Investing in Canadian Equities
TWST: Please begin with a brief history and an overview of your firm.
Mr. Majendie: We call ourselves Majendie Wealth Management. We are part of the Scotiabank Group. The individual investment dealer subsidiary that we work with is ScotiaMcLeod. Scotiabank is one of the top 25 banks in the world if you look at it from the safety point of view. It's a substantial firm. We run chiefly private client money at Majendie Wealth Management, as well as some foundations, trusts and small pension funds. We're totally Canadian managers, so we don't invest outside of Canada. We have six different portfolios. These run the spectrum of risk/reward or a range of risk/reward from the extremely conservative to reasonably conservative. We set longer-term return targets; these would be pre-fee annual return targets for each of these portfolios, and what we think the risk level of these portfolios will be, or certainly has been over the last number of years. We find it's very helpful to clients to talk about risk/reward, but always in relationship to risk - the higher the reward, the greater the risk. We deal in the very conservative end of the spectrum. Thus, on the equity side, for our universe we use 70-odd companies, which are basically the TSX 60, the largest blue chips in Canada, plus 10 or 15 for diversification sake. On the fixed income side, we use investment-grade bonds, whether they be government or corporate. So it's the high-quality end of the conservative investment spectrum.
TWST: How would you describe your overall investment strategy and philosophy?
Mr. Majendie: Really, we're value managers. In terms of our investment process, we use both top-down and bottom-up analysis. For many years, I was a ranked Institutional Portfolio Strategist, and therefore always looking at the macro picture. In that light, to give you a very brief synopsis of our top-down stance, in 2000 we took the view that we were in a secular bear market much like the 1960s and 1970s, which would see a lot of volatility but effectively flat equity markets in North America, which was very akin to the 1966 to 1982 period. So you had to be more active, and asset allocation would be important. On the macro side, we also regularly project an overall market target for the TSX, using our extensive fundamental database. For example, in terms of the cash flow data, we have a unique database which goes back 30 years, which I don't think is duplicated in Canada. We also have some of our own proprietary tools. One I might mention is what we call our Majendie Deflation Monitor that I've been keeping for almost 20 years, which consists of 17 different indicators, 12 of them short term, and five long term. It has been very helpful in indicating when the deflationary risk, both in North America and globally, is elevated. When this Monitor reaches a level of 60 - zero being no risk of deflation - then one should consider, if it persists, changing one's investment strategy for a deflationary environment. When you're in a debt situation that the largest economies currently find themselves in, deflation, which is involuntary debt liquidation, definitely has to be taken into account from the point of view of risk and the need to change strategy. So that's the macro side or the top-down side.
On the bottom-up side, I'm not saying we're unique in this, but what distinguishes us from most is we have a real discipline of visiting the CEOs and CFOs of those 75 companies twice a year. And we have a strong concentration on not just the companies' one-year outlook, but the five-year outlook as well. We find that very valuable in terms of us choosing our core holdings for the various portfolios. I think in terms of performance over time, that's the critical factor. For example, one of our portfolios is the Dividend Growth Portfolio, and at the end of March it will have a 12-year track record of in excess of 10% a year, on average, with only one losing year. And in that 12-year period, the TSX 60 Total Return index, which includes dividends, is up about 4%. It's really the stock-picking side that helped us beat the benchmark by that significant degree. Again, we're not just trying to beat the benchmark, we're trying to do it with lower risk. We aren't benchmark huggers; we have really quite concentrated portfolios. In the six portfolios, the number of equities that we have - three of them are balanced portfolios - is between 12 at the lowest and 25 at the highest.
Just a final comment on the bottom-up - we do discuss with the CEOs and CFOs in those company interviews the long-term outlook for earnings, cash flow, capex, free cash flow and dividends, and some of those obviously are more predictable than others, depending on the industry. This allows us to estimate the five-year total shareholder return for each company in our equity universe. That's very helpful, as I said, in helping us select our core holdings.
TWST: Dividends - is that a theme you've been emphasizing recently?
