Resilient and ready – Canadian equities with untapped potential

Investing in Canadian equities can pose a challenge for investors. Most of the largest companies in Canada are concentrated in a few key sectors, such as Financials and Energy. The S&P/TSX Composite Index (the “Index”) reflects this composition, where the performance of this Index may not be representative of broader corporate Canada.

The Canadian Equity team at Guardian Capital LP believes there are many compelling Canadian equity opportunities, they just might not be the largest names in the Index, which tend to dominate a lot of Canadian equity portfolios.

The Canadian Equity portfolio management team behind the Guardian Canadian Focused Equity Fund (TSX: GCFE) (the “Fund”) believes in a different approach, deploying a bottom-up fundamental process favouring select Canadian equities that exhibit quality growth at a reasonable price, all while being index-agnostic towards sector allocation for the Fund. The Fund was developed with the lens of looking at Canada from the outside in and buying attractively priced companies, while sizing positions by relative valuation and prospects for appreciation. This process helps the Canadian Equity team to uncover companies that they believe have yet to experience the market catalyst to realize the potential of their future valuations. We believe markets, although efficient in the long run, can have perceived valuation gaps, even for well-positioned companies that are waiting on the right catalyst to reach their full potential. The difference in our approach is most evident by looking at the top 10 holdings of the Index versus the Fund’s portfolio, as detailed below:

Source: Guardian Capital LP for the Fund holdings, Bloomberg for the Index constituents as at February 28, 2025

High-quality companies, being those that retain high levels of free cash flow and earnings, regardless of the company’s existing stock price, have the potential of being highly asymmetric, from a risk-reward perspective. When the market prices in the normalized profitability leading to company valuations having no choice but to reflect this potential, the Canadian Equity team relies on its bottom-up fundamental process to uncover these opportunities.

Example for Illustrative Purposes Only
* Expected Return is the Manager’s proprietary estimate of a stock’s relative return opportunity, and is not a prediction or forecast of future return. Based on Manager’s proprietary Valuation Analysis: Free Cash Flow (FCF) Yield + Long-term Growth Rate. The Long-term Growth Rate is calculated based on proprietary long-term growth drivers based on a scale from 1 to 5%. The long-term growth drivers include historical Profitability, Organic Growth, Inorganic Growth, and Capital Management. Manager’s assigned Hurdle Rates: Defensive Growth (REITs, Staples, Pipelines, Utilities) – 8%; Quality Growth (Industrials, Technology, Banks/Insurance, Health Care, Consumer) – 10%; and Cyclical Growth (Resources) -12%.

Guardian Capital’s Canadian Equity portfolio managers characterize the stocks they target in the following categories:

• Defensive Growth companies are companies with historically lower volatility than the broader equity market, and generally lower, but sustainable earnings growth. Stocks that would fit in this category include grocers and utilities.
• Cyclical Growth companies are that tend to have more sensitivity to economic cycles, for example, these would consist of resource upstream companies (such as commodities).
• Quality Growth companies that exhibit strong fundamentals, lower volatility, and a sustainable business model which can consist of insurance, industrials, and software companies, to name a few.

The category the portfolio managers primarily focus the Fund’s portfolio on is Quality Growth. The example above represents a range of each category’s return profile, against the Manager’s threshold hurdle rate for inclusion in the Fund’s portfolio. Over 60-years, the average total return for the Canadian equity market has been roughly 7-9% (based on the S&P/TSX Composite Index¹), which coincides with the Defensive Growth categorization returns. However, the bulk of the Fund’s portfolio, having a Quality Growth focus, applies a higher target hurdle rate, while Cyclical Growth stocks have an even higher hurdle rate imposed by the Portfolio Manager before they will be considered for the Fund’s portfolio.

The key return attributes of a company under consideration throughout the security screening process are normalized free cash flow yield and long-term growth expectations. When combining these two components, the Canadian Equity team arrives at their overall forecast for return profiles, which is then measured up against the respective categorized hurdle rates. The higher the expected return over the hurdle rate, generally the higher the relative allocation in the Fund’s portfolio. If the drivers of return for a stock begin to lag or fail to meet expectations, the Portfolio Managers will look to reallocate into more relatively attractive companies with higher expected returns. Each company on the Canadian Equity team’s watch list, including the invested securities, gets its business model stress-tested for its ability to navigate whatever is impacting its current profitability, striving to illuminate the path to valuation appreciation. The risk is always the timing of the “coiled spring”, defined as an equity that is trading below its forecasted valuation but maintaining strong fundamentals with a defensible business model ready to “spring” and reach its valuation potential.

Below, the Canadian Equity team has highlighted some of the more underappreciated Canadian stocks that met our criteria for inclusion in the Fund’s portfolio:

Element Fleet Management Corp. (TSX: EFN) (“Element”) is a fleet management company operating mainly in Canada but also in Mexico, Australia, and New Zealand. The stock was first purchased in the Fund’s portfolio after the COVID outbreak, due to its attractive relative valuation at that time. We believed that the company had an attractive business model that was poised to benefit from the outsourcing trends in fleet management. Initially, the performance of this company was strong, up until the semiconductor shortage pinched the production rate of vehicles, which held back Element’s ability to accelerate and generate revenue due to the lower vehicle availability at OEMs (original equipment manufacturers). Although Element experienced challenges during this time, we remained confident and, over the subsequent years, saw strong growth at a reasonable price. Having done the proper groundwork in terms of deep analysis and identifying the company’s fundamental levers of return, we were able to maintain great conviction in a solid business, even through some rough patches, to eventually realize its true potential and get rewarded in the Fund.

