Conviction over convention in Canadian Equities

Canadian investors like the familiarity of core Canadian equities. But are they missing opportunities to unlock the value in allocations to quality companies with better risk/reward profiles; that is, stocks that may be underrepresented in the traditional index or less correlated to the broader market? Guardian Canadian Focused Equity Fund is a concentrated portfolio quite different from a traditional basket of Canadian stocks. Thinking outside the box means being index-agnostic in favour of a “best ideas” portfolio.

Canadian equities have served as a core holding across many domestic investment portfolios for decades. Familiarity with the household names of Canadian stocks across the Financials, Energy and Utilities sectors have been staples in a passively managed portfolios but is this the best way to be invested in Canadian equities? The traditional benchmark for Canadian equities, the S&P/TSX Composite Index, has a significant sector bias that is difficult to ignore, especially when sector concentrations can lift or depress the market all by themselves.

The Guardian Canadian Focused Equity Fund is here to provide a fresh perspective for an asset class ripe with potential.

Canadian equity markets can be seen as anything but stagnant in recent times, contending with a variety of fiscal and monetary shocks, including:

• persistently elevated short-term interest rates
• rising borrowing costs
• rising refinancing costs with the knock-on effect on consumer discretionary spending
• rising cost of capital for Canadian companies, elevating risks to continued sustainable growth.

Elevated interest rate regimes can create environments of greater uncertainty, especially in key sectors of the Canadian economy. These risks also happen to impact a large portion of passive investments in Canadian equities, such as high-beta and index-tracking investments with more concentrated allocations to Financials, Utilities, and Telecommunication Services, the most interest-rate sensitive sectors.

What do all these mean for the Canadian equity market and how can portfolios be positioned to navigate these risks?

Challenging the status quo

Guardian Canadian Focused Equity Fund’s portfolio managers, Ted Macklin and Sam Baldwin, take a different approach to investing in Canadian equities, favouring a more diversified perspective to uncovering opportunities and hedging against some of the inherent concentration risks in the S&P/TSX Composite Index.

We take a truly active approach that looks beyond Canada’s lopsided index to seek out the best risk-reward opportunities. While the fund’s top 10 holdings often look quite different than what investors are used to seeing in the index, this is purely a reflection of where our team has bottom-up conviction.” – Sam Baldwin

S&P/TSX Composite Index Performance

Source: Bloomberg (as at May 31, 2024)

The Fund’s portfolio managers believe a better approach is to have high conviction and be index-agnostic by focusing on growing, quality companies that they believe can potentially provide strong returns over the long term. The Fund’s portfolio managers have conviction that their approach makes for a more resilient strategy, focusing on 15-20 of their “best ideas” in Canadian equities. Maintaining a high active share and a lowered correlation to the S&P/TSX Composite Index (the Fund’s benchmark), the Fund offers access to a portfolio of “all-weather” companies that the portfolio managers believe are strong, fundamentally, and are undervalued.

Correlations converging

When thinking about portfolio defensiveness, a typical association is the principle of diversifying across asset classes, such as fixed income and equities. While historically true, this pattern has been challenged in recent times as the correlation between the two (fixed income and equities) has shown signs of converging and offers altered risk-return profiles. An alternative to this is buying into “bond proxies”, seen as equities with lower volatility and stable dividend yields, such as (Banks, Utilities, Real Estate, Communication Services, and Oil & Gas Storage) to serve as ballast in a portfolio seeking shelter from outsized volatility. The S&P/TSX Composite Index has a forward-earnings yield favourable to corporate bond yield and cash yields on a relative basis, indicating that dividend-paying equities can remain resilient, but they are not bulletproof. These defensive sectors tend to be asset-heavy, highly indebted, and dilutive through share issuance.

