%* | ||
| Total return 10Y | 17.5* | ||
| Revenue growth (3yr. avg) | 75.0% | ||
| EPS growth (3yr. avg) | 71.6% | ||
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*As of Nov. 16, 2009 |
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Given the stock's considerable volatility and the highly competitive nature of the industry in which RIM operates, "you need high expected returns to justify investing in the stock." Dye's estimated average annual return on the stock over the next three years is 19%.
A small-cap company that also has a commanding market share, and that Dye considers could do well over the next three years, is Transat A.T. Inc. ( TRZ.B). The travel-industry firm, which has a current market capitalization of $547 million, is a long-standing holding in the fund. "Transat, which is one of the largest integrated tourism companies in the world, has a good balance sheet and is well run," says Dye.
Despite the economic downturn, "people are still taking vacations, albeit less expensive ones, and Transat's business is doing well." Furthermore, he says, a large percentage of the company's costs are in U.S. dollars, so it is benefiting from the weakness in that currency.
Finally, Dye says the overall Canadian travel business will benefit from the recent merger of Toronto-based Sunwing Travel Group with the Canadian operations of UK-based TUI PLC, including its money-losing Signature Vacations business.
"This consolidation should produce more rational, less cutthroat pricing in the Canadian packaged holiday industry," says Dye. His expected total return on this stock over the next three years is 19% per year. The company does not pay a dividend.
As a result of stock selection, Leith Wheeler Canadian Equity has an overweight position in the financial services sector at 39%, versus 31% for the S&P/TSX Composite Index. A mid-cap addition to the fund in this sector earlier this year was Genworth MI Canada Inc. ( MIC), which has a market capitalization of $2.9 billion. Genworth MI is "the leading private residential mortgage insurer in the country," Dye says.
Genworth provides default mortgage insurance to Canadian residential mortgage lenders in "the high loan-to-house-valuation category and in 2008 had 30% of this market," says Dye. "Genworth MI is well managed, has strong underwriting skills and has been consistently profitable."
The stock was an initial public offering priced at $19 a share and listed on the TSX in July. Dye participated in this offering. The U.S. parent, Genworth Financial Inc., ( GNW) spun off part of its holdings in this Canadian subsidiary to retain 57.5%, he notes.
"Genworth Financial was looking to raise cash and was a motivated seller and the IPO provided an opportunity to buy stock in the Canadian operations at a reasonable valuation." Dye estimates that Genworth MI can produce a total annualized return over the next three years of 16%. This includes the dividend payout, which is currently 88 cents annually.
The top three holdings in Leith Wheeler Canadian Equity Series B are major banks: Royal Bank of Canada ( RY), Toronto-Dominion Bank ( TD) and Bank of Nova Scotia ( BNS) "These are long-standing positions in the fund," Dye notes.
As an example of the increased turnover in the portfolio, reflecting the high degree of volatility in the Canadian equity market this year, Dye recently sold his position in the Canadian wealth-management giant IGM Financial Inc. ( IGM). He had bought IGM, which he describes as a "high-quality" stock, in the first quarter of this year.
IGM's stock price took a beating in the early part of the year as a result of the extreme weakness in the global equity market, which is when Dye and his colleagues bought it. Propelled by the stock market rebound, IGM's stock has risen rapidly since and came close to Leith Wheeler's target price, "much quicker than anticipated," so it was sold. Dye says that according to his firm's analysis, "the potential returns on IGM's stock over the next three years were slimmer than other opportunities in the Canadian equity market."
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