Franklin Bissett Canadian Equity Update: A Q&A with Garey Aitken

Note: Effective May 6, 2024, all Franklin Bissett strategies were renamed. Equity strategy names were changed from “Franklin Bissett” to “Franklin ClearBridge”, reflecting the equity team’s recent integration into specialist investment manager, ClearBridge Investments.

Garey, there has been no shortage of different narratives around the markets. Can you comment on the Canadian equity market in the first quarter of 2024 and how it compares to the U.S. market? 

Following the 8.1% return in the final quarter of 2023, the Canadian equity market started 2024 on a strong footing, advancing 6.6% in the first quarter. The market’s advance during the quarter, particularly in the month of March, propelled the S&P/TSX Composite TRI to new all-time highs. Positive sentiment extended from the previous quarter on the back of hopes for a pivot in monetary policy as inflation trended closer towards the central banks’ target.

That said, gains in Canadian equities continued to pale compared to the ongoing boom in U.S. equities. The S&P 500 TRI returned 13.4% in Canadian-dollar terms during the first quarter, capping a two-quarter advance of 23.4%. A large portion of these gains derived from mega-cap information technology and related names.

Much has been made of soft landing/hard landing economic scenarios and where Canada will end up (perhaps relative to the U.S. economy as well). What is the team's thinking with respect to interest rate moves since the U.S. Federal Reserve’s dovish pivot in the fall?

Economic growth continued as the quarter progressed, though more moderately amid evidence of lingering inflation and heightened concerns that the path back to the central bank’s desired 2% target may be slower than expected, and likely uneven. This dampened prospects for the timing and magnitude of the anxiously awaited course reversal for interest rates.

Markets began the year with six to seven U.S. interest rate cuts priced in over the course of 2024, with the first cut expected in March. Over the quarter, however, expectations moderated to only three cuts, and the timing of the first cut has now been pushed out to June. A similar dynamic played out with Canadian interest rates.

The resulting bifurcated market was particularly painful for interest rate-sensitive areas of the market such as utilities, communication services and real estate. In contrast, less interest rate-sensitive stocks, where investors anticipate continued broad-based growth from a sector perspective, were propelled to new highs.

Speculative themes did have a hand in overall market sentiment and performance over the last quarter—and the last 15 months, for that matter.  Can you comment on a couple that have been most prominent in your mind?

In the U.S., artificial intelligence (AI) continued to be a dominant theme during the quarter, driving a considerable advance for the S&P 500 TRI; however, the Canadian equity market, with less direct exposure to “AI-enablers” compared to the U.S. and still awaiting tangible benefits associated with “AI-adopters”, lagged the U.S. market.

The Bitcoin rally was another prominent example of renewed speculative activity in the quarter. The surge was buoyed by an influx of institutional investors entering the crypto market following U.S. approval of spot Bitcoin ETFs by the SEC (Securities and Exchange Commission). Bitcoin is increasingly being perceived as a legitimate alternative asset.

Let’s move on to the value versus growth discussion. Where do you think leadership will be going forward and why?

Although the Canadian equity market has less exposure to pure growth stocks than the U.S. equity market, this dynamic has played out on both sides of the border. It’s difficult to capture these factors in Canada using growth and value indices, so let’s talk about U.S. data.

As this U.S. MSCI Growth and Value Indices graph illustrates, from the beginning of 2023 through to the end of the first quarter of 2024, Growth handily outperformed Value. This is similar to most periods since the 2008 Great Financial Crisis, with 2016 and 2022 notable exceptions. Growth in the U.S. equity market, perhaps best epitomized by the “Magnificent Seven” (more recently the “Fantastic Four”) experienced a remarkable run over this period. The economy was surprisingly strong; companies generally met or exceeded expectations; artificial AI emerged as a strong investment theme; and investors felt a need for exposure to the evolving industry leaders.

Now that we have heard some of the team’s insights on a broader scale, perhaps we could look more closely at performance. Which sectors of the market were positive and/or negative performers in Q1?

The health care sector, though lacking in relevance due to its sub-1% weighting in the Canadian benchmark, was the top-performing sector. After lagging in the fourth quarter last year, the energy sector reversed course and re-emerged as a leader in Q1 as mounting geopolitical tensions elevated crude prices, which especially benefitted upstream producers and integrated oil and gas companies. The industrials sector was a close runner-up, returning 11.1% as stocks in this sector continued to benefit from a resilient economy and solid growth prospects.

On the other hand, after staging a short-lived rally in the fourth quarter of 2023 and early days of 2024, more defensive and interest rate-sensitive sectors—notably communication services and utilities—experienced weakness over the first quarter as hopes for a pivot to a more accommodative monetary policy continued to be delayed. The more pronounced underperformance in communication services partly reflected industry-specific challenges associated with intensified competitive pressures and regulatory oversight, which diminished expectations for the sector’s profitability in the near term.

How did the Fund perform during the quarter and what were the drivers of the relative performance? Where did we gain advantages and which sectors were a challenge in the shorter term?

