While the bear market grinds inexorably onwards, veteran stock picker and contrarian investor Hugo Lavallée, who oversees the 5-star rated $341.8 million Fidelity Canadian Opportunities Class F, simply focuses on finding long-term winners that are undervalued and pays little attention to the market gyrations.
“Rising interest rates have a two-pronged impact. First, they raise the risk-free rate. Second, it impacts the consumer. But that can take up to a year to show up. So we’ll have a much better idea next summer,” says Lavallée, a Montreal-based portfolio manager with Fidelity Investments Canada ULC. Counting all series of the fund, there is $3.3 billion in total assets.
See the Trees for the Forest
For Lavallée, the focus is not on markets. “It’s not a stock market, but a market of stocks. There is a big difference,” says Lavallée, a 20-year veteran who joined Fidelity in 2002 after graduating with a bachelor of commerce degree from McGill University. He observes that defensive stocks such as consumer staples, are more popular and their price-earnings multiples have expanded. As for natural resource stocks, Lavallée believes that energy names are the real stand-out, and not base metals and gold: “The rest of the commodity complex is not working. It’s really just energy. And that’s part of my thesis: it is a sector that has strong momentum right now. But it is economically sensitive and at some point the bear market will catch up with them. It has the ability to slay all the sectors, but at different times.”
Until two months ago, Lavallée observes, investors were taking shelter in Real Estate Investment Trusts and utility stocks. But they have also taken a beating. “Consumer staples and oil and gas are the last areas doing well. But I am less interested. You have to pick your levels. I am more on the offensive, than the defensive.” Lavallée focuses on individual securities and in particular the 100 or so stocks in the portfolio. “I have price levels in my head and as the stocks hit ‘buy’ levels, I tend to be more interested and buy them. That’s how I do my job.”
Year-to-date (Nov. 4), Fidelity Canadian Opportunities Cl F returned -5.24%, compared to -5.71% for the Canadian Equity category. The fund has also outperformed on a longer-term basis. Over three and five years, the fund returned an annualized 15.37% and 13.01% respectively. In contrast, the category returned an annualized 7.16% and 5.51% for the corresponding periods. “I don’t pay attention to my peers,” says Lavallée. “If you beat the benchmark, the rest will take care of itself. I am beating the benchmark by a little. There’s a lot of nimbleness involved in managing the fund.”
Cash Deployed
Over the summer Lavallée gradually used up the cash in the fund, which declined from 10.6% at the end of August to 3.1% as of Sept. 30. “As a contrarian investor, I am always looking a few years out, and some prices were attractive. That’s how I run the process for the fund.”
From a sector standpoint, the fund is dominated by an 18.72% weighting in basic materials, followed by 16.65% in consumer cyclicals, 13.57% in industrials, 12.04% in technology and 11.20% in financials. From a geographic viewpoint, 82.3% is invested in Canada, and because it is mandated to have some U.S. exposure, there is 12.48% in the U.S.
Can the Company Double?
In seeking attractive stocks, Lavallée is focused chiefly on one attribute: can the stock double in the next five years or generate a compound annual growth rate of 15%? “What I look for is a doubling of my money. It cuts to the core of what we are trying to accomplish: a doubling of capital. I think about the portfolio as many individual decisions. And at the time they were made, we had a goal of an investment return greater than the market over five years.”
Rather than weighing stocks against a fixed set of attributes—such as strong management or a defensive moat protecting a company against competitors--- Lavallée examines each stock on its own merits. “It depends on every situation. Some could have been good businesses but were mismanaged. So you’re looking for a catalyst that over three-to-five years will unlock the value,” says Lavallée, who is backed by a team of nine analysts in Canada and 30 in the US, all of whom generate ideas for the portfolio.
Top Stock Picks
Take, for instance, Dollarama Inc. (DOL) a leading discount retailer. Lavallée identified the stock about a year ago when the firm encountered a variety of headwinds during the pandemic. “In Ontario, they could only sell essential products, so 40% of the products were unavailable. At some point, in Quebec, shops were forced to close on Sundays. And markets were worried about container costs coming out of China and that would squeeze margins.” Yet there were two things that gave Lavallée confidence. First, he knew that Dollarama would move to higher price points and find good value for their customers, which gave a tailwind to same-store sales. Second, Lavallée was confident that COVID restrictions would eventually be lifted. “They provide exceptional value to their customers. As these two catalysts occurred you had a re-rating of the stock,” says Lavallée, adding that the while p/e multiple has risen from about 19 to more than 28 times, the firm has a 30%-plus return on invested capital (ROIC). “The holding is smaller than a year ago. But it’s still in my top 10.”
Another favourite is Boyd Group Services Inc. (BYD), a Canadian-owned chain of collision repair shops that has grown rapidly through industry consolidation. It has a market capitalization of $4 billion. Last summer, Lavallée increased the holding as the firm faced some stiff headwinds. “Historically, it’s a consolidator, well-managed and good return on invested capital. But it faced three challenges. First, there was a problem with availability of parts because of supply chain issues. Second, there was a challenge with availability of labour. Third, there is a lag between input costs and [money from] insurance companies who pay a fixed rate for their business. They saw margin compression in late 2021 and going into 2022 because they could not complete jobs on time. Parts were also more expensive and they had to eat that, hurting their margins. And they had less access to labour became it became more expensive.”
Boyd Group has survived the challenges, Lavallée believes, as supply chains have normalized and there’s more skilled labour available. “The prospects for margins are improving again.” Currently, Boyd Group is trading at $201, for a 2022 p/e multiple of more than 50. The firm generates a 30% return on tangible assets, and its ROIC is 12-13%, including acquisitions.
Looking back over a 20-year career that includes taking over the helm of the fund in 2008, just before Lehman Brothers collapsed and sent the world into a downward spiral, Lavallée considers that this bear market is relatively mild.
“Back in 2008, it was scary because you were looking at the collapse of financial markets. This feels more like a garden-variety recession where the air is coming out of the free-money balloon. The cost of capital has gone up and it’s going to be a headwind for consumers,” says Lavallée. “There’s no quick fix this time because monetary and fiscal policy was a little too loose. Now we are paying for those sins and we need to rein in the inflation number, because no one wins at these levels.”
As a fund manager, he puts aside geopolitical issues, such as the Russian-Ukraine war, and concentrates on stock-picking. “You have to focus on finding good values, at good prices. The war was unpredictable and the same will be true of the ending. You have to control what you can control, and focus on that.”
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