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by  Jennifer McClelland, CFA Oct 24, 2022

Jennifer McClelland, Vice President & Senior Portfolio Manager, North American Equities, discusses the current state of the Canadian equity market, and how she is managing portfolios through heightened volatility. She also shares her thoughts on risks and opportunities for the energy, banking and real estate sectors.

Watch time: 12 minutes 36 seconds

View transcript

How do periods of volatility change the way you approach investing?

Well, I think that emphasis on diversification definitely continues. I think in this period where we've seen irrational, volatile markets, some of the things we maybe triage a little bit more is an enhanced focus on sustainability of dividends. And we have market actions, but we also have the underlying fears that are driving that market action.

So re-upping all of our numbers on our scenarios and looking through particularly on dividend coverage and making sure that things are well covered for all of our companies in any period of time and enhanced focus on balance sheet, which makes sense. Certainly those companies that maybe we had more comfort in them being a little more stretched beyond their targets, we spend a little bit more time thinking about that and making sure that they've got options and things like that.

And then maybe an enhanced focus on companies that are able to execute even if they can't access the equity or the debt markets. And there's some strategies out there that that was the main part of their business plan. And if they can't do it, then that's a problem. So we make sure that all of our companies still continue to have the optionality. And then talking to management teams and seeing if they have a clear ability to pivot or manage costs if need be.

And lastly, I think we spend a lot more time communicating with management teams and analysts and others. We’ve picked up the pace of that in terms of check-ins and things like that. I know in the early COVID period, we were having weekly calls with some companies that were directly impacted. And so we're starting to do a little bit more of that today.

What are your thoughts on the energy space?

I think overall, we still have a pretty supportive outlook on the energy space. I think the energy companies themselves have been quite disciplined on spending and investing new capital for lots of good reasons. And at this point, because their spending has been held back, production growth – the outlook for production growth – over the next few years is pretty modest.

So that really backstops – puts a good back stop – on underlying prices. And the energy companies themselves, even at recent lows – we've had a bit of a reality [check] in the last couple of days – but even lower down, when the companies were selling off. Their free cash flow yields are extremely robust today, in the double-digit level. You add the boost, particularly when you add the U.S. dollar impact –

These companies are getting U.S. dollar-based prices on their commodities. So lots of cash flow coming in. The balance sheets are extremely robust and they're spending a lot of time thinking of ways – and lack of other big projects to spend capital on – ways to return capital to shareholders. So we have in the energy space lots of strong dividend growers.

We have balance sheets that are net-zero. We have companies that are starting to pick up the pace of buybacks and to me, within an income portfolio, they become pretty interesting inflation hedges as they make more money on higher commodity prices; they have more money to return. It offsets other companies in our portfolios that are getting hit by the negative impact of that.

And then in terms of the longevity of the sector, I think that's been questioned over the last few years, particularly over the COVID period. I think now, given all the things that are going on geopolitically, there's growing recognition that these players are… energy security is a big factor and it's going to be a long time, as we continue to need natural gas and oil to start to transition to more climate-friendly ways of producing power.

And we're going to need these companies and they're going to play a huge role in starting to reduce our carbon footprint. So they're being seen as players in the solution as opposed to a group of companies that are left for dead. And that may, God forbid, actually backstop in multiples that we pay on these companies over time.

I'd say the one thing that we really take pause and have to look at closely is our government and the government support needed to maintain the sector's relative competitiveness in this area. There's lots of work to be done there and we're not quite keeping up with what's going on in other countries. So we're keeping a close eye on that right now.

Real estate is bearing the brunt of volatility. How are you navigating this space?

It's been difficult to watch. This is a sector that plays a big part in the income funds for sure. And then also in the Canadian equity funds that I manage. And we're seeing a real sell-off in these sectors that are in these names, just given anticipation of rising rates, the actual showing of rising rates, and then worry that this is going to lead to increasing cap rates.

So seeing a lot of money flow out of this sector. We believe that there has been a bit of a turn in asset values given the change in interest rate environment. But I think what's being priced into the stocks is way too drastic compared to what's happening in terms of underlying fundamentals. So based on where analysts are putting their net asset values – and they've made some haircuts, given the current scenario and made some assumptions on cap rate changes – these stocks are still trading at a good 20% below these low, early marked asset values.

So in the meantime, the cash flows these companies are earning, they’re rental streams that are long-term leases and short one-year leases. And the current leases are well below what we're seeing in terms of market value. So whether that be residential, whether that be retail; we're seeing still seeing some interesting growth in pricing in the leases that are being signed.