Mr. Majendie: Of the themes that we've been emphasizing really since 2000, the dividend income theme, that income will be king, has been very much a key theme for us. In addition, we have always said this, but I guess the 2008-2009 financial crisis really emphasized that quality is critical, meaning a quality balance sheet, strong free cash flow. That's why we spend so much time discussing free cash flow with the senior management of these companies. The other final theme is, although we're Canadian managers, in the 1980s and 1990s we encouraged clients to diversify as much as they felt comfortable with outside of Canada, because we didn't like the Canadian currency and on the commodity side we had a poor outlook. We thought that, for example, the U.S. market would substantially outperform Canada, which it did. But we reversed in 2000.
And I would make this comment: the top Canadian companies, in say the TSX 60, have become globally extremely competitive - whether you talk about our banks; whether you talk about some of our other financial companies, like life insurance companies competing in China and India; whether you talk about Brookfield (BAM) and the assets it owns in South America, Australia, the U.S., the U.K.; whether you talk about investment in SNC Lavalin (SNC.TO), which is the global go-to engineering company in certain aspects of the mining business. So if you look at that TSX 60, you can diversify internationally through globally competitive companies, and not just commodity-producing companies but service companies as well. And thereby you can reduce your currency risk, because your investments are still in Canadian dollars but you're getting nevertheless some pretty good leverage, particularly to the emerging economies.
I mentioned China and India for the life insurance companies; for example, Manulife (MFC) and Sun Life (SLF). And while we don't own either of these companies currently, Manulife is the largest foreign life insurance company in China, and the same applies to Sun Life in India, where it has 150,000 agents. So that's been a very definite theme for the last decade, and I think this will apply for the next five or 10 years. Certainly, the advanced or the developed economies won't be growing nearly as fast as the emerging economies, but you can lower risk and get access to those emerging economies through globally competitive Canadian companies.
TWST: Do you aim to have any specific sector weightings or allocations?
Mr. Majendie: Each of the six portfolios has an investment policy statement attached to it, and some of them say we're going to be in at least seven of the GICS sectors, seven of the 10; others are less restrictive. Because, again, we're not benchmark huggers, and so we tend not to replicate or have exposure to every sector.
For example, in the summer I became very concerned about the European situation, which obviously gets 24/7 press these days, so we really made sure that we reduced commodity exposure and also reduced bank stock exposure, because although Canada has the safest banking system in the world, if there is concern about credit or debt problems, it would reflect itself in the banking sector quite quickly. And that's actually been true. Even though the markets have been fairly strong, Canadian banks have not performed particularly well, and so we've been light in that area over the last six to nine months.
TWST: Those are sectors you have reduced your exposure to. Are there industries that you are particularly bullish on right now, that you see as especially promising?
Mr. Majendie: I am very bullish, on a longer-term basis, on companies that have reliable free cash flow growth, that are not particularly economically sensitive and that can grow their dividends. Now, that has been a theme that has worked over the last decade, but I think it will continue to work. When there is a new flush of liquidity into the major global banking systems, as there has been particularly since December - you already had the Fed in that mode effectively with their Operation Twist, you've got the ECB with its LTRO there, and India and China now are either cutting interest rates or reducing reserve requirements. There has been, therefore, a lot of excess liquidity that has actually meant over the last two or three months all those stocks that didn't do well last year started to do well, because the money has to find a home. But I think on a longer-term basis those companies with predictable increasing free cash flow will continue to outperform.
So in Canada that includes some of the utilities. It includes some of the infrastructure companies. It includes some of our REITs, and some of the pipeline companies, although some of them have done so well; Enbridge (ENB), for example, has done so well. Its valuation is quite high, so if they have a short-term stutter in earnings, which they published today, the stock can come off quite quickly. But on a longer-term basis, that company should continue to grow its earnings per share 11% to 12% a year and its dividends about 10% a year. So we're trying to highlight companies like that, with lower risk and more predictable return.
