Value-oriented Dividend-paying Canadian Equities
TWST: Why don't you please start with an overview of ScotiaMcLeod and your investment philosophy there?
Mr. Majendie: Majendie Wealth Management is part of Scotia McLeod's Wealth Management operation. Scotia McLeod is the brokerage arm or investment dealer part of the Bank of Nova Scotia. Our money management has a value-oriented style, exclusively geared to Canadian securities, but we think of them in global context and relative to the US.
TWST: What was the impact on Canada of the events that occurred over the last 12 to 18 months in the United States?
Mr. Majendie: The impact equity market wise was equally as severe as in the US. We are an interconnected economy and the global perception is that as goes the US so goes Canada. In the short-term, that can be true. There are some differences, however. The market reacted in very similar fashion to the US and actually globally, of course, because all equities were down substantially in varying degrees. But as we have come out of that recession and markets have recovered, it's clear that Canada's economic performance has been somewhat different and particularly the banking system performance has been different. If I could highlight the banking side, we have an oligopoly here, which comprises six major banks. None of our banks had to be bailed out and there were only very minimal government programs to help the banks. Really the safety of the Canadian banking system stood out not just against the US, but also on a global basis coming out of this. Also, economically speaking, what we found out as we came out of the recession is that the consumer is in relatively better shape in Canada since our savings rates have been better. There has been a modestly better recovery in the consumer sector of the economy, which has now even got some of the authorities concerned because the housing market, which was never nearly as weak in the first place as south of the border, is starting to firm up really quite strongly, and we've had significant year-over-year gains in real estate prices depending on the region. In sum, the stock market impact was similar, but I think Canada has come out of this situation stronger both in terms of its banking system and its overall debt-to-GDP ratio, which is obviously a considerable concern in the States.
TWST: Do you incorporate a top-down macro approach at ScotiaMcLeod?
Mr. Majendie: Yes, Majendie Wealth Management at Scotia McLeod does take a macro view. We execute it, so far as the equities are concerned, through selecting stocks from a universe of blue-chip companies based in Canada, actually 67 of them and these are the largest companies in Canada, where we go across the country every six months and interview either the CEO or CFO of those companies. Thus, we approach it from both a top-down and a bottom-up point of view.
TWST: Focusing on the bottom-up perhaps could take us through your investment process and tell us the criteria that you look for in potential holdings?
Mr. Majendie: We are value-oriented and so we are looking for companies that are cheap in historical perspective. What do we mean by cheap? We use conventional criteria such as price to earnings, price to cash flow and price to book value. What is very important to us, however, is not just the short-term but also the longer-term. In every interview we have with the CEO or CFO of these major companies, we are discussing the three to five year outlook. Obviously, crystal balls can be cloudy at times, but how the company is strategizing its own business plan over time is extremely important to us. We end up with earnings and dividend forecasts for each of our companies on a five-year basis as well as a one-year basis.
TWST: What about your sector weightings, are you represented in all the major sectors in equity market?
Mr. Majendie: What makes us different from many money managers is that we are not strict adherents to benchmarks. In other words, there are ten major sectors, and we only have to be in six out of the major ten. We tend to be more concentrated because over time we think that provides better performance. But obviously, if you are in Canada, you cannot but be exposed in some measure to the commodity sectors or to some degree to the financial sector. Those two segments alone account for about two thirds of the weighting of Canada's S&P/TSX index.
TWST: How would you say that your equity portfolios have shifted in emphasis over the last 12 months or so?
Mr. Majendie: From February of last year, we had initially quite a strong exposure to the commodity area as we thought that markets had been very much assuming the worst- this is going back a year ago- when the world was coming to an end and the fear was that we were going into a depression. The hardest hit areas had been the commodity segment, so we increased our exposure there. We were exposed significantly too to the financial area. Since that time, I would say we have shifted over the last three months to a less overweight commodity position, a rearrangement of the financial sector such that we have more weighting towards the life insurance and near financials now than to the Canadian banks. The Canadian banks had exceptionally strong recoveries off the bottom.
When I say exceptionally, they never got hammered down to the degree of a Bank of America and so on. The percentage gain off the bottom may not be as much as some of the major US banks. But over the two-year period, the recovery took the Canadian banks back to not far off where they were a couple of years ago. Now we think those gains took them to the upper-end of what we perceive as their likely P/E multiple range based on this year's earnings whereas life insurance companies had a much less robust recovery, and I am talking about the Manulife (MFC) and the Sun Life (SLF). They are selling at the bottom-end of their historical P/E multiple ranges, so there has been a valuation shift.