The Fund’s advance of 6.2% (gross of fees) lagged the Index gain of 6.6%. Despite the slight relative underperformance, it was encouraging that security selection was positive during the quarter.

At the sector level, relative performance was favourable in materials as we were underweight in a lagging sector while selection was strong. Industrials also contributed as our overweight position was complemented by strong selection; but this was more than offset by overweight positioning in the underperforming utilities and communication services sectors. From an individual security perspective, our outsized position in Open Text was the primary detractor from relative performance in the information technology sector.

It is worth emphasizing that a critical element of the Fund’s performance objectives is the delivery of solid absolute returns over time. Specifically, we target an absolute return of at least our estimated cost of equity for each investment we make. We continue to feel good about our fundamental analysis at the security level. The Fund’s holdings are largely delivering results at least in line with our expectations, and we don’t overpay for equities. In an absolute sense, the Fund’s returns remain strong.

The Fund continues to have a trailing beta of 0.8 to 0.9. Beta is a measure of volatility, or systematic risk, relative to the benchmark. This means that, all else being equal, the Fund should move up or down 10%-20% less than any given move in its benchmark. A strong market over a short period of time, such as we saw in the first quarter with the S&P/TSX Composite Total Return Index gaining 6.6%, is generally a challenging environment. The Fund’s gross-of-fee return of 6.2% in the quarter represented 94% of the benchmark’s gain, so we feel the Fund performed well given the market’s strength. Of course, we would always prefer to outperform the market from quarter to quarter regardless of the market’s return, but this is not realistic given the efficiencies in the market and our investment style.

Which individual names were most impactful for absolute returns in the quarter?

The Fund’s solid advance in Q1 was driven by several holdings with strong returns. Top contributors to absolute returns included Canadian Pacific Kansas City, Waste Connections, SNC-Lavalin Group, Agnico Eagle Mines and Loblaw. Conversely, the biggest detractors to absolute returns were BCE, Toronto-Dominion Bank, TELUS and Open Text.

How about performance relative to the Fund’s benchmark, the S&P/TSX Composite TRI?

Top contributors to relative returns included SNC-Lavalin Group, ARC Resources, Loblaw and Agnico Eagle Mines. The Fund also benefitted from not owning Shopify, which lagged during the quarter. On the flipside, the Fund’s overweight positions in Open Text and TELUS, as well as an underweight position in Canadian Natural Resources, detracted from relative performance. Not owning the outperforming Suncor Energy also adversely affected the Fund during the quarter.

Let's turn to the macro environment for a moment.  What do you see as the backdrop for Canada with respect to inflation and perhaps the economic environment in general.

Inflation continues to be the biggest near-term driver for equity markets, given its influence on central banks’ decision-making regarding interest rates. Generally, inflation data remains on an encouraging trajectory. We are well past the highest levels for the cycle. Year-over-year inflation rates, depending on whether one is looking at headline or core, are now in the 3% plus-or-minus range.

Despite the improving inflation picture, pockets of stubborn inflation remain (such as shelter costs) and are expected to linger for longer. These concerns have been further exacerbated by geopolitical conflicts, more recently the situation in the Red Sea, which poses a threat of heightened energy and transportation costs.

These headwinds have kept the Bank of Canada and the U.S. Federal Reserve on hold despite signaling in late 2023 their intent to pivot from monetary tightening to monetary easing. Wary of risks associated with cutting rates prematurely, both central banks await incremental data prior to making their move.

The path of the last mile for inflation—the move from current 3%+ level to the central bank’s target of 2%— could prove to be a critical one that will greatly influence central bank actions, and by extension, equity markets. Markets continue to discount interest rate cuts in 2024, although expectations regarding the number, magnitude and timing of initial monetary easing have been pushed back.

What are your thoughts on the impact of continued higher rates on the equity market?

The December U.S. Federal Reserve (Fed) meeting indicated central bankers’ inclination to cut interest rates in 2024, marking a drastic departure from the Fed’s hawkish stance that began in March 2022 and extended through majority of 2023, which buoyed markets to all-time highs. This positive sentiment carried over into the early days of 2024. However, as the quarter progressed, continued economic strength (albeit moderating) and evidence of lingering inflation diminished prospects for the timing and magnitude of the highly anticipated reversal of the course for interest rates.

Both the Bank of Canada and the Fed have remained on hold, which has contributed to higher rates across the yield curve. The effect was particularly painful for the generally interest rate-sensitive areas of the market such as utilities and communication services, but pockets of the market that were expected to continue to grow were not deterred by the yield curve shifts and continued to advance.

What are the team’s thoughts on the Canadian economy moving forward?

The economy—although decelerating—continues to show sufficient resilience, with customer spending remaining robust since economies reopened after the pandemic. While fiscal stimulus has moderated since the immediate aftermath of the pandemic outbreak, fiscal policy continues to operate at odds with monetary policy. Labour strength and wage gains have further reinforced this view, fuelling fears of lingering inflation and the potential for a higher-for-longer rate environment.

