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

Can you please start with some comments on Q2 (April 1 to June 30, 2022) as it relates to the Canadian equity market?

• It was a weak quarter for equity markets generally, Canadian equities included, as concern about inflation rates, rising interest rates and the risk of a recession, were dominant drivers.
• Overall, the S&P/TSX Composite Total Return Index (TRI) was down 13.2%.
• Energy was again the best performing sector given the strong commodity price environment. However, even the Energy sector finished the quarter on a weak note given recession fears, and with the steep decline in June the sector posted a decline of 1.9% for the quarter.
• Similar to Q1, speculative and expensive “growth” stocks were under pressure given higher interest rates and a long stretch of positive price momentum has decisively turned to negative price momentum.
• Other than Energy, the more defensive sectors outperformed during the quarter.
• On the flipside, the Health Care sector was down 50% and the Information Technology sector declined 31%. Materials and Real Estate were also down 24% and 18%, respectively.

Thanks Garey. How was performance for the Franklin Bissett Canadian Equity Fund (FBCEF) in Q2?

• The Fund outperformed the Index for the 4th consecutive quarter, reflecting a much better market environment for our fundamentally driven investment style.
• The Fund declined by 9.4% (Series F – Net of Fees) but outperformed the Index by 380 bps in Q2 and 1,080 bps over the past twelve months as well as the Morningstar Canadian Equity Category Average by 230 bps in Q2 and 930 bps over the past twelve months.

Let’s talk about inflation, interest rates and recession risk in more detail, starting with inflation.

• Inflation has surprised many of us, central bankers included.
• The drivers of this inflation spike are well known and include the unprecedented fiscal and monetary stimulus provided during the pandemic, a surge in goods demand, supply chain issues, periodic lockdowns, and now the War in Ukraine.
• Fortunately, we are likely close to, or have already seen, the cyclical peak in inflation. Goods inflation appears to be on an improving trajectory, but services inflation will likely take more time to rollover.
• Even if inflation is in fact on the descent, the great unknown is the trajectory of inflation rates over the coming quarters.
• Inflation fears are clearly now the dominant driver in equity markets. Until we see signs that inflation pressures have abated, equity markets will likely remain challenged. However, as sentiment is now so negative with respect to inflation, at some point positive news on the inflation front could provide a meaningful boost to equities.

To battle the inflationary pressures, the Bank of Canada’s and the U.S. Federal Reserve’s policy rates jumped from 25bps earlier this year to 150 bps in June. What are your thoughts on the interest rate trajectory for the rest of the year and beyond?

• After unprecedented monetary stimulus to combat the economic impact of the pandemic, the escalation in inflation pressures has caused central banks to do an about face with their monetary policy. We are now seeing the largest interest rate increases in decades in the battle with inflation. Unfortunately, monetary policy works with a lag, and to the extent some inflation is rooted in supply shortfalls, its effectiveness is limited.
• Central banks will continue to tighten, but this will likely largely have played out by year-end. In fact, if and when inflation rates surprise to the downside and/or the economy weakens meaningfully, we will likely see a new cycle of easing monetary policy begin within the next year or two.

Do you think we will experience a recession?

• It’s fair to say that the odds of a recession have increased over the past few quarters given the extent of the increase in interest rates.
• While the historical precedent for monetary tightening to combat the level of inflation we are now experiencing would suggest that a recession is very likely, we do not believe that it is a foregone conclusion. To the extent that inflation rates abate later this year without too much pain in the form of higher interest rates, a soft landing may be in the cards, but a hard landing cannot be ruled out.

Do you see the Canadian equity market dropping further?

• While the Canadian equity market has held up better than the U.S. equity market year to date, June was a poor month for Canadian equities as the fear of recession weighted on all sectors, Energy and Materials included.
• Investor sentiment is weak, and stocks and sectors that would be more negatively impacted by a recession have generally been most pressured.
• Many market observers make compelling arguments for more market downside given the ongoing central bank tightening and a slowing economy. However, this should be balanced against a few considerations. One, many equities have already corrected significantly in the past several months. Two, as dire as conditions now look, we all should recognize that the future is inherently unknown and thus can change quickly.

The Fund has a notable allocation to industries with quite predictable cash flows, like rail, energy transportation, grocers, REITs, waste management, utilities, and telecom. What do you find attractive in these companies?

