Breaking up is hard to do—unless you’re a discerning portfolio manager. Here’s how five PMs divested with no remorse after the deed is done.

Case 1: An investment no longer meets performance criteria

The breakup: Mackenzie U.S. Midcap Growth Class minus Cyberonics

The makeup: Mackenzie U.S. Midcap Growth Class plus Broadridge Financial (among others)

The competitive landscape is always changing, says Phil Taller, senior vice-president of investment management at Mackenzie Investments in Toronto. “We’re always scanning the horizon to see if there’s something new that’s going to rise up and possibly change the landscape.”

That’s what happened with one of his holdings, Cyberonics, a company with a core business of marketing an implantable medical device for vagus nerve stimulation (VNS).

“The main thing Cyberonics does with VNS is treat epilepsy—especially drug refractory epilepsy,” says Taller. “If you’re drug refractory, you don’t respond to any of the epilepsy drugs out there.”

Cyberonics performed well. It announced a merger with a European company called Sorin, through which it would form a new firm, LivaNova. “The reception to that merger was [initially] very positive,” says Taller.

Then things went to pot, literally. A competitor, GW Pharmaceuticals, was “working on commercializing a drug based on cannabis to treat some severe forms of epilepsy,” says Taller, and early clinical studies showed the drug was reasonably effective. If it proved successful, consumers would probably choose the drug over a device that required them to have minor surgery.

The newly formed LivaNova, a producer of surgical heart valves, would also be facing competitive disadvantages, contributing to his decision to divest. “We know the heart valve business from our ownership of another company that is the global leader in surgical heart valves,” says Taller. “We felt like we were getting exposure to an also-ran.”

Another downside of the merger was that Taller and his team would have to deal with new management based farther away.

When deciding to divest, Taller reviewed data, talked to sector players and considered the share price through discounted cash flow modelling. “If you put a scenario in our model where some of those competitive issues came to the fore, [the stock] was definitely overvalued.”

Liquidity was also a divestment concern. “In the U.S. midcap space, you don’t get in or out of a position in a day because that kind of liquidity is not there,” he says. Rather, it takes weeks or months, especially with Taller’s significant weightings. On any given day, his method is to trade counter to the market.

The sale went well because he divested the stock while other buyers, not focused on Taller’s particular performance criteria, were happy with it.

Taxes weren’t a concern because the fund is corporate class and can share gains and losses among a group of funds.There’s no one company that replaced Cyberonics, says Taller, who looks at buys idea by idea and company by company. But he added Broadridge to his portfolio in the past year, which he considered undervalued, as well as other tech-related stocks.

The breakup: Fiera Global Equity Fund minus Air Liquide

The makeup: Fiera Global Equity Fund plus Unilever, Johnson & Johnson, 3M Company and AutoZone (a rebalancing across existing holdings)

Sometimes a company’s management makes an uncharacteristic business decision that asset managers can’t ignore.

For instance, “when a company goes to make an acquisition,” says Tim Hylton, senior vice-president and equity strategist at Fiera Capital in Toronto, “if it’s a big one that stretches the balance sheet, we’re going to review it and possibly eliminate the position.”

That’s exactly what happened when Air Liquide, a holding in Hylton’s global fund, acquired competitor Airgas.

“Strategically, it was a very smart fit,” says Hylton. “But in our view, they paid too big a premium and levered up the balance sheet. Now, there’s more risk and more volatility in that name.” The deal was announced in November 2015, and Hylton’s team trimmed the position in Q1 2016, going from 2.2% to 1.7%.

But as long-term holders of Air Liquide and fans of its management, Hylton’s team decided to meet with them, thinking, “They’re probably going to convince us how smart the deal is.”

Hylton’s team left the meeting unconvinced. They trimmed again the next quarter, down to 1.4%. “We really like the management,” Hylton says, recalling his reasoning. “They’ve done a fantastic job up until this. We need to meet with them again.”

After a second disappointing meeting, Hylton’s team eliminated the position in Q3. It was the only sale made in the fund in the first three quarters of 2016. With the proceeds, “we reallocated across a number of holdings that we felt had better risk-adjusted return profiles,” he says.

