Manager Believes Central Banks have a Credibility Issue

To combat a Canadian equity market in limbo, Mackenzie’s Tim Johal focuses on companies with a strong cash flow, and dependable dividends.

Michael Ryval 13 July, 2023 | 1:12AM
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The unrelenting forces of inflation, coupled with strong employment numbers and central banks sending mixed signals has produced a Canadian equity market that has seemed to be stuck in limbo. Nevertheless, seasoned stock picker Tim Johal argues that in the face of lingering uncertainty and volatility, it’s preferable to focus on companies with strong cash flows and dependable dividends.

“Coming into 2023, multiples had contracted and earnings expectations had come in a bit. The consensus was for a recession in the first half of 2023. But it became apparent that the recession was not going to happen in the first half, and corporate earnings proved to be more resilient than expected,” says Johal, vice-president at Toronto-based Mackenzie Investments and a 25-year industry veteran who is the lead manager of the $2.4 billion 4-star bronze-rated Mackenzie Canadian Dividend F.

Based in Winnipeg, Johal joined sister company Mackenzie in 2017 after a lengthy stint in North American equity investing for Investors Group. He works with Darren McKiernan, senior vice-president and head of the global equity and income team, and Katherine Owen, vice-president, who selects U.S. and international dividend-paying equities.

When Will the Recession Happen?

Looking ahead, Johal concedes there is a lot of uncertainty in the markets. “Will there be a recession? And, if so, when? Part of the reason for using a bottom-up process is because the top-down has been very difficult. The market has talked about a recession for over a year. If you had positioned yourself for a recession, it would not have served you well. So, given that uncertainty, I would expect continued volatility and have modest expectations for returns. If anything, that approach favors dividend stocks and companies that pay cash to shareholders.”

While the consensus view has changed to calling for a recession more likely to happen in late 2023 and early 2024, the Mackenzie team have anticipated a soft landing type of recession in 2023. Notably, Johal believes, there was greater acceptance of a risk in equity markets.

“The consensus is now moving towards more of a soft landing, rather than a hard landing. The difference between the two views is how deep employment might contract and how much damage that would do to the economy. But that caused a risk-on move within equity markets.”

Meanwhile, until two U.S. banks failed in March, the Federal Reserve had taken liquidity out of the system with quantitative tightening and higher rates. “But perversely, when the banks failed, the Fed actually injected liquidity into the system. It wanted to ensure the financial system functioned properly. In my view, that liquidity injection supercharged the rally and multiples were re-rated higher,” says Johal.

Central Banks Have a Credibility Issue

Although inflation has gradually declined, Johal argues that the main concern is wage inflation, which is being driven by strong employment numbers. “Labor markets remain tight. In the U.S., for every job applicant there are 1.7 job openings. The Fed wants to see wage growth come down, but we haven’t seen any indication of that, so far,” says Johal.

“The problem with wage growth is that you can get into a wage price ‘spiral,’ where wages continue to drive higher, which drives demand and pricing for goods and services. You can get into this ‘spiral’, where the Fed can’t meet its objective of 2% inflation. The Fed will have to get ahead of this. That’s the risk out there—that it may have to keep raising rates. But the market is not pricing that in. It believes that everything is fine.”

While Johal is essentially a stock-picker, he does worry about macro-economic developments. “Central banks have a bit of a credibility issue. They went from viewing inflation as being more transitory, and not moving on short-term rates, to having raised rates at the fastest pace in modern history,” says Johal.

“The Fed began raising rates in March 2022, but we haven’t seen the effect of the move from 0.25% to 5%. That’s a risk. Have they been too aggressive, or not enough? We’ll have to wait and see.”

Meanwhile, Johal notes that the market rally has been confined to selective technology related players, such as Microsoft Inc. (MSFT), Alphabet Inc. (GOOG) and Meta Platforms Inc. (META). Conversely, under-performing areas include utilities, telecom services, and financials, where Johal and his team focus their efforts.

A Focus on Risk Management and Price Ensure Long-Term Outperformance

“Our top-down view does matter in terms of portfolio construction and how much risk we are willing to take in certain positions and [degree of] concentration in the portfolio. It also plays into our modeling of our companies and the earnings expectations for our companies,” says Johal, “We think about issues such as, where is there potential reward in the market? What are our price targets and how much return do we see in our holdings? And, importantly, how much risk are we taking on to achieve those price targets?”

Johal notes that from time to time they are contrarian and will sell or trim stocks that became fairly valued. “We want to get paid for the risks that we are taking. If we’re not getting paid, we’ll sell or trim these stocks,” says Johal, noting that they have sold some technology and consumer discretionary names that had reached price targets, but added to utilities and consumer staples that became attractive. Compliance rules prevent him from being specific.