Source: BMO Capital Markets Investment Strategy Group, FactSet, Compustat, IBES. As at October 11, 2023

Source: BMO Capital Markets Investment Strategy Group, FactSet, Compustat, IBES. As at October 11, 2023

The portfolio managers believe that a better way to tilt a portfolio to a more defensive positioning is by investing in “asset-light(er)” companies with strong balance sheets. Fundamentally, emphasizing asset-light companies with financial flexibility (i.e., TMX Group Ltd (TSE: X)’s most recent, and one of its largest, M&A transactions was financed all with cash) and accretive business practices (M&A and share buybacks) adding to shareholder value. These equities tend to have a strong margin of safety and free cash flow (FCF) and can serve as a hedge against the impact falling bond yields may have on interest-rate-sensitive sectors like Financials, which tend to make up a large portion of the benchmark index. It has become far more costly to take on debt and, as a result, grow in a persistently high-rate environment. The portfolio management team believes defensive alternatives, rather than traditional defensives can add more value to a Canadian equity portfolio.

For Illustrative Purposes Only

Our approach

The Guardian Canadian Focused Equity Fund invests from a benchmark-agnostic perspective, aiming for a better defensive allocation from the portfolio manager’s “best ideas” in the Canadian equity market without sector bias.

The portfolio managers’ universe of investible securities goes through a vetting process of more than 250 Canadian stocks to arrive at between 15-20 high-conviction holdings.

For Illustrative Purposes Only

The quality analysis consists of an assessment of a company’s growth potential, profitability, risk, and stewardship. Equity selection focuses on finding high-quality, growing companies with a meaningful valuation asymmetry (i.e., where the team sees greater upside vs. downside risk).

The team refers to these opportunities as “coiled springs”, where the current valuation implies a less robust outlook than that of the investment team.

For Illustrative Purposes Only

“Walking the walk” — Fund holding examples

MDA Space Ltd. (TSE: MDA):

Falling launch costs have led to an inflection point in space exploration and space-based communications. As more satellite constellations are being announced and awarded, MDA has a technological advantage and is expected to be a prime beneficiary. As the manufacturer of the iconic Canadarm, MDA is also an incumbent in robotics and its radar satellite technology positions the company well for growth in earth observation. As the company completes a key growth project in the coming year, MDA’s capital-light business will begin to produce strong FCF, making it an excellent re-rating candidate.

Maple Leaf Foods Inc. (TSE: MFI):

Maple Leaf is another company whose improvements are hiding in plain sight. Major capital projects have been successfully completed and margins are generally expected to rise as agricultural markets normalize after a period of disruption following the pandemic. FCF is expected to dramatically improve as margins expand, paving the way to rapid deleveraging and increased shareholder returns. Cloud software, on the other hand, has yet to harness the power of AI and has a much longer runway to do so. The returns haven’t yet been fully priced in, which is why we see great potential in this segment.

Summary

The Canadian equity market has long been a poster child of high concentration, and investors are faced with difficulty when it comes to finding a truly differentiated and diversified portfolio within which to invest. There will likely always be the traditional passive security selection process tied to the index, however, the Fund’s investment team believes active management, focusing on a high-conviction, benchmark-agnostic portfolio of defensive companies is the best way to invest in Canadian equities.

Key reasons to consider Guardian Canadian Focused Equity Fund:

1. 1. 1. High-conviction holdings
      2. Focus on high-quality growth companies
      3. Benchmark-agnostic

To learn more about Guardian Capital LP’s Guardian Canadian Focused Equity Fund, please visit guardiancapital.com/investmentsolutions

¹ The Management Expense Ratio (“MER”) represents the trailing 12-month management expense ratio, which reflects the cost of running the Fund, inclusive of applicable taxes including HST, GST and QST (excluding certain portfolio transaction costs) as a percentage of daily average net asset value the period, including the Fund’s proportionate share of any underlying fund(s) expenses, if applicable. The MER reported herein is from the Fund’s most recent Management Report of Fund Performance (“MRFP”), as updated semi-annually, and which can be found on our website.
² The Management Fee is the total fee paid to the Fund’s Manager for managing the investment portfolio and for the day-to-day operations of the Fund.

Series A Units may pay sales charges at the time of purchase and have ongoing trailer fees paid to the Dealer, as outlined in the Fund’s prospectus. Series F Units are available to investors who have a fee-based account through their Dealer. Instead of paying sales charges, such investors pay fees directly to their dealer for investment advice and other services. The Fund does not pay any sales charges or services fees in respect of Series F Units and, thus, can charge a lower management fee.

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Published: July 2, 2024