• The visibility of their cash flow and their long-term secular growth are some of the more favourable attributes we find in these companies.
• Other characteristics that fit well with what we look for is the healthy balance sheets and the high barriers to entry for competition.
• These companies also have pricing power, which can mitigate the impact of rising inflation on their profitability.
• In fact, most businesses we own will ultimately see top line growth due to inflation. The offset relates to the cost increases for the businesses.

The Fund is now overweight the Information Technology Sector. Can you please explain your recent activity and your thoughts on the Sector?

• We are now overweight the IT sector, which is a function of both the collapse of some larger cap IT stocks in recent months as well as our buying in names such as Kinaxis and Telus International.
• However, we still approach the sector with trepidation, as there are still many stocks with unsustainable long-term business models and/or still carrying unattractive valuations, notwithstanding some of these stocks down 80%-90% in recent months.
• While the rise in interest rates may have been the catalyst for the sector weakness, the flaws with many of the business models – principally an uncertain future with respect to true free cash flow generation – is now becoming apparent.
• For us, this reality check for the sector has been welcome, as it has contributed to the Fund’s relative outperformance and allowed us to add to high quality businesses with better valuations.

What are your views on the Energy Sector, particularly in light of the weakness we saw in June?

• The Fund has a similar weight to the Energy sector overall, but is overweight the upstream production and integrated names – accordingly, the Fund has more sensitivity to swings in crude oil and natural gas prices.
• We have been modestly fading our exposure to our producers and integrated holdings, but continue to like our holdings. As I stated last quarter, we believe we are still in an environment with strong commodity prices, excellent balance sheets, pathways for decarbonizing their businesses, and a shareholder friendly management mindset. However, valuations have become somewhat less attractive with the general strength in stock prices, even recognizing the commodity price picture.
• The key to the sector will be the direction of crude oil and natural gas prices. While the medium-term supply and demand outlook is supportive for prices, the nearer term risk is the extent to which the economy slows or tips into a recession.

Your largest overweight is in the Consumer Staples Sector. Can you please discuss your thoughts on this Sector?

• Even though we trimmed Loblaw meaningfully over the past several months, we continue to be significantly overweight the sector. This has been beneficial to relative performance given the outperformance of this defensive sector.
• Consumer Staples valuations have become somewhat less attractive relative to our holdings in other sectors, but still sufficient to warrant our weighting in Couche-Tard, Loblaw, Metro and Saputo.
• Historically, this has been a relatively large weighted sector for the Fund given our ability to find names with attributes that fit well with our growth at a reasonable price investment style.

While FBCEF does not have an income objective, looking at the historical growth of its annual income distributions, we notice an attractive growth rate that has outpaced inflation. What were the drivers of this growth?

• That’s right. Our focus is on total return. Our investment approach lends its though to investing in high quality business, with long-term secular growth and shareholder-friendly policies. This often results in us owning companies that pay regular and growing dividends over time. 
• These Fund holdings also tend to have higher Return on Equity and lower payout ratios.
• As a result, the Fund has experienced higher historical dividend growth than that of the index.
• An initial $10,000 investment 15 years ago increased to $20,967 by December 31^st, 2021 and annual distributions grew to $460.*

Can you discuss the overall positioning of the Fund?

• As always, we focus on high quality businesses, with visible free cash flow profiles and clear pathways to surfacing shareholder value. These fundamental attributes have seen renewed interest during this correction, and our Fund’s unitholders have been rewarded for their patience.
• For us, we are being careful. Our risk profile is somewhat higher than ideal if we remain in a weak equity market environment. Valuations have improved through this market decline, but the risk-reward may further improve over the coming months. Overall, we will likely need to see further weakness or a real market dislocation to cause us to shift our current positioning.

What is your long-term outlook for the Fund?

• While market participants are currently preoccupied with inflation, interest rates and the risk of a recession, it is important to put these near-term concerns in context. Sources of worries, and reasons for optimism, continually wane and wax in capital markets.
• As a result of our long-term orientation with an investment framework predicated on free-cash flow-based valuations, tumultuous markets have historically provided us with opportunities to reposition the Fund and ultimately differentiate our results from our competitors.
• We continue to find a variety of high-quality businesses, with present valuations that we believe will translate into attractive long-term returns, regardless of the near-term direction of stock prices.
• Accordingly, we recognize the near-term uncertainly facing the market, but the value proposition of the Fund for long term-oriented unitholders is excellent.