A Q&A with Garey Aitken on Franklin Bissett Canadian Equity Fund

Can you comment on the last quarter, as it relates to the Canadian equity market?

• The first quarter of 2022 was another good quarter for the Canadian equity market, with the S&P/TSX Composite posting a total return of 3.8%.
• Resources, namely Energy and Materials, were very strong, but defensive sectors such as Consumer Staples, Communication Services and Utilities were also positive. In stark contrast, the Information Technology Sector was down 35% during the first quarter.  
• The Canadian equity market was one of the best markets globally, as most other country markets in U.S., Europe and Asia posted negative returns.

How about the performance of Franklin Bissett Canadian Equity Fund (FBCEF) in the last quarter?

• The Franklin Bissett Canadian Equity Fund gained 8.1% (Series F), during the quarter, which was 420 basis points ahead of the S&P/TSX Composite Index (3.8%).
• The Fund’s 8.1% return in the first quarter was driven by its holdings in the Energy and Materials sectors, and to a lesser extent CN Rail and CP Rail. Brookfield Asset Management and the Fund’s IT names were the leading detractors.
• In terms of relative performance, the Fund primarily benefitted from not owning Index heavyweight Shopify, which was down 52% in the quarter. Overall, our security selection was generally favourable across sectors. Offsetting these positives, our underweight stance in Materials was a drag on performance.

Inflation has been on the top of mind of investors. What are your thoughts on inflation?

• We are now seeing inflation levels that haven’t been witnessed in four decades.
• There has been a near perfect storm as a result of the COVID pandemic, ultra-accommodative monetary & fiscal policy, supply chain disruptions, and now the war in Ukraine, which is particular cause for concern as it relates to energy and food inflation.
• The war is compounding what was an already problematic situation and will likely result in higher, more persistent inflation than we could have envisioned even at the beginning of the year.
• It remains to be seen how successful more restrictive monetary policy will be in taming inflation. We suspect that monetary policy tightening may ultimately prove unsuccessful in meeting the inflation targets of central banks, as the root causes of the inflationary pressures are challenging to combat with higher interest rates and central banks may not have the fortitude to raise rates to a sufficient level to choke off inflation.
• Having said that, we expect current inflation rates to subside over the next few years, but at a level higher than we have become accustomed to in recent years.
• Our Fund has good exposure to equities that should be able to withstand, if not thrive, in a higher inflation environment, but clearly a drawn-out scenario of very high inflation would be negative for the equity market and the Fund.

Bank of Canada raised its overnight policy rate by 50bps in April. Are you concerned about the recent rise in interest rates and bond yields?

• We’ve been anticipating a rise in interest rates for some time, and we have now finally seen a more meaningful increase in rates across the yield curve.
• Central banks arguably waited too long to tighten monetary policy and are now scrambling to increase rates and start unwinding their quantitative easing programs.
• We think there is a risk that central bankers will ultimately be unwilling to take sufficiently bold measures to control inflation and we therefore end up with a scenario of higher interest rates, stubborn inflationary pressures and a continuation of negative real interest rates. This could result in longer term interest rates in the 3 to 4% range, but with inflation rates running higher than this.
• If this plays out, it should be a much better multi-year set up for equities than conventional fixed income, as real earnings growth should be sufficient to offset valuation contraction while fixed income would provide negative real returns.
• With our internal valuation work, we are constantly monitoring various equity’s sensitivity to changes in interest rates and take this into account in our Fund positioning.
• Rising interest rates are undoubtedly a headwind for equity valuations, but we think this would only be a significant concern if rates rose meaningfully more than current market expectations.

Do you think a recession is likely and how are you positioning for this possibility?

• There is definitely an increased concern in the market that we are headed for a recession. Those bearish on the economic outlook point to the normalization of fiscal and monetary policy, ongoing COVID challenges in parts of the world, supply chain issues, and inflationary pressures. The much-followed recession indicator, namely the inversion of the yield curve, has been flashing a warning sign.
• While a recession is a possibility, we expect this will be avoided. Although central bankers are now focused on taming inflation through monetary policy tightening, I believe they will be careful not to push too aggressively so as to see economic growth stall.
• We are not positioning the Fund with an expectation of a recession in the near term, but we do manage for the long term, and periods of above trend and below trend economic growth are expected. We base our valuation work with a view to a normalized economic growth trend, and remain very comfortable with valuations, which imply still solid long-term return potential. Of course, unforeseen events such as the occasional recession can cause equities to correct in the short term and recognize this is a possibility.  

Getting back to the Fund, what recent actions have you taken in the Fund?

• It was a relatively quiet quarter for the Fund. We have been trimming some of our exposure to more defensive names given their strength and rising valuations. Specifically, we trimmed Loblaw, but retain a solid weight, and eliminated Rogers Communications. We continue to add to some of our newer mid cap Industrials names, specifically Boyd Group, CAE and SNC Lavalin, all of which were introduced to the Fund in the past three quarters.  We also introduced two mid-cap IT names, Kinaxis and Telus International, given the significant weakness in this sector. In the Resource area, we trimmed Nutrien on strength and added to Prairie Sky Royalty in the Energy sector. The overarching theme of our Fund activity continues to be that of buying quality names with attractive valuations and selling names where valuations have become less attractive.

We have seen a lot of weakness in the growth stocks and the IT sector. What’s driving this weakness?