The other one point that I should make, which, over the last three months, has been reflected in our portfolios is a focus on dividend-paying stocks. Other than the Canadian banks, a lot of the dividend paying securities like pipelines, utilities, communication stocks where dividends are really quite attractive, got left behind in the recovery off the bottom from last March. We built up our weightings in those sectors over the last three or four months, and they have been performing really quite well of late because there is a tremendous hunger for income developing. When you compare them with competing bond yields, some of these companies, particularly in Canada, have very attractive dividend characteristics; and this is one of the key themes that they are espousing not just for this year but also for the next number of years. If I could contrast the US and Canada, the S&P 500 has a yield currently of about 2%. That is really because you had a number of dividend cuts particularly in the financial sector and the banking sector in the US, whereas, other than Manulife, you haven't had any dividend cuts in the financial sector in Canada. So the S&P yields about 2% relative to a US ten-year treasury yield of about 3.7%. In Canada, the S&P/TSX, which has 200 odd stocks in it, has a yield of almost 3% - about 2.9% to be precise - whereas the Government of Canada ten-year bond yields about 3.5%. Thus, the dividend yield on our index is not far off the bond yield and historically that's heralded some pretty good returns over the next five and ten years when you have had a situation like that. In contrast, US stocks are currently much less competitive with bonds on a yield basis. Thus, we are trying, in our portfolios, to have a significant dividend paying stock component.
Currently, at Majendie Wealth Management at Scotia Mcleod, we have five different portfolios, which range from what we call aggressive being pure equity (albeit high quality blue chip companies) to very defensive. And the more defensive they are, the more dividend paying securities they have.
TWST: Since the universe of these large-cap stocks is pretty limited, how many stocks do you have generally in your portfolio?
Mr. Majendie: In our equity portfolio, we are pretty concentrated; we have 15 to 20 securities. The largest in terms of number of securities would be in our balanced portfolio where we might have -- and I'm just talking the equity segment -- we might have 25 to 30 securities.
Could I just illustrate something to you, just how different Canada is from the U.S? I can talk about why it's different in terms of commodities, why it's different in terms of some of the globally competitive product and service offerings that Canadian companies have, but we can also do that separately a little later on.
What I would like to highlight here is that Canada does have a much greater proportion of solid dividend paying companies where we see the potential for sequential increases in dividends over the next five years. To illustrate, let's take our 67-company universe and select 30 companies from it that have a dividend of at least 2%. Then, if I also remove all commodity stocks, I'm making it more conservative (and less volatile) than the index. This portfolio of 30 companies paying 2% or over would have an average yield currently of about 4.6%. I have to say that includes a few royalty trusts and a few REITs as well, but they are principally common equities. The underlying average 5-year earnings growth rate of those 30 companies is just below 7% a year in our estimation, and this is taken from all our individual company interviews. And the dividend per share growth rate, we estimate over the next five years will be 5%. If you take the current yield plus the long-term earnings growth rate, if P/E multiples don't change, you should get a healthy double-digit return from that type of portfolio.
TWST: Which is very important to your investors who are losing the dividends right on the royalty, income trust and capital.
Mr. Majendie: Right. Essentially, all trusts other than REITs, will disappear at the end of 2010. From our universe, we find, however, that there are quite a few trusts that will be able to convert to a corporate entity but be able to maintain their distributions going forward but in the form of dividends, which have a more favorable tax treatment, and I will give you one example.
It's a company called Just Energy (JE.UN), which is a trust currently. It's a form of utility because it buys and sells natural gas and electricity on a fixed term, five-year contract to customers in Canada and the US. This is a company that historically has grown its cash flow about 10% a year, it has a distribution of $1.24 per unit and it sells at just over $14, so it has about a 8.75% yield. They have just last week announced their conversion to a corporation and they will be continuing to pay the $1.24 after conversion. I believe that, since cash flow should continue to grow at close to 10% a year, they should be able to increase that dividend over time. So that company is going to disappear as a trust, but it will continue to be a high yielding and potentially dividend growing company when it becomes a corporation. Thus, in Canada, a number of those opportunities exist in the income area, which excites me both in terms of the individual securities and the long run potential for our market as well. I have many other reasons for liking Canada in a global context, but I think that's one of the key reasons.