From a performance standpoint, Mackenzie Canadian Dividend F has returned 1.03% year-to-date (July 10), versus 2.10% for the Canadian Dividend & Income Equity category. However, on a 5-year and 10-year basis the fund has outperformed the category. It returned an annualized 6.44% and 7.93% for the corresponding periods. In contrast, the category returned an annualized 5.79% and 6.75%, respectively.

Johal observes that in 2022 the fund had a strong relative performance, but it has given some of that back, mostly in the U.S. portion of the fund. “This year, the defensive positions in the U.S. have not performed as well [as in 2022]. We are more value-oriented. But growth has worked in the U.S. market and that has hurt us,” admits Johal, adding that the fund has not held strong performing engineering and construction companies because they are expensive and don’t generate dividends.

Canada is a Value Market, Canadian Stocks Appear More Attractive

From a strategic viewpoint, the fund is split between 80% Canadian stocks, 16% U.S. holdings and 4% international positions. “There is a strong reason to be invested in a Canadian dividend strategy. Canada is a value market and very reasonably priced,” says Johal, noting that the benchmark S&P/TSX Composite Index is trading at 13.2 forward earnings, versus 19.5 times forward earnings for the S&P 500 Index.

 In fact, Johal argues, in an environment where returns may be more modest, the dividend yield should represent more of the total return going forward. “That has not been the case in the last 10 years across U.S. and global markets,” says Johal. “But if you go back decades, the dividend yield has represented more than half of the total return over time. If we get back into a more ‘normal’ environment, where dividends represent more of the total return, Canada [will benefit because it] is a higher-yielding market. If you look at the S&P/TSX Composite Index, the indicated dividend yield is 3.6%. On the S&P 500 Index, the yield is only 1.6%. If dividends are going to be important for total returns, Canada naturally appears to be more attractive.”

The portfolio, which has about 45 Canadian stocks, and about 90 holdings in U.S. and international markets, is allocated on a sector basis between about 37.4% in financial services, 16% energy, 8.8% industrials, 5.9% utilities, 5.5% consumer cyclical and smaller holdings in areas such as basic materials and consumer defensive. The fund’s overall underlying yield is 3.8%, before fees.

Top Stock Holdings in Mackenzie Canadian Dividend Fund

One top holding is Sun Life Financial Inc. (SLF), a leading insurance firm with interests in Canadian, U.S. and Asian markets. “It’s a high quality company led by a very strong and capable management team and it’s been able to add value over time. It’s done so by employing a very strong risk culture,” says Johal. He notes the firm has three so-called drivers that will propel earnings:

  1. The investment in the U.S. health and group insurance business, where Johal sees significant growth, on a ‘capital-light’ basis.
  2. Sun Life’s alternative asset management platform, where Johal foresees strong growth.
  3. The firm’s Asian business, which is also experiencing strong, risk-adjusted growth.

SLF trades at 10.5 times forward earnings, which is slightly lower than its historical price-earnings ratio of 11.5 times. It has a 4.4% dividend yield. “We see strong double-digit return potential over the medium term.”            

Another top holding is Emera Inc. (EMA), a Canadian utility with a focus on electricity transmission and distribution in Nova Scotia, Newfoundland, Florida, New Mexico and the Caribbean.

“The driver for the stock is Florida, which is seeing population growth,” says Johal, adding the beneficiary is Tampa Electric, or TECO, which Emera acquired in 2015. “TECO is seeing very strong base load growth, which is surpassing what Emera is seeing other markets.” Meanwhile, EMA has some coal-fired generating plants which are being converted to solar-power, which will improve its ESG (environmental, social and governance) score. “This will also help its base-load growth with that capital investment.”

EMA, which has a dividend yield of 5.2%, is trading at 16 times forward price-earnings, versus a historical ratio of 18 times. “They do have some leverage on the balance sheet. But free cash flow generation has been strong and we think Emera will have the ability to bring its debt down,” says Johal. “That should drive a re-rating of the stock higher.”


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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Alphabet Inc Class C178.00 USD-0.86Rating
Emera Inc49.65 CAD-0.66Rating
Meta Platforms Inc Class A467.78 USD0.68Rating
Microsoft Corp430.52 USD0.34Rating
Sun Life Financial Inc50.74 USD-0.98Rating

About Author

Michael Ryval

Michael Ryval  is regular contributor to Morningstar. He is a Toronto-based freelance writer who specializes in business and investing.

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