“Right now I’m running 8.5% more equities - consistent with where I think the cycle is right now,” says Damian Fernandes, Vice-President and Director at TD Asset Management in Toronto.
“It’s our belief to turn off the TV. There’s just so much noise - and it confuses the underlying profitability that we’re living,” says Fernandes. “The companies that we own, versus their own history and versus their peers, are at the most profitable levels that they’ve ever been. And I think that’s the hidden gem or the value creation.”
The focus on businesses with cash flow generation drives the four-star TD Diversified Monthly Income fund, according Fernandes, the lead manager.
When it comes to asset allocation in the balanced fund, the approximate 69% position in equities and 25% in fixed income has been characteristic for the past three years. The benchmark in general is 60% equities and 40% fixed income but wide ranges are allowed at any given point in time, based on the macro outlook. If the research tools indicate that growth is slowing, that may result in an increase in the fixed income weight and a reduction in equities.
Overweight equity for an extended market cycle
Since 2016, the fund has held an overweight position in equities and an overweight in cyclical assets, based on the research indicators and data. “Literally,” says Fernandes, “this has been one of the longest cycles that I can remember.”
The research process for stocks draws on a blend of the TSX and MSCI World indices, seeking the best companies across sectors and industries. After screening more than 1600 stocks, the portfolio holds a select 60 to 70 names.
As well as the focus on companies that are “churning out” excess cash, the quantitative research tools look for businesses with high returns on investment capital, high gross margin, high operating margin, low leverage versus the sector, and a competitive advantage, among others.
Among the predominantly large-cap equity holdings, the approximate 31% in financials and 20% in energy has been the case for a while. Canada currently represents 48% of the equity component. “A good chunk of that,” says Fernandes, “is in those two sectors because, to put it plainly, the highest quality companies we’re finding in the Canadian market place come from those sectors.”
Energy and big banks bring predictable cash
Along with four of the big banks among the top names that meet the fundamental stock criteria, are Canadian oil and sands producer, Suncor Energy Inc. (SU), and energy generator and distribution company Enbridge (ENB). “Yes, they’re large-cap names,” says Fernandes,” but actually they’re more predictable cash-flow names.”
Enbridge is favoured because the company has completely retooled its organization structure to become much more clear in its disclosures and has improved its leverage profile. “You look at a name like Enbridge now and it’s paying you 6% in dividend yield that grew 10% last year. So the business model is industry leadership, with a strong competitive advantage. Enbridge has the only pipe that’s in transport from the oil sands.”
Canadian National Railway Co. (CNR), among the top 10 holdings, is favoured for its ability to transport goods effectively and efficiently. “When you think about just growth,” says Fernandes, “rail is a leveraged play on positive growth; there’s only a few ways to transport goods and there’s more goods going to be on CN rail cars.”
Adding to the portfolio’s diversification is a “bias” towards global opportunities, currently represented in the approximate 16% equity weight in the U.S. and 7% internationally. In that respect, the selection process groups companies according to global economic growth themes, such as oil and gas companies, industrial commodities, or Chinese consumption, among other buckets.
For example, “Airbus SE (EADSF)”, “is in this fund,” says Fernandes, the world’s second-largest aerospace defence company, “and we also own a company like Amadeus IT Group (AMADF), a tech company in airline software,” with the largest share of global bookings in airline, rail and hotel. “So those are different industries and sectors but they’re tied to the same economic theme or air travel consumption.”
The overall positioning of the portfolio is based on a long-term strategy of compounding cash flows. “Our portfolio on average,” says Fernandes, “doesn’t really move more than 20% to 25% in turnover, and some years, such as 2017, the turnover has been below 5%. The only reason we’ll sell a stock is if our business model or our confidence in that cash flow production has changed. Or if there’s just a much better idea.”
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