So it's a pretty interesting dichotomy between what's being priced in the stock market versus what's actually happening at the companies. And then from a transaction level – what's going on in the underlying companies or the underlying assets – we're still seeing transactions in the various sectors has certainly slowed, but there is transactions taking place in the private market that is really backstopping the valuations that are feeding into the net asset value estimates that analysts have out there.

And then lastly, the sector is very domestically focused and it's a reason why it's played a big part in our funds, because I believe the robust immigration levels in Canada are really underpinning real estate values here, particularly in the residential side where we have a big gap in terms of the need for housing and the ability to supply it.

And so even though we worry about affordability and all these sorts of things, people have to live somewhere and our population continues to grow. So that's really backstopping the rental rates and the underlying value of these names. And we're seeing that in the retail sector as well. There's no new supply coming in retail. And on the industrial side, there's a real supply-demand imbalance.

So fundamentals look good, private values look good, the stocks are acting terrible. So the last thing we focus on is, these are companies that have become REITs to use their access to the equity markets to continue to accumulate assets. And if they can't do that today, where their stocks are trading, they're going to make some drastic decisions.

So I think this is a sector where we could see some really interesting things happen in terms of either privatizations or M&A. And that's something we're watching quite closely right now because I think some of these companies are strategically stuck at the moment. They're getting by either by selling assets in the private market and getting good prices for them, and then using that to either continue the development plans they have or buy back their own stock quite aggressively.

So pretty interesting right now. And, an area where we kind of held our ground and we do believe in the long-term viability of this sector. The one sector that we're still a little bit more concerned about and it's definitely more of a wait and see, is on the office market. Clearly the back-to-work theme has really picked up here in Toronto, but now we're starting to hear with talk of recessionary environment and I think some of the tech companies that were really growing office space are starting to rethink some of those expansion plans.

So that is one area we're watching a little bit closely. I think the companies that we invest in that have office exposure are the blue chip buildings that are going to be here for a long time. But that overhang and that lack of clarity on what the future looks like, like the Canadian banks, is going to kind of keep them from really recovering in terms of value.

So that's how we're thinking about real estate today.

What is the outlook for banks in terms of earnings and dividend growth?

Yes, I would say that we've had some volatile times in the Canadian bank stocks as well. And I would say, you know, looking at where the banks are trading today, that a lot of risk has been priced in. I think the forward multiples on most analyst estimates have declined from 12 times, which is more of a normal earnings multiple, to around nine.

So to me, there's a lot of anticipation of slower growth environment being priced into the stocks. And if we assume a modest recession and a relatively quick recovery, using normalized multiples on earnings – on forward earnings – assuming a relatively modest slowdown scenario, there's really robust upside in the banks here. So that is encouraging. And that being said, we're kind of in the early day period of this anticipation of a slowdown.

The banks themselves are not seeing any signs of stress in the consumer. They have plenty of data to monitor to see this happening pretty quickly when it does take place. So that's good. But we all know something is going to happen. We are starting to see a pickup in slowing loan growth and unfortunately, it's a waiting game at this point.

We don't know what kind of recession we're going to see. So it's hard to see a recovery in multiples until we get more of a picture of what kind of recession and what kind of slowdown is in front of us. And in terms of earnings and dividends, in terms of near-term earnings growth, expectations have been revised down a few times now.

We're now in the low single-digit earnings growth rate expectations. This is kind of assuming that modest recession scenario. If something worse takes place, we probably need to see more of a revision down from that. But at this point, this seems quite realistic. And there's a bunch of things that are adding and subtracting to those estimates. We're seeing, assuming a modest increase in loan losses from very low levels post-COVID, a modest slowdown in slow loan growth, and then offset by better in net interest margins from higher rates and the ongoing expense discipline from management.

So lots of moving parts, but I would say at the margins, slow, modest single-digit earnings growth. And then on the dividend side, again, they tend to grow their dividends in line with earnings. I would guess that they're probably going to be more conservative in terms of their dividend decisions in the next year, given the uncertainty in the environment.

So we probably should see growth, but it would be probably modest and at the lower end of anticipated ranges. And I think, in the case that things do get really dire in terms of where the economy is going and whatever scenario we start to live through, I think the banks are in really great shape. Their capital levels are extremely strong, they have very diversified businesses.

They have lots of levers and tools in place to manage through it. They're in much better shape than other probably Canadian or North American consumer facing sectors. So I think they're well positioned to come out of this in really good shape. But I think that the anticipation of that is a long way off.

So we continue to monitor all things that they're seeing quite closely and keeping close touch with management teams as well.

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Recorded on October 7, 2022