I'll add another one. I was just interviewing the CEO of a company called Emera (EMA.TO); its primary asset is Nova Scotia Power, but it also has operations in Maine and the Caribbean. Its outlook over the next five years is to grow its earnings 5% to 6% a year, and grow its dividend accordingly. Not that all the future projects are sanctioned, but in excess of 80% of the earnings are regulated, so that's why it's relatively predictable. It currently yields 4.1%, so if you grow that 5% or 6% a year for five years, the average yield becomes in excess of 5%. And if the multiple doesn't change, its earnings per share growth of 5% to 6% should give you a double-digit return. So that's the type of company we're looking for.
And Canada is, I should mention, different from the U.S. to this extent. We have a much larger proportion of higher-dividend-paying and growing companies. Partially this is because our banks didn't cut their dividends in the financial crisis, whereas many U.S. banks did. But we have a very interesting situation in Canada where the TSX dividend yield is roughly the same as the 30-year bond yield. Now, that did happen once before, at the depth of the financial crisis in February/March of 2009, but otherwise that really hasn't happened since the mid-1950s. So what that's telling you, at least, is that Canadian dividend-paying companies are extremely competitive with fixed income investments, or specifically with 30-year government bonds. So despite short-term cyclical changes, the outlook for those companies over the next five to 10 years should be excellent, because as bond yields move up, historically they are very competitive, and they should garner increasing cash flows from investors.
TWST: You mentioned Enbridge and Emera. Are there other examples of current holdings or top investment picks you would share?
Mr. Majendie: I mentioned the long-term performance of the Dividend Growth Portfolio. Let me tell you about another of our portfolios. About 2.5 years ago we started another portfolio, our High Income Portfolio, which is "the best of the best" of the dividend-paying companies in our universe. It's a concentrated portfolio. It normally has 12 to 15 dividend-growing companies in it. It currently owns 12. All but one has increased their dividend in the last year. By the way, that portfolio over the last 2.5 years is up just in excess of 65%.
I will single out three holdings in that portfolio for you. Brookfield Infrastructure (BIP), which is a spinoff from Brookfield Asset Management, has infrastructure investments in the North American energy business. It owns infrastructure assets in Chile. It owns a port in the U.K. It has a monopoly railroad in Western Australia. And it pays a dividend of $1.40. But I believe, largely through the western Australian expansion and together with two assets they recently bought in Chile, that the dividend will grow over the next four years from that $1.40 to about $2.25. So that's in excess of 50% dividend growth. And that's based on the strong cash flow we project over that period. So that's a core holding in that portfolio.
I would also mention TELUS (TU), which is one of our telcos. It operates in eastern Canada, but its primary market is in western Canada. Incidentally, if you look at it on a global basis, it has had the best total shareholder return of any incumbent telco in the world over the last 11 years. I think its earnings will grow 9% to 11% a year over the next three to five years, and dividends should increase by a similar amount. And yet its valuation is in line with the historical norm. So I would expect a double-digit return from it.
And the last one I might mention is actually the only one in this portfolio that hasn't increased its dividend in the last year, a company called Just Energy (JE), which used to be one of our royalty trusts but was converted to a corporation at the beginning of 2011. It pays a $1.24 dividend, so it has about a 10% yield at the moment. It sells electricity and gas on either side of the border, chiefly in Ontario but also in Illinois, New York and Texas, on a fixed-price contract, historically largely to retail customers, but through acquisition it has gotten into the commercial business over the last two or three years to a greater degree. Its cash flow should, in our view, continue to grow in the 5% to 10% area over the next several years, and we believe its dividend will be increased over the next year. So that's, to us, a very attractive investment. It just, incidentally, last month was listed on the New York Stock Exchange, so there are not very many U.S. shareholders, but I think there will be more over time as people become familiar with it and coverage in the U.S. picks up.
So those would be three I would mention in the portfolio. The overall portfolio yield is about 5%. Longer term, I think that yield on today's cost will grow by at about 5% a year, and the underlying earnings growth rate for those 12 companies is, in our view, about 7.5%. So we are very hopeful and confident that in a continued flat overall market environment, with swings above and below the flat line, that this portfolio will grow at close to a double-digit pace on an annual basis over the next five years.
