Canadian Equity Manager Maintains a Contrarian Approach

While the COVID-19 pandemic created a lot of opportunities for stock pickers such as Hugo Lavallée, this year may not be much different. But he also admits there is still considerable work in identifying potential winners.

“It’s always relative. Stocks were cheap last year because things were really tough,” says Lavallée, a Montreal-based portfolio manager at Fidelity Investments Canada ULC, who oversees the 5-star rated Fidelity Canadian Opportunities Fund, which in aggregate has $2.2 billion in assets. In 2020, the F series returned 29.09%, compared to 2.37% for the Canadian Equity category. “Back then, we were staring into the abyss. But it fits my style as a contrarian investor, to look at opportunities when things are really difficult.”

Investors were pulling money from mutual funds, recalls Lavallée, who assumed the portfolio in Sept. 2008, six years after joining Fidelity and working alongside veteran Maxime Lemieux. But the opportunities quickly came to the fore.

There Are Always Sales
“For me, it’s about coming to work every day and finding what’s relatively attractive. But recall that even though the stock market was down 40%, some stocks, such as grocery stores, were up. People were emptying the shelves,” says Lavallée. “It’s always a relative game. Right now, yes, cyclical stocks are doing well, but people are selling off other stuff, such as quality names. On a relative basis, there are always things to buy. We believe we do a good job as a team and look at what’s cheap right now, versus expectations. We ask ourselves: What are the contrarian ideas right now?”

Lavallée notes that he is fully invested, but as a high-turnover investor, he is prepared to quickly reallocate the fund’s positions. Portfolio turnover was 100.6% in the year ended June 30, 2020, and 90.2% in the year ended June 30, 2019.  From a sector standpoint, consumer discretionary stocks account for the largest sector, at 16.32%, followed by 13.84% financials, 15.21% materials and 9.68% industrials, as of December 31, 2020.

“In Canada, the market is chasing copper and other commodities. But it is selling off low-volatility, quality, high free cash flow names,” says Lavallée. “They are a lot more attractive than they were 10 months ago when all the cyclical stuff was going down. There are lots of opportunities. You just have to stay aggressive and keep pushing the rock uphill. There is always stuff to do.”

Better to Focus on Businesses
Lavallée is reluctant to make judgements of the overall market and finds it a futile exercise. “My day-to-day work is looking at companies. And a ton of them are reporting earnings right now,” says Lavallée, who works closely with a team of 20 analysts based in Toronto who provide potential candidates for his portfolio. “Some of them are going down [in portfolio positioning], and others are going up. I am always re-adjusting the portfolio.”

Share price valuations are another topic that he shuns. “To me, it’s a market of stocks and not a stock market,” says Lavallée, who tends to favour companies in the small-to-mid-cap space and uses the S&P/TSX Completion Index, which excludes the TSX 60, as his benchmark. “I don’t think about market valuations. I try not to sit on my hands, so I am always looking at a ton of companies. I’m interested in free cash flow yield. If a company is reporting 5-9% free cash flow yield, that interests me. Quality is cheap and free cash flow yields have gone out of favour. That’s what I think about today.”

In searching for companies, Lavallee is attracted to strong businesses that for a variety of reasons have fallen on hard times and are out of favour with investors. “The stock could be cheap based on earnings for the next couple of years. But the company has the balance sheet strength to survive this tough period,” says Lavallée, adding that on some occasions there have been management changes that give him confidence. “There is no magic formula.”

Over the longer term, the fund has proven to generate superior performance. For the past five and 10 years, it returned an annualized 16.55% and 9.32%, respectively, as of February 25, 2021. In contrast, the category averaged 7.79% and 4.35% respectively, for the same period.

Discount Opportunities
Running a portfolio with about 105 holdings, Lavallée cites as an example of a beaten-up stock Five Below Inc. (FIVE), a Philadelphia-based specialty discount retailer focused on the teen and so-called “tween” market. (The fund is allowed to have up to 10% in non-Canadian stocks). Lavallée acquired the name in January 2020 and watched as the pandemic slashed the share price in half, to US$50. “This created an opportunity for us,” recalls Lavallée, noting that Fidelity’s analysts estimated that the firm’s earnings would recover in 2022. “We keep it simple and don’t get lost in the noise [of the market]. We believed that Five Below would get past the pandemic. And by the end of 2020, the stock tripled.” Since the stock is now about US$190, Lavallee has reduced the position considerably.

Another favourite, and a top holding, is Dollarama Inc. (DOL), a leading Canadian discount retailer with over 1,000 branches across the country. “It’s a great business and has a track record of opening more stores every year. But it became out of favour when COVID came along and people were very concerned about the lock-down in Quebec. But I see it as a strong business which generates about 4-5% free cash flow yield,” says Lavallee. “People are chasing automobile and copper stocks. I did that nine or 10 months ago. Today free cash flow yield is out-of-favour. But that’s what I am looking for.”

Going forward, Lavallée is reluctant to forecast returns, except to express confidence that he and his research team can continue to produce strong results, relative to the peer funds. “We will do our best to deliver alpha,” says Lavallée, referring to the excess return relative to the return of a benchmark. “We are working hard at searching for contrarian ideas.”