Canadian equity funds and their managers have been on a wild ride of late. When looking at 10-year returns, however, there is one that stands out among its peers: The Mackenzie Saxon Stock Fund.
Behind the scenes at the Canadian equity fund, Suzann Pennington, senior vice president of investments at Mackenzie Financial and team leader of the Saxon group of funds has her thoughts about how events have shaped markets in the past 10 years and some interesting insight into factors lining up to influence the future.
Her investment conclusions (and the fund’s returns) are based on an approach where all members of the five person team are involved in research. The fund is first built with focus on deep diversification by sector, economic sensitivity, market cap and more, followed by individual stock selection using the classic Benjamin Graham value investing approach.
Each team member’s research focuses on specific sectors with each person’s mandate overlapping the next. In dividing their sector coverage up in this way – with one person covering royalty trusts, one covering oil and gas producers, a third person covering energy infrastructure and a fourth covering coal and uranium, for example, “you can see we’ve actually got four different people looking at the energy sector from different angles,” she says.
Sticking to a discipline, meanwhile, is a common enough refrain among managers in general when asked about what makes them successful. Pennington is no different in this respect but in this case, her discipline is a little less conventional than some other straight up, large cap value managers.
“We put a lot of effort into our discipline of staying deeply diversified,” she says. “This means not just looking at the index but also looking at economic sensitivity, economic defensiveness, BRIC country sensitivity, U.S. dollar exposure, domestic exposure and so on. We look at a lot of very specific factors and then we look at diversification by market cap. We use the entire all cap space. We think that improves diversification as well.”
This mandate, she says, allows the team to find names more effectively throughout different investment or economic cycles. “Most Canadian managers tend to focus on those top 90 names that are already so heavily covered. We’ve got about 400 stocks that we consider to be investible stocks in Canada.”
Valuation, meanwhile is the next area where the team’s approach can be a little different. “We may actually buy a stock with an extremely high price to earnings multiple because we’re not using current earnings to value that stock, we’re using asset value to value that stock,” she says. If you only use a couple of valuation metrics and require that a stock have both low PE and low price to book, you pretty well always get the cyclicals wrong in Canada.”
Although managers on the Saxon fund are of the camp that believes equities will always outperform in the long run, Pennington does point out that we’ve just come through a 10-year period where the bond index has outperformed the equity index. “That has almost never happened over a 10-year period,” she says. “I really don’t expect it to continue.”
Over the course of the past 10 years, she agrees there are a few lessons that were learned along the way. Rather than succumb to “closet market timing” and invest in proven staples like Shoppers Drug Mart when markets were low, the fund continued to invest in relatively unknown companies like Methanex, a methanol producer. “Even though we were very, very nervous, we were looking to add economic sensitivity to the portfolio,” she says. “The best decision we made, I would say, is sticking with our discipline.”
At the same time that discipline, on the surface anyway, lead to a less than desirable outcome when the team held on to a few value stocks in the fall of 2007, simply because they were so cheap. “The credit crisis happened so fast,” she says. “Part of our discipline is also monitoring quarterly cash flows relative to debt repayment schedules. I would say we could have responded a little more quickly to that.”
In looking to the future, she says there are a number of themes playing out today which will likely have a significant impact on future earnings.
Thanks to the current low interest rate environment many companies have restructured their debt loads and improved their balance sheets overall. “That’s an ongoing phenomenon,” says Pennington. “A good company might generate 2% revenue growth. You can say that’s terrible but if you take that 2% and flow it right through to the bottom line because they’ve cut costs so much, you might grow your earnings at 5% or 6%. That’s very common and it’s not a stretch; it’s just pure arithmetic.”
Second, she says exchange-traded funds are making things easier than ever for value managers. With so many people flocking to passive investing, she says there are more mispriced stocks in the market today than there used to be, thanks mostly to the fact that industries are market weighted.
Using energy as an example, she points out that as stock prices go up, so does their weighting in the index.
“At the end of 1998 oil prices bottomed at around $10.70 a barrel,” she says. “The energy weighting in the TSX Composite was about 8%. Energy prices were very low. In July 2008, oil prices peaked at about $146 a barrel and the energy weighting in the S&P/TSX Composite was over 30%. Anyone buying an index ETF was putting only 8% of their money into energy when oil prices bottomed at $10.70, and nearly 1/3 of their money went into energy when oil prices were peaking. That sounds like buying high and selling low to me. If you were in an index ETF you would have been much lower weighted in oils at exactly the wrong time and much heavier weighted in oils at exactly the wrong time.”
Finally, she says going forward the influence of demographics will have an impact as more people willing to pay will increase the demand for income producing assets. Along with the continued unwinding of the trust sector, she says more companies will be focused on returning income to shareholders and dividend yields will become a larger part of total returns.
“They’re already playing a bigger part and I think they’re going to continue to play a bigger part in total returns,” she says. “Companies will perhaps make a greater effort to increase dividends and try to stabilize their cash flow to support steady dividends. If you look back through history, dividends have represented a very large part of total equity returns but a much smaller portion over the last ten years. I think they’re going to return to the status of being a bigger contributor to total returns.”