TWST: Talk about the global context a little more, and how the global competitiveness is in companies in which you invest?
Mr. Majendie: If I could just first make one longer-term secular point. Since the beginning of 2000, we have been saying that over the next 15 to 20 years, in other words, through to 2015-2020, the US would be suffering from what we call a secular bear market, which would be very similar to that which it went through between 1966 and 1982 where the Dow Jones fluctuated hugely but around a flat trend.
In fact, you didn't make any money by investing in the Dow 30 stocks in 1966, and holding them through to 1982 you basically had zero capital gains; very different from 1982 to 2000 where you actually made about 15 times your money by simply holding those 30 stocks. In contrast, in the 1960s and 1970s, Canada's stock market did very well and invariably outperformed US equities because Canadian banks did very well and, particularly in the inflationary environment of the 1970's, commodity stocks did very well also. That's where the Canadian market is principally weighted and oriented. Of course, by the same token between 1982 and 2000, our equities invariably underperformed the US. Now, in 2000, we said that in the next decade and a half to two decades the US would underperform because it was a highly indebted nation and ultimately the only way to fight its way out of that problem was to go the inflationary route, which would come through a depreciating dollar or monetizing its debt. Now, I don't think that's going to happen over the next year or two, but I think the inflationary potential is very high in the longer-term. What has happened to Canada versus the US in the first ten years of what could be potentially two decades? The TSX has outperformed the US every single year. If you measure from high-to-high in each cycle or low-to-low, our index has outperformed the S & P 500 by about one-third without taking into account the change in currency. If you did consider the change in currency, the Canadian dollar in 2000 was in the mid-to-high 60s and it is now in the mid-90s. Thus, as a Canadian investor, you would have been a further 30% better off by investing in Canada versus the U.S.. We think that's the overall context.
Our other strong theme is that the industrialized nations are going to have a tough time of it relative to the emerging economies over the next five to ten years. Now this isn't a unique thought but if you just take the IMF's latest forecast for example- published in January - they're saying that the developed economies will have about 2% growth this year and the emerging economies 6% growth. If you look at the debt-to-GDP ratios of the developed economies I think it's clear that all of the industrialized nations have to get their debt-to-GDP ratios in line, which means for each of them lower spending and greater saving as a nation, and that particularly applies to the US. So that's the longer-term context.
Now Canada's TSX is a very interesting index. If you break it down you can say Canada as an economy is very levered to the U.S. In fact, 75% of our exports do go to the US. However, our stock market index, the TSX, is much more levered to the global economy now. Why is that? If you look at Canada's exports to the U.S., a lot of them are in steels, autos, auto parts, lumber, pulp and paper and so on. All of those sectors are suffering. However, in terms of our index, other than Magna (MGA), those same sectors, which involve major exports to the U.S., represent less than 1% of the weighting of the TSX. In sum, our index is much more geared to the global economy than it is to the U.S even though clearly 75% of our exports go south. I think that's a point worth making.
I can talk about how individual companies look in global context. Everybody knows about Canada being a major commodity producer much as Australia would be, and that is true; thus, for example, if you look at the major gold companies in the world, four out of the six major top gold companies in the world are Canadian.
Teck (TCK) is the largest zinc producer in the world and one of the top producers of metallurgical coal. The oil and gas sector is very important for us and very important for the U.S. too, because we are the largest energy exporter to the U.S. Globally speaking, if you include the oil sands, which everybody now does, we also have the second largest oil reserves in the world after Saudi Arabia.
Finally, in terms of uranium, Cameco (CCJ) is the largest uranium producer globally and Potash Corp (POT) is the largest potash producer in the world. But those are fairly well known facts. What isn't so well known is that in other products and services, Canada also has a lot of very globally competitive companies.
As an example, clearly in the life insurance industry, Manulife and Sun Life are important competitors or participants in the US. But what isn't so well known is that both Manulife and Sun Life are the largest foreign life insurance companies in China and India respectively, and both of them are investing heavily. For example, Sun Life has over 10,000 agents and sub-agents on the ground in India. If they weren't reinvesting, they could show very handsome earnings, but it's all being ploughed back into the growth of their operations in those countries. I mentioned Magna earlier as being the one healthy exception in the auto parts industry. It is the fourth largest auto parts company in the world, has a pristine balance sheet with about a billion and half dollars of cash.