The Fund has held Celestica Inc. (TSX: CLS.TO) (“Celestica”) in its portfolio since 2018. Celestica is a Canadian company that provides supply chain solutions, hardware platform solutions and hyperscaler data solutions to many industries, including defense and aerospace companies. The company benefited considerably over the COVID period, due to demand for electronics products, and grew alongside key customers all while expanding its profit margins. In the following years, Celestica decided to move on from their largest client, Cisco, and replace it with a much more profitable revenue stream, which took some patience to come to fruition. In parallel, the company was reselling its manufacturing capacity to other higher margin partners, eventually serving as a key tailwind in profitability from 2020 through 2022. The higher margins came from hyperscalers looking to diversify outside of China as an electronics manufacturing source, which led to a series of better business results relative to market estimates, even in the down year of 2022 for the Information Technology sector. Celestica was well positioned for the wave of AI adoption and did, in fact, benefit to the point where the stock had appreciated to the Portfolio Manager’s hurdle rate, at which time our sell discipline was activated, and the proceeds were reallocated to new “coiled springs.”

Maple Leaf Foods Inc. (TSX: MFI.TO) (“Maple Leaf”) is a Canadian company that produces food products in Canada, the United States, and internationally. The company has worked hard in building its capacity to be highly automated and modernized. Maple Leaf has also been focused on replacing multiple old facilities, which are high cost to the company’s balance sheet, and which should bode well for the company’s long-term margin profile. As the company enters the building phase of this project, we expect capital expenditures to fall away and profit margins to receive a boost. The company’s exposure to pork markets has been a persistent headwind, but now, the company’s cash flow is ticking up as these big projects are being completed. It is expected that the company’s stock price will realize the positive momentum of these priorities, along with improvement in pork markets. The company is still trading at a low valuation, and we think the normalized free cash flow yield is strong, as it corresponds to the profit margin rate the company has been targeting during normalized pork markets. We believe this to be a positive sign, especially at the bottom of a commodity market (in this case, pork), which Maple Leaf has exposure to, but which has not yet been reflected in the company’s valuation. To remedy its valuation, Maple Leaf has made the decision to spin out its pork and fresh meat businesses, to a new public company called Canada Packers Inc., which will begin trading separately sometime in the beginning of 2025. The tailwinds from this decision are expected to be positive both in the short term and once this is in action we anticipate a potential multiple normalizing upwards in line with some of its peers south of the border.

Spin Master Corp. (TSE: TOY.TO) (“Spin Master”) is a Canadian children’s entertainment company operating in North America and internationally. Spin Master experienced the post-COVID pandemic consumer spending shift, where people started purchasing experiences and services, with the demand then shifting to alternatives such as travel. The result of this change in spending patterns meant that Spin Master and its toy business faced headwinds in 2023. The company shifted strategic focus and used its excess cash to purchase Melissa & Doug, LLC (“Melissa & Doug”), in what was the biggest acquisition in the company’s history, rounding to $1 billion. Unfortunately for Spin Master, right after the sale the prior ownership stopped investing in the newly acquired business, which coincided with a weak holiday selling season. Spin Master continued to invest significantly in geographic expansion and remodelled its current lineup of products, executed on its digital game expansion, and established a new value toy line which has led to significant improvement in sentiment towards the company.

The Canadian equity market, although at times viewed as a less prominent barometer of global market strength than US equities, can be a great source of diversified returns via companies that are global leaders in their respective sectors. The shiny glimmer in the dirt is not a mirage, but rather an underappreciated and differentiated source of return that we believe has the potential to achieve yet-to-be-realized company valuation and stock price performance. The stocks highlighted here are all ones the Canadian equity team likes, given they are trading at attractive valuations, have many operational levers (mechanisms or drivers within a company that can be adjusted or optimized to improve business performance and value) to pull, and are “asset-light”, providing flexibility and room for future growth. With the approach of the Guardian Canadian Focused Equity Fund, the management team is scouring the Canadian universe for a collection of their “best ideas” and, due to the disciplined buy and sell discipline employed, the Fund does not run out of good ideas/stocks to allocate towards therefore not becoming exhaustive in its allocation. The portfolio management team has great conviction in its investment process and security selection, all while being Index-agnostic, seeking to deliver long-term returns to investors who also want to take a discerning approach to Canadian equities.

Features of this approach to Canadian Equities

1. Lower correlation to Canadian Equity Index: By looking at company fundamentals rather than market capitalization, the components of this Fund’s portfolio can be very different than the Index
2. Stocks You Might Not Own: Stocks held in the Fund’s portfolio are generally not held by other more benchmark-centric Canadian equity portfolios
3. Strong Performance track record: The Guardian Canadian Focused Equity Fund continues to demonstrate a strong performance track-record relative to the S&P/TSX Composite Index.

Source: Guardian Capital LP as at February 28, 2025.
The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. Performance is calculated net of fees. Mutual funds and ETFs are not guaranteed, their values change frequently and past performance may not be repeated.

To read more about the Guardian Canadian Focused Equity Fund, along with the Canadian Equity team’s methodology and investment process, please visit our website and view the Fund Spotlight here.

¹ Source: Bloomberg as of December 31, 2024

DISCLAIMER

This communication is for informational purposes only and does not constitute investment, financial, legal, accounting, tax advice or a recommendation to buy, sell or hold a security, and shall under no circumstances be considered an offer or solicitation to deal in any product or service mentioned herein. It is only intended for the audience to whom it has been distributed and may not be reproduced or redistributed without the consent of Guardian Capital LP. This information is not intended for distribution into any jurisdiction where such distribution, publication, availability or use is restricted by law or regulation.

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