TWST: What would prompt a sale from one of your portfolios? Is there a recent example you can tell us about?
Mr. Majendie: I would mention in that same portfolio, we currently own no financial stocks. As I said before, in the summer I got concerned again about the European debt situation. We were also very light in that portfolio in the financial sector anyway, but we did own National Bank (NA.TO), which actually had been the best-performing bank, but I figured with long-term interest rates coming down, margins would be under pressure, and the type of earnings growth that they had enjoyed might come down a bit. And I felt valuation had improved sufficiently that it was getting into the upper end of our valuation range, certainly on a short-term basis, so we took profits in it.
In this portfolio, too, just talking about the summer, we had about 15% of our holdings in oil and gas, in what were previously royalty trusts but the government mandated that they had to convert to corporations. There were a number of them in Canada that were a hybrid of growth and dividend-paying companies. We had three of them in this particular portfolio - Baytex (BTE), Enerplus (ERF) and Vermillion (VET.TO) - and we sold them in the summer. Now, what's interesting is that one of them, Baytex, we did sell at about the same level as it is currently as are oil and gas prices, but the other two companies are quite a bit lower in price. So it has really been a valuation play. We like all three companies in the longer term, but we think the economic risks of a global slowdown are still reasonably significant, so we wanted to cut our exposure to the global economy through the commodity, and hence took our position from 15% to zero.
TWST: How do you expect the Canadian equities market to perform over the next five or 10 years compared to the U.S. or other markets around the world?
Mr. Majendie: We really expect it to do what it has done in the last five to 10 years. Actually, in the last few months the U.S. market has outperformed the Canadian market, but since 2000, the S&P 500 has had an annual average negative return per year of about 1.5% without dividends, whereas Canada's TSX 60 return has had modestly positive annual returns - 4%-plus if you include dividends. I would expect that sort of performance to continue. I know there's a lot of bullishness on U.S. stocks currently on a shorter-term basis, but we tend to use CAPE, cyclically adjusted p/e, or inflation-adjusted long-term earnings in calculating multiples. And the cyclically adjusted multiple for the S&P 500 is almost 22 times, and we regard that as very expensive. Canada is cheaper.
On a very short-term basis, I think Canada is exposed to a global slowdown because of commodities, but we do think we're in a bull market still long term for commodities such as copper, oil and some of the precious metals, so that on a longer-term basis we think that the kind of performance that those companies have had since 2000 will continue over the next five to 10 years. So to answer your question, we do expect Canada to continue to outperform the U.S.
One of the things that really concerns me is that U.S. corporate profits as a percentage of GDP are at an all-time high at the moment, and if you look at it - we have charts going back to 1929 for that particular metric - it always reverts to the mean, so I think the U.S. corporate profit margin is very likely to come down, whether through taxation or higher interest rates or whatever. Strategists tend to look on a short-term basis and project margins to continue at the current level, but I think that's highly unlikely.
TWST: Do you have any final thoughts or words of advice for investors?
Mr. Majendie: The one thing I would say, having been a strategist for 30 years, is I've never seen the degree of uncertainty that we see right now, because so much of what happens in the economy is dependent on political decisions yet to be made, whether in Europe, whether in the U.S., with the debt situation there - not that I think we'll see any change in that till next year - or whether it be in China, where we get a changing of the guard over the next year, so we'll have new leaders there. It's very hard to predict, but one thing that we can predict, I think, is the advanced economies of the world, because of very high debt levels - Canada is a bit of an exception to that, certainly on the government level - have got to delever significantly still. That's a 10-year process, and we're maybe three years into it. So that's why we go back to that theme of predictability of income. It will be very important in a slow-growing economic environment. And with bond yields where they are today, I think strong quality dividend-growing companies will continue to attract investor dollars. So be highly cognizant of risk and look for predictable income-generating securities would be my final bit of advice.
TWST: Thank you. (MN)
Director & Senior Portfolio Manager
Majendie Wealth Management
650 W. Georgia St.
Vancouver, BC V6B 4N9
(604) 661 1522
(604) 661-7494 - FAX