Although much of the pandemic-induced bear market has recovered, when it comes to valuations, stocks can be split into two camps, says long-time value-oriented stock picker Don Simpson, as he seeks to find reasonable prices in both 'loved' and 'unloved' sides of the market.
“The good companies that are in the right place and growing their margins and have all the secular growth opportunities are very well-loved right now,” says Simpson, vice-president at Toronto-based 1832 Asset Management and lead manager of the four-star rated $240.9 million Dynamic Canadian Dividend Series F. “We can’t say they are under-appreciated. But there is also a good reason why they are highly-priced.”
For example, technology stocks such as Microsoft Inc. (MSFT), which have growing margins and no debt on the balance sheet, and their free cash flow yield is close to 3%, are getting a lot of attention. In contrast, banks are far less enticing because they are facing challenges to generate earnings when interest rates are less than 1% and they are forced to focus on cost-cutting. “They [high-multiple technology stocks] are definitely not cheap,” says Simpson, a 26-year industry veteran who joined the Dynamic fund family in 2012, after 12 years managing funds for Invesco Canada. “Whether they are over-valued, I don’t know. I wouldn’t be surprised if they have a pull-back.”
Opportunities in the ‘Restart’
Instead, Simpson points to opportunities among “unloved” stocks that are undervalued. “They will have some challenges until someone comes out with a vaccine [against COVID-19]. That’s where we look for opportunities and see if there are businesses that on a longer-term basis—three-to-five years down the road—are attractive,” says Simpson, who favours companies with good balance sheets and management that he can trust. “When we look at their earnings power there are some really good opportunities. It is a split. That’s how we run the portfolio and have a collection of both kinds of companies.” About 80% of the portfolio is well-positioned for today, adds Simpson, while about one-fifth is held in firms that are unloved today but are well-positioned for the future.
This approach has helped the fund achieve performance ahead of the Canadian Dividend and Income Equity category. Year-to-date (Sept. 25), the fund returned -3.39%, compared to -10.46% for the median fund. Over three and five years, the fund has averaged 3.44% and 7.29%, respectively, versus 1.01% and 4.47% for the category. The fund has a trailing 12-month yield of about 5.08%.
Actively Values So You Don't Have To
“There’s no shortage of opportunities. The market as a whole is not cheap but we own enough of what we believe is reasonably valued and we feel good enough about the valuation of the fund,” says Simpson, who shares duties with Rory Ronan, vice-president and Eric Mencke, portfolio manager. “That’s our job: making sure that what we own in the fund is reasonably valued. People can own these funds for a decade, rather than flipping in and out on a good day or a bad day. A dividend fund is something you should buy and put away and not worry about.”
When the pandemic struck in mid-March, Simpson and his team had to re-assess whether their stocks were as low-risk as initially believed. After emphasizing management teams and balance sheets, they reduced the number of names in the portfolio to the best ideas and best management teams they could find. “If we owned four banks, we went with the three strongest banks. If we owned some energy names, we chose the ones with the better balance sheets. We did it very quickly. The goal was to make sure that we didn’t have anything to worry about getting through to the other side.”
At the end of that process, the fund was reduced to about 30 names, but since then has grown to about 37.
From a sector viewpoint, financials comprise the largest weighting at 28.5% (with banks accounting for 15.2% of the fund), followed by industrials at 11%, materials 9.9%, energy 9% and information technology at 5.8%. Interestingly, the fund shows itself as a non-traditional dividend fund because it has 19.3% invested in the U.S. and 2% in the U.K. “One of the problems we have in Canada is that our market is not well-diversified. We have high weightings in financials and resources. But sectors such as healthcare and information technology are under-represented. I know that firms like Shopify Inc. (SHOP) have a 5-6% index weighting. But our goal is to make sure we have enough diversified ideas.”
Four Elements for Strength
Simpson favours companies that have four key attributes: industry leadership, the ability to generate strong free cash flow, solid balance sheets and, most important, strong management. One top U.S. holding is United Parcel Service Inc. (UPS), a leading shipping provider, “The freight delivery space is such a large one that there is plenty of growth for everyone. The reason UPS hasn’t grown earnings as much as it should is because management has always loved spending on growth but has not focused on returns,” says Simpson, adding the firm could do this because it generates a lot of free cash flow.
What sparked Simpson’s interest was the appointment of a new chief executive officer, Carol Tomé, previously chief financial officer at The Home Depot Inc. (HD). “She has said that ‘it’s time we got paid for our assets. If you value your shipment arriving in a day, instead of a week, you have to pay us for that capability.’ This is a welcome change. When you take a company with US$80 billion in revenue and change how you pay for their services, it is amazing how powerful that can be.”
Simpson, who likens the change in attitude to the one that Hunter Harrison applied in re-organizing Canadian Pacific Railway Ltd. (CP), expects considerable growth in the next couple of years. UPS, which trades at 20 times forward earnings, pays a 2.5% dividend.
On the Canadian side, Simpson likes Power Corp. of Canada (POW), mainly because of a corporate shake-out that consolidated operations and brought a renewed focus on earnings. The stock is trading at a 30% discount to net asset value, and also pays a 6.8% dividend. “There is a lot of hidden value there,” says Simpson, referring to the under-performing Putnam’s division which has been a drag on the stock. “The net asset value is higher than people think. There is a real opportunity for this company to be loved again, once they show they care about investors. It will take time, but I am getting paid almost 7% to wait.”