Bombardier (BBD.B) is one of the companies in our universe based in Montreal. It's Number 2 globally - Number 1 or Number 2 depends on how you count it - versus Siemens in terms of fabrication of trains for the global market. In regional jets, Bombardier and Embraer vie for the Number 1 spot over time. SNC-Lavalin (SNC) is our largest engineering company and it has now become a leader globally in providing engineering services for key parts of the mining industry. If you want to build an aluminum smelter or a nickel smelter, SNC-Lavalin is the "go to" engineering company.
I mentioned earlier the Canadian banks. None of them cut their dividends during or after the financial crisis. Two organizations have rated the Canadian banking system the safest in the world. The earnings of the Canadian banks didn't collapse; we weren't exposed to the derivative area to nearly the same degree as the major American and European banks. We are on very solid ground in terms of our banking system.
To give you a last few examples, the Research In Motion (RIMM) story is well known. But in terms of a global smart phone supplier, the company has made major inroads in Europe and Europe accounts for close to 30% of its sales and now it is just getting off the ground in China and India. Saputo (SAP) is a name you may not be too familiar with. It produces milk and cheese, dairy products, but it's the 11th largest producer in the world currently with a very strong balance sheet and could move up that list with an acquisition, which I expect them to make in the next year or so. Thomson Reuters (TRI), a Canadian company, vies with Bloomberg as the Number 1 or Number 2 provider of financial information. In terms of legal information, it's the largest supplier in the world as well.
Getting down to the last two or three, Enbridge (ENB) is an oil pipeline company. On a global scale, it's either the Number 1 or Number 2 oil pipeline company in the world. The other one is a Russian company that's privately owned, so the numbers are harder to come by, but it is certainly way up there on a globally competitive basis. WestJet (WJA) is a Canadian airline, it was formed I think 14, 15 years ago. Don't tie me to that, but they have been extremely successful and they are the second most profitable airline in the world currently. Finally Canadian National Railway (CNI), yes it's just a North American player, but it has the best operating ratio of any of the North American rails, is a tremendous producer of free cash flow and consistently increases its dividends. That's another example of Canada's raft of really excellent dividend growing companies. The same could be said for Enbridge, Transcanada Pipelines (TRP)and so on.
TWST: I am surprised to hear about so many dividends and growing dividends. It is a very attractive area.
Mr. Majendie: Just to give you an example, Enbridge that I just referred to, you asked how Canada performed during the last 18 months. Enbridge was 45 bucks a couple of years ago, got hit like everything else; the stock went down to 33 bucks. That was quite a fall but it's now back in the $46, $47 area. In the meantime, it had two 12% dividend hikes. As an investor, you have seen your yield on original cost grow by 25%. Now that's one of the better examples, but we have many companies in our universe where we can foresee consistent dividend growth over time. That is one of the things that makes me relatively confident of Canada continuing to outperform the U.S. as an index over the next number of years.
TWST: What about the sell discipline, what does trigger an exit from your portfolio?
Mr. Majendie: For every single security, we establish our sell targets. And when we get there, we take the money off the table. Obviously, you can't blindly follow history in terms of P/E multiple ranges or price-to-cash flow ranges, but we use those as guidelines. For example, Teck Corporation, we have liked very much. It has had a phenomenal run; our sell target on it was 41 bucks. When it hit that we sold the position even though we think it continues to be very well run and we would reposition at lower prices.
TWST: How about controlling risk at the portfolio level and at the individual stock level?
Mr. Majendie: One thing I think all of us should have learned over the last couple of years is that risks are significantly higher than we might imagine. One of the key risks is balance sheet risk and financial risk, and I really spend a huge amount of time concentrating on the balance sheets of the companies in our universe to make sure that they are not exposed to those sort of funding problems that many companies suddenly found themselves in over the last couple of years. That's one method of doing it. The other is, the higher yield dividend component in the portfolio, which is a limitation of itself on risk. Again just going back to the Enbridge example, clearly our market was down over 50% like the US was in 2008 to early 2009, but Enbridge as a defensive stock only fell by one third. Obviously, you also require some diversification and you can't have all your stocks in one industry. As I said previously, we are allowed to have as few as six out of ten sectors, and some of the more volatile industries are the riskiest industries. We can reduce our exposure to them as we see risk levels rise in the marketplace.
