Why to consider oligopolies

Football was Dennis Mitchell’s first love. But the rigours of playing took a toll on his knees, forcing him to turn to his second love—finance. Fifteen years later, this executive vice-president and chief investment officer of Sentry Investments is still in the thick of the action with ambitious new mandates and growth funds.

Three-time winner of the Brendan Wood International Canadian TopGun Award, Mitchell is lead portfolio manager of the new Sentry Global Growth and Income Fund, and co-lead manager of the Sentry Global Balanced Income Fund. He has an HBA from Wilfrid Laurier University (1998) and an MBA from the Schulich School of Business at York University (2003). Mitchell is also a CFA charterholder.

How do you choose your investments?

We don’t try to time the market or mirror an index. Individual businesses catch our eye. We seek 30 to 40 of the world’s best companies. We screen for dividend growth, low leverage and return on invested capital, among other things. The screening is the beginning of a much longer process to arrive at 30 to 40 businesses we want to own. Some we eliminate because we may not like the industry; others because they might have had one good year that made them appear on our screen.

Read: Careful: Canadian stocks near record highs

We do more research on companies that have consistently performed well and are in industries we like. As we go deeper, we may still eliminate them if we find the business is deteriorating, or will be subject to greater competition in the future. Once we hone in on companies that are great businesses in well-performing sectors, we find out if they’re cheap. If our valuation model tells us the company offers attractive returns, we may initiate a meeting with the management, or start buying immediately. First and foremost, we’re looking for companies domiciled in OECD nations because:

• we can trust the accounting data and conventions applied in those countries;
• there are peaceful transitions of power; and
• the judiciary is separate from the legislature.

Ultimately, by investing in OECD nations, we feel comfortable we’ll be able to compound capital at high rates of return and repatriate that capital when desired.

Businesses we like…

• Generate strong returns on invested capital: if we’re trying to generate strong risk-adjusted returns in our portfolios, it makes sense to invest in businesses that have generated strong risk-adjusted returns themselves.
• Operate with low leverage: leverage magnifies operating risk. Less leverage means less volatility in returns and more free cash flow for equity investors.
• Operate in favourable industries: industries with high barriers to entry mean less competition, and higher margins and returns.
• Are run by competent, rational management teams: management teams that squander capital by making poor acquisitions, hoarding capital or mismanaging the business can destroy capital instead of generating returns. We want management teams that behave like owners, preferably because they own stock.

When picking companies, we track return on invested capital and dividend growth because those tend to be the best scorecards for management effectiveness. We’re cognizant of payout ratios because we’re looking for sustainable distributions, as opposed to just high yields. We also pay close attention to balance sheet and leverage levels.

Read: A short-term approach to long-term returns

We’re interested in oligopolies (companies that have few competitors). They have pricing power, less competition, and the ability to pass on inflation or cost increases, which usually means higher returns on invested capital.

Take the pharmaceutical distribution industry in the U.S., which has only three big players: Cardinal Health, Amerisource Bergen, and McKesson. There’s enough room for each to offer differentiated services so they don’t have to compete on price and volume. And consider Schlumberger, the world’s leading supplier of technology, integrated project management and information solutions to the oil and gas industry, which spends more on research and development than all its competitors combined.

That gives it huge technological and competitive advantages. For example, its technological expertise in enhanced recovery techniques (such as horizontal drilling) has rejuvenated the Bakken region, the Permian Basin and the Western Canadian Sedimentary Basin.

Some companies we eliminate right away. We’re not interested in businesses that offer commoditized services and have to constantly compete on price: for example like food and beverage or retail businesses. A brand like Michael Kors might have had a good run, but 10 years later it might not exist—fashion is ephemeral. When I first started investing in 2000, I bought Abercrombie and Fitch at $9. I sold it at $36 in 2001. You can now buy it for $39. That’s not much growth.

How do you evaluate asset classes?

For our balanced mandate, we pay attention to risk-adjusted returns. With interest rates at historic lows, unemployment rates beginning to fall and inflation picking up, rates are probably going to be higher a year from now.

Read: Manage portfolios to fixed risk levels

Directionally, that tells us we should maintain overweight in equities, and minimum thresholds in fixed income. In our balanced funds, that’s where we currently are.

We’ve often been rewarded with share buy-backs and consistent dividend increases. Year-to-date the Sentry Global Growth and Income fund has already seen 17 dividend increases, and the average increase has been about 11%.

How do you determine a company’s real worth?

A business’ worth is the present value of future free cash flows. For example, with a business like RioCan REIT, I can tell you what 90% of its cash flow will be, because only about 8% of the leases mature in any given year. By extension, I know what the business is worth. Compare that to a firm like Chipotle Mexican Grill. I have no idea how many tacos it will sell tomorrow, let alone next quarter or next year. I don’t know if minimum wage might go up, and how much that would impact the future cost of making each taco. There’s much more uncertainty around their cash flow, and consequently their true worth.

If the business is worth $100 a share and trading at $98, I’m not too interested. But if I can buy it for $70, that’s good value. Sometimes value is reflected in the price-to-cash-flow multiples, sometimes in PE multiples and stock charts. If there’s a material gap (15% or more), you buy.

Do you hedge on currencies?

To hedge, you have to feel strongly that a currency is going to decline materially against the Canadian dollar for an extended period. We’re currently hedged against the Japanese yen and Brazilian real. We’ve done well being relatively unhedged against the euro and U.S. dollar, as those currencies have appreciated versus the Canadian dollar.

Read: Which stocks are hot right now?

We’re hedged against the yen because the Japanese government has unequivocally stated its goal is to depreciate the currency by 15% every year for the next three years. And Brazil, because it has a big budget deficit and huge opposition internally to structural reforms that are desperately needed in both the economic and public sectors. In that environment you can expect the real to be weak. In both these countries, we’ve purchased currency futures.

How do you ensure superior risk-adjusted returns?

Tapping into emerging growth but getting developed market volatility is the best way to generate superior risk-adjusted returns in a global growth and income fund. We’re invested in companies like BMW, which now gets 50% of its global profit from China; alcoholic beverage company Diageo, which has a target of generating 50% of its revenue from emerging markets by 2015; and consumer goods company Reckitt Benckiser, which is on pace to deliver 50% of their earnings from emerging markets by 2016.

Performance

(As at December 31, 2013)

3 Mo	6 Mo	YTD	1 Y	S.I.	Inception date
7.4	9.7	11.9	11.9	8.1	May 29, 2012

A weak dollar may benefit canada

Canada’s poor performance this year is impacting the loonie.

But there’s a silver lining: if our dollar remains weak, it could end up helping the economy, says Pablo Martinez, assistant vice president at CIBC Asset Management.

That’s because the U.S. receives 85% of our exports, he suggests. And if the dollar continues to dip, American companies may be more inclined to do business with us.

The only downside is that a weak loonie could negatively impact companies that import, because it’ll be “a lot more expensive for them to do [business],” says Martinez.

He adds, “The Bank of Canada is predicting that GDP growth will shift…towards private investment and exports” and away from depending on housing and consumer spending. And “if you want to [focus on] exports, you have to have a low dollar…[So], I think the Bank of Canada doesn’t mind…having a dollar that remains weak.”

Martinez also notes the Canadian dollar has historically been correlated to U.S. oil prices. Now, however, the loonie is more strongly impacted by foreign financial flows.

– Suzanne Sharma, associate managing editor, Advisor Group

Kanupriya Vashisht is a Toronto-based financial writer.