Brian Madden's Top Picks Sept. 13, 2018

MARKET OUTLOOK

Canadian equity markets are showing signs of moving into a late cycle phase wherein the leadership baton is passed from pro-cyclical segments of the market like energy, materials, consumer discretionary and technology companies to more defensive businesses in the real estate, utilities, telecom, and consumer staples sectors. Trade worries and the frustrating lack of progress on the North American Free Trade Agreement (NAFTA) renegotiations are exacerbating the shift in sentiment, but while it’s tempting to blame the defensive rotation in the stock market solely on this, there is ample evidence of slowing global growth evident in industrial commodity prices, for instance, as well as in various broader coincident and leading economic indicators. At the same time, central banks are tightening monetary policy, with interest rate hikes expected to continue both here and south of the border. This often will depress the price to earnings multiples investors are willing to pay per dollar of corporate earnings, as bonds become relatively more attractive vs. stocks, spawning a substitution effect as investors re-evaluate their overall asset allocations.

Markets also begin to discount a slowdown in earnings over the medium term as tighter money restrains corporate expansion and hiring plans and discourages big ticket consumer purchases. Indeed this is exactly what we have seen this year, with the P/E ratio on the S&P TSX Composite Index de-rating from 16.2x down to 14.1x since the start of the year, fully offsetting the impressive 13 per cent growth in S&P TSX earnings that corporate Canada has delivered year to date.  P/E multiples are now about 3 per cent below long run averages, which affords some margin of safety in the event that corporate profits do turn down from somewhat above trend levels (roughly 5 per cent) where they now stand, as will inevitably occur at some point over the next few years.  All of this, of course, highlights the importance of “total return” in managing an equity portfolio, with more than all of the S&P TSX Composite’s admittedly modest total return of 1 per cent deriving from dividends year to date.

For our part, we have been repositioning our portfolio away from cyclical companies and emphasizing the more defensive sectors, with recent sales of high beta technology and industrial companies funding new lower beta investments in real estate and in consumer staples, for instance. A corollary of this repositioning has been a modest uptick in the expected dividend yield of our portfolio, which has been an important element of investors’ overall return year to date, and which we expect to continue to play an important role. Higher yielding portfolios increase the “certain” income component of total return and lower beta portfolios de-risk the variability in the “uncertain” capital appreciation component of total return. We believe this is the prudent stance to take at this juncture - in symmetric, but opposite fashion to the stance we took in mid-2016 to increase portfolio beta and decrease yield as economic growth accelerated.

TOP PICKS

ALIMENTATION COUCHE-TARD (ATDb.TO) - Latest purchase Aug. 2018 at $62.99
Alimentation Couche-Tarde is North America’s largest independent convenience store operator with nearly 11,300 stores and a further 2,700 locations in Europe. The company earns returns on equity in excess of 20 per cent, and has grown earnings per share at a 22 per cent compound rate over the last decade. Their business approach has been to use procurement scale to price sharply on fuel, thus drawing traffic to their sites and then luring shoppers into attractive, modern and well merchandised stores where merchandise gross margins are 3-5 times higher than their profit margins on gasoline. The company has also been a very capable serial acquirer with a demonstrated pattern of realizing significant synergies from acquired businesses, in this still highly fragmented industry. Their largest deal to date, the $5.2B purchase of CST Brands closed last June and the acquisition of Holiday Stationstores, another sizable deal which added 522 stores to their network, was completed in December. Both should be meaningfully accretive to earnings.

SCOTIABANK (BNS.TO) - Latest purchase Aug. 2018 at $75.99
Scotiabank is Canada’s third largest bank and is the nation’s most globally ambitious bank, with a long established footprint in Mexico, Latin America, the Caribbean and Asia. Scotiabank earns a 14.3 per cent return on shareholder’s equity and has grown earnings per share at a 7 per cent compound rate over the last five years, with commensurate increases in its dividend. The company has the largest exposure to fast growing and “underbanked” emerging markets among the big 6 banks, and further has internal efficiency and excess capital levers to pull in driving superior earnings growth over the next several years. The bank has aggressively deployed some of this capital with the recently closed $2.9B acquisition of BBVA’s Chilean bank as well as two other smaller South American banking deals and a small banking deal in the Dominican Republic as well as two large asset management acquisitions here in Canada with the purchase of Jarislowsky Fraser and MD Management. Trading at 10 times 2019 expected earnings, and yielding 4.5 per cent Scotiabank is well poised to continue its consistent pattern of outperforming the TSX…a feat that it, along with other members of the Canadian banking oligopoly, has accomplished in 18 of the last 25 years.

FRANCO-NEVADA CORP (FNV.TO) - Latest purchase Aug. 2018 at $84.92
Franco-Nevada is a resource royalty and investment company whose management team and founders pioneered the resource royalty concept over thirty years ago. The business model affords shareholders exposure to commodity prices via a royalty payment for each ounce produced (primarily, gold, silver and other precious metals and to a lesser extent, oil and gas and other metals) but insulates them from the operating and capital cost overruns that are endemic to the mining industry. The business model also affords shareholders long term optionality on future discoveries on any of their royalty lands, across a portfolio of 377 royalties that is well diversified by commodity, by geography and by operator. Franco-Nevada has consistently and significantly outperformed its gold mining peer group, in eight of the last ten years since its initial public offering, on the strength of this superior business model.

PAST PICKS

ROYAL BANK OF CANADA (RY.TO)

• Then: $100.85
• Now: $103.00
• Return: 2%
• Total return: 5%

INTER PIPELINE (IPL.TO)

• Then: $27.10
• Now: $23.24
• Return: -14%
• Total Return: 10%

POTASH CORP (POT.TO) - Merged with Agrium to form Nutrien (NTR.TO) on Jan 2 (1:0.4 share)

• Then: $25.32
• Now: $73.36 (as NTR.TO)
• Return: 16%
• Total Return: 18%

Total average return: 4%