He sells in a measured fashion, as the Air Liquide divestment demonstrates, with sales usually taking place across three fiscal quarters.

“It’s not market timing. It’s more to avoid whiplash: we don’t want to sell it after all the bad news is out, and then suddenly the stock recovers.”

Case 2: Rebalancing is required

The breakup: Canadian equity portfolio minus George Weston

The makeup: Canadian equity portfolio plus Loblaws

Kelly Trihey, a private wealth portfolio manager with Industrial Alliance Securities in Montreal, says rebalancing clients’ portfolios includes assessing individual securities based on defined criteria, like price, assessing global holdings using a top-down approach, and maintaining the strategic asset allocation after market fluctuations.

Typically, she assesses portfolios monthly and rebalances them quarterly, or whenever proportions climb beyond 5% of target weights.

“We added Loblaws at the end of November 2016,” she says, and divested Weston, a decision based on the companies’ financials, 12-month expected price and intrinsic value. “Loblaws had better potential growth than George Weston at that point in time.” Often, “since we’re not taking any sector bets, whenever we add a stock, we remove a stock from the same category.”

Before divesting, she considers the tax impact on the net performance of clients’ portfolios. “But, ultimately, you cannot have taxation guide your investment choices,” she says. “It has to be based on your criteria and performance of the stocks.”

Case 3: Tax is top of mind

The breakup: the whole portfolio (to realize gains)

The makeup: the whole portfolio

Tom Trainor, managing director of Hanover Private Client Corporation in Toronto, continually assesses clients’ tax positions both within the portfolio (gains/losses, interest, dividends) and from personal income (e.g., trust income and employment income). He also considers clients’ outside investments with other managers, and talks with clients’ accountants.

Based on that data, plus client conversations, he decides whether the client would benefit from tax-loss selling or income generation. Plus, “you also want an outlook on their long-term tax position,” such as changing tax brackets. It’s very client-specific, he says.

For instance, to take advantage of a client’s expiring non-capital loss (which can’t be carried forward indefinitely, like capital losses), he rolled over the portfolio to create gains, after having the client and tax accountant sign off on the move.

“We sold every single position,” he says, at about 3:30 p.m. on one day and repurchased at 9:40 a.m. the next. “You don’t have to wait overnight, but it gives you a better audit trail if the trades are done on two different days.” Also, there’s no 30-day waiting period to repurchase when realizing gains, as is required under the superficial loss rules.

The client made a small win on overnight market movements, but reaping tax benefits was the intention, he says. At institutional rates, the commission cost was low. Rebalancing was done at the same time. “The client’s portfolio had moved around a little bit during the year,” says Trainor. “We rebalanced back to what we had outlined in the investment policy statement as their strategic asset allocation.”

Case 4: An investment fails ESG (environment, social and governance) criteria

The breakup: Meritas Responsible Investing (RI) funds minus Enbridge

The makeup: per aggregate portfolio requirements

“We work with our suppliers and RI screening companies to make divestment decisions,” says Manmeet Bhatia, senior vice-president and CIO at Qtrade Financial Group in Vancouver. For instance, companies are screened for controversies in their products, services and processes. Further, his team assesses a company’s sustainability commitments—and how they prevent and fix sustainability issues.

In the case of Enbridge, “the decision came largely down to a poor environmental performance period, culminating in some spills that took place,” he says, referring to 2012 spills in Wisconsin and Alberta.

“Divestment is the last resort,” says Bhatia, who prefers working with companies to improve undesirable behaviour. Divestment is “in recognition of the areas we’d like to see improvement on. [A] company could turn around and be eligible for investment again.”

Divestment happens over a few days at most, with the aim of minimal financial impact. When a security fails ESG screening, “you don’t want to transition that over an extended period, but you also don’t want to dump your shares on the market. A short transition out of the security is generally what we’d focus on executing.”

To replace the divestment, the funds’ subadvisors considered the portfolio in aggregate, he says. “They wouldn’t necessarily replace it on a one-to-one basis with an energy company.”

by Michelle Schriver, assistant editor of Advisor Group.