Despite the seemingly resilient macroeconomic backdrop, we remain mindful of the typical lag between interest rate changes and their associated impact on economic growth. As such, we expect the pick-up in rates that started in 2022 will inevitably have an impact on growth. Additionally, geopolitical risks remain top of mind and could further weigh on the prospects for the economy.

The market consensus is for somewhere between a soft landing and no landing. Given extreme equity market levels (i.e. valuations), we see considerable risk if the economy fares worse than expected. Whether the inflation rate falls to 2% or stalls out at around 3% will remain an important issue given the impact on short-term interest rates, but we expect that concerns about economic growth will take on a more important role in 2024.

Can you discuss the activity in the Fund during Q1?

While trading activity during the quarter was broad-based from a sector perspective, the continued market advance presented opportunities to trim certain holdings that exhibited strength, while weakness in interest-rate sensitive equities provided opportunities to add. Additions during the quarter mainly encompassed interest-rate sensitive areas of the market, including communication services and utilities. The seemingly higher-for-longer interest rate environment placed asymmetrical pressure on these equities and the resulting weakness surfaced attractive risk/reward opportunities for us.

In communication services, we once again added to BCE, remaining mindful of sector-related near-term challenges associated with escalated competitive pressures resulting from the Rogers/Shaw merger and Quebecor/Freedom combination, as well as lingering regulatory fears.

In utilities, we added to Fortis and re-introduced Brookfield Renewable Corporation (BEPC) to the Fund. BEPC, the common share equivalent investment to the limited partnership units of Brookfield Renewable Partners L.P. (BEP), is a leading global developer, owner and operator of renewable power generation facilities, and a past holding in the program. The advent of higher interest rates put pressure across the entire renewable energy space in 2023, and we saw the shares trade well below our estimate of intrinsic value. Through its sponsor, Brookfield Asset Management, BEP has access to large pools of private capital it can deploy in attractive co-investment opportunities.

One area of strength during the quarter was industrials, where the seemingly resilient economy fuelled favourable sentiment toward both cyclical growth and less-cyclical growth businesses, propelling their valuations to levels beyond what we view as attractive. This motivated us to trim names such as SNC-Lavalin, Boyd, Stantec and Waste Connections, all of which exhibited pronounced share price advances recently.

Pockets of the market reflecting a combination of quality and growth represented another area of strength during the quarter. Several consumer names benefitted not only from constructive consumer trends but also abating inflationary pressures, which further boosted confidence in prospects of solid profitability over the foreseeable future for these companies. We took advantage of this opportunity and trimmed our holdings in Dollarama, Alimentation Couche-Tard and Loblaw.

Last year, the team mentioned that they were concerned about the riskiness of defensives, which is indicative of how the team thinks about investing overall and the great lengths taken to ensure long-term success of the Fund.  The portfolio is positioned defensively, but what does that mean to you and the team?

We manage the Fund with a consistent investment style. Importantly, the Fund maintains a much better valuation profile than its benchmark, based on our free cash flow valuation approach. With the equity market discounting a seemingly ideal, optimistic scenario of rate cuts, continued economic growth and a solid corporate earnings profile, there appears to be little margin for error. Accordingly, we continue to maintain a relatively more defensive positioning than is typical for the Fund.

As the chart shows, the Fund remains underweight the more cyclical sectors and overweight the more defensive sectors. The Fund has become more defensive over the past 12 months. The largest weighting change over the last year was the 350 bps reduction in the information technology sector as Shopify’s gain drove the sector weight higher and TELUS International transitioned from this sector to Industrials. This was offset by the 300 bps increase in the utilities sector as we purchased ATCO, Fortis and Hydro One, and introduced Canadian Utilities. Additionally, we re-introduced Brookfield Renewable Corporation into the Fund after the security was eliminated in the second quarter of 2023.

Effectively, our defensive positioning and cash serves as dry powder that we will deploy when better opportunities arise. We look forward to a market environment, possibly a market correction, when the Fund will benefit from our patient and deliberate positioning. When this time comes, it should also allow us to shift towards a more aggressive stance and transition the Fund’s beta profile from the current lower end of our targeted range (0.8) to the upper end of our target range (0.9).

Can you speak to the Fund’s performance objectives?

I like to end these discussions with a look at the long term. Earlier, I mentioned our focus on absolute returns and our target for superior risk profile relative to the benchmark. At the same time, we want to deliver compelling relative returns over full market cycles.

Looking at rolling five-year returns on a monthly basis since the Fund’s inception in 1983, our annualized gross-of-fee return was negative only once in 434 discrete five-year periods. The Fund’s return was at least 10% in 51% of these discrete five-year periods. On a 5-year rolling basis, the Fund outperformed its benchmark 78% of the time. The Fund’s annualized return since inception is 11.6%, compared to 8.8% for its benchmark.

Keep in mind that we’ve delivered these returns with a consistently better risk profile; the Fund has maintained a long-term beta below 0.9. Furthermore, its long-term standard deviation has been 5% to 10% lower than that of the S&P/TSX Composite TRI.

Thanks for these insights, Garey.