TWST: You have painted a pretty optimistic picture for 2010 for investing in Canadian securities, are there any headwinds or challenges ahead that investors should be wary of now?
Mr. Majendie: I would be deceiving you if I didn't say that there are lot of uncertainties in the world right now. A degree of conservatism is required. If you look at all the leading economic indicators whether globally or in North America, they are improving. But there are lot of still very concerning underlying trends, for example, the debt-to-GDP ratios of many countries and what happens when ultimately central banks and the fiscal authorities stop easing to the extent that they have or start increasing interest rates. We have never previously had the degree of coordinated fiscal and monetary ease that we have seen over the last two years, that's unprecedented. We don't quite know what the situation will be when governments and central banks start to reverse that.
As we move out through 2010, I personally think that risk levels will be increasing and you want to become more conservative and more risk averse in your portfolios as those decisions start to be made. Now it's very possible we may not have any increases in interest rates at all this year in the major industrialized countries (apart form Australia) such as in the UK, the US and the Eurozone. But as you get closer to that point I think the risk levels increase. That's my overriding concern; I don't think we will have a double-dip recession in 2010. But if the authorities get it wrong in the latter part of this year, early next year, that risk increases in 2011.
TWST: Taking conservatism into the picture, is this a good time to invest in Canadian equities?
Mr. Majendie: I think it is, I really do. I do have some short-term concerns in the commodity area, but I think that's a very good long-term play. This high-dividend paying component of our index makes me very optimistic too. To the extent that you are risk averse, we have one portfolio, for example, which even in the pullback recently has being doing very well. It has no commodity exposure and it's a balanced portfolio with a healthy weighting of these high-income paying securities. Depending on what the clients' needs and risk aversion is, we can use a mix of our five portfolios. Thus, they can be tailored to the specific needs of the clients.
TWST: What differentiates the investment approach at ScotiaMcLeod toward Canadian equities that other tier companies might not be able to provide?
Mr. Majendie: I don't want to say we are unique at Majendie Wealth Management here at Scotia Mcleod but I do think some of the key factors that make us different are as follows: the first would be our not staying totally close to the benchmark. I am very much of the view that a typical pension fund manager will tend to have 40, 50, 60 or 70 securities that are slight variations from the benchmark. That's not our approach. We like to concentrate whether it's in a pure equity portfolio or the degree of income generating securities in the portfolio. We like to concentrate because we think that provides better returns over time. Also, our stock picking benefits from the great effort we put into going across the country and interviewing the CEO's and CFO's of the companies in our universe twice a year. I think our clients benefit from our willingness to depart from the benchmarks in a sensible way and also a willingness to make asset mix decisions that can be tough to make. In the past few years, for example, we were extremely defensive in the face of what we regarded as a very risky situation in terms of the whole derivative build up. Many portfolio managers are very much geared to or restricted to having limited amounts of cash in their Canadian equity portfolio; we can actually go to 50% cash.
TWST: Is there anything that we didn't touch on that you would like to add?
Mr. Majendie: I think we have touched on the sort of bottom-up and top-down approach we use and in that context, we very much like, relatively speaking, the longer-term outlook for Canada. We have many globally competitive companies outside of the commodities area, which I don't think, is generally recognized by international and domestic investors. I do think -- and this is a point worth making -- that Canada's attraction globally will be enhanced because of what has happened over the last couple of years. In other words, people are paying attention to how our banks performed relative to the other major banks in the industrialized world, and I think that will attract the attention of global investors to Canada.
Another key point is that Canada is a safe way to gain exposure to the emerging economies. We tell our clients that it is much better to invest in Canadian companies selling to China and India than directly in those indexes, because the latter tend to be much more volatile. We also know the legal and the accounting rules in Canada and there's less good history, put it this way, of those rules and standards in those other countries. Thus, for a global investor, Canada is a good way of getting global leverage on a much safer basis.
Finally, the other theme that I would like to just clarify is that I think over the next five to ten years, dividends should be a greater proportion of the expected overall return. If you can find portfolios and markets that offer that I think there is an inherent advantage and I think Canada is definitely one of those.
TWST: Thank you. (PS)
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