• For quite some time, we have been questioning the valuations of many names in the Canadian IT sector and supposed growth stocks more generally. Until recently, we have been in a market environment that was fixated on growth, whether that was growth in revenues, subscribers, or other, with little regard for the profitability of the business. This was a very difficult period for us as fundamental investors as we want to be aligned with management teams that understand profitability and are focused on same.
• However, starting last November, we have seen intense weakness in non-profitable growth stocks. The Canadian IT sector was down 35% in the first quarter. Perhaps the catalyst was higher interest rates, or perhaps market participants were having second thoughts as to the game they were playing with speculative equities. It remains to be seen whether this growth correction continues, but there are still many businesses that have little focus on making money in the near to medium term, so they remain inherently speculative.

So are you now seeing opportunities in growth stocks and the IT sector?

• During this IT selloff, we have been selectively adding exposure, and now have a weight comparable to that of the Index at approximately 7%. However, our exposure is to names that generate cash flow with durable business models where the valuations are attractive. It is worth noting that we evaluate IT businesses no differently than businesses in all other sectors, and our expectations for future free cash flows must support the current share price. 
• We see this IT selloff as an opportunity, but we are being careful and selective.

The Energy sector has outperformed the overall equity market year-to-date. What are your thoughts on the Energy Sector and your current positioning?

• The Canadian Energy sector is as well positioned as it has been in quite some time. We have quickly moved to an environment with strong commodity prices, excellent balance sheets, pathways to decarbonizing their businesses, a shareholder friendly management mindset and still attractive equity valuations.
• Ironically, even the perceived headwinds facing the sector, such as the focus on ESG, climate change and the myriad challenges to bringing on new production, are now showing up in the problematic global supply profile for oil and natural gas and this has contributed to a constructive outlook for pricing, given the still long term need for hydrocarbons even during the multi-decade energy transition.
• We have a good balance of crude oil and natural gas production with our upstream exposure and over the past few quarters have fortified our positioning in the leading oil sands producers, a high growth producer in arguably the most profitable conventional crude oil play in North America, producers in leading natural gas resource plays and a dominant oil and gas royalty business. We have been less active with respect to our midstream, infrastructure and pipeline exposure, but we retain solid exposure to this aspect of the Energy sector as well.

Same question on the Materials sector and your current positioning?

• Similar to the Energy sector, there looks to be a strong multi-year run for many other commodities, not only for those that will benefit from the energy transition and growing battery needs, but now agricultural linked commodities have received a further boost from the unfortunate war in Ukraine.
• We have less exposure to Materials than to the Energy sector, but have sizable positions in Angico-Eagle, a gold producer, Lundin Mining, a copper focused mining concern, and Nutrien in the fertilizer space. We have actively repositioned the Fund over the past few quarters to target these three names, all of which have solid business plans and we expect they will reward us with shareholder friendly actions given the very strong industry environment.

With the Canadian equity market advancing in the last quarter, do you still see the opportunity relative to other markets?

• For a long time, we have been stating the case for Canadian equities, both in absolute terms and relative to the U.S. equity market. Over the past decade, the Canadian equity market has significantly underperformed its U.S. counterpart, and while some of this was likely warranted, it was also driven by valuation expansion in the U.S. By this we mean that U.S. equities became meaningfully more expensive than Canadian equities. While we saw a reversal of this dynamic in the first quarter of this year, this reversal is small within the context of the Canadian equity market’s underperformance over the past decade.
• We still think the setup is good for the Canadian equity market overall, given valuations, generally conservatively managed, shareholder friendly businesses and the prominence of the resource complex and other sectors that should be able to better withstand rising interest rates and higher inflation.

And more specifically with FBCEF, where do you see the best opportunities currently for the Fund?

• Where we see the best opportunities is reflected in the Fund’s positioning. We see great potential in names across a number of sectors. The Financials sector is perennially the Fund’s largest weighted sector, and although we have not been overly active in this sector of late, we are very comfortable with our holdings and the long-term total return potential of these franchises. Even with the big run in the Energy sector over the past several quarters, we still like this space and it represents the second largest sector by weight. The same applies to the Materials sector. As well, I commented earlier on our recent buying of Industrials names such as Boyd Group, CAE and SNC Lavalin, where we believe recent weakness has created a very good opportunity, as well as Telus International and Kinaxis, both of which have been caught up in the Information Technology sell-off.

How would you describe the current positioning in the Fund?

• From a sector perspective, we are most overweight Consumer Staples and most underweight Materials. However, as is often the case, simply looking at the Fund’s sector weightings versus the Index does not tell the whole story.
• We think there are three notable differences between the Fund and the Index at present.
• First, we believe we are better positioned than the benchmark with respect to high quality businesses, with visible free cash flow profiles and clear pathways to surfacing shareholder value. Effectively, the quality, profitability and means to reward shareholders is better for the Fund.
• Second, we continue to manage the Fund in a way that results in much better valuations than the Index. While this did not reward us for several years, in recent quarters our valuation advantage has translated into significant outperformance.
• Third, our internal ESG framework allows us to understand the positioning and direction of our holdings from an ESG perspective and we feel that our Fund’s ESG profile, through active management, is superior to the passive benchmark’s ESG profile.  

And one last question. What is your outlook for FBCEF in the current environment?

• We remain confident in the long-term risk-adjusted return potential of the Fund given the current availability of solid businesses and existing valuations, notwithstanding the recent increase in inflation and interest rates, and the potential for further rate increases.