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

Let’s start our quarterly Q&A with comments on Q3 (July 1 to September 30, 2022) as it relates to the Canadian equity market.

• It was the second consecutive challenging quarter for the Canadian equity market, given the spectre of rising interest rates, persistent inflation and the growing risk of a recession.
• For the third quarter, the S&P/TSX Composite Total Return Index declined 1.4%. The Index was down 15% from the all-time high reached on April 4^th of this year to the end of September, putting it firmly in correction territory.
• Unlike the second quarter, when sector returns were highly divergent, for the third quarter, many sector returns were similar. Even though the market was down in the quarter, the traditionally defensive sectors overall did not outperform their more cyclical counterparts. This was on account of three interest rate sensitive sectors, which are generally defensive, namely Communication Services, Utilities and Real Estate, being among the weaker performers.
• Of note, after a strong start to the year, Energy has been quite weak over the past four months and was down 5% in the third quarter.

Given this market backdrop, how was performance for the Franklin Bissett Canadian Equity Fund (FBCEF) in Q3?

• The Fund outperformed the Index for the fifth consecutive quarter, reflecting a better market environment for our fundamentally driven investment style.
• The Fund benefitted modestly from both positive sector allocation as well as positive security selection & interaction.
• Gross of fees, the Fund declined by 0.4% in the third quarter. As a result, the Fund outperformed the Index by 100 bps in Q3 and 1,120 bps over the past twelve months.

As we did last quarter, let’s get an update on your thoughts regarding two of the key macro topics – inflation and interest rates.

• The equity market is currently dominated by macro factors, with less influence from company specific developments.
• The inflation and interest rate dynamics are interrelated, with the present inflation scare driving interest rates higher.  
• While hope for a dovish “Fed pivot” gained traction during the summer, this hope abruptly faded, starting with the U.S. Federal Reserve Chair Jerome Powell’s hawkish Jackson Hole speech and punctuated by the higher-than-expected August U.S. CPI data and the September FOMC (Federal Open Market Committee) meeting.
• The 10-year U.S. Treasury yield increased 82 bps to 3.83% to end the quarter while the 10-year Government of Canada bond yield declined a modest 5 bps during the quarter to finish at 3.17%.
• As well, foreign exchange markets witnessed some significant moves in the quarter. The Canadian dollar fell 5% versus the U.S. dollar as the U.S. dollar saw significant strength against most currencies.
• Our view is that we’ve likely seen the cyclical peak in inflation as goods related inflationary trends seem to be improving, but services inflation will likely be slower to normalize. However, it remains unknown as to the path of inflation rates over the coming quarters.
• At present, central banks appear committed to combating inflation through aggressive interest rate increases and quantitative tightening will further restrict liquidity. We expect that central banks will continue to tighten, but this will likely have largely played out by the first half of next year.

Do you think we will experience a recession?

• We believe the odds of a recession have continued to increase over the past several months given the extent of monetary tightening, yet with continued high inflation levels.
• The magnitude of monetary tightening, given the amount and pace of interest rate increases, combined with the switch to quantitative tightening (or selling of bonds by central banks), should not be underestimated.
• Monetary policy is a blunt instrument with a lagged impact on economic activity, so the ultimate impact of higher interest rates that we’ve witnessed over the past two quarters will not be felt until 2023 and 2024. Accordingly, we expect that coincident economic indicators will progressively weaken in the coming months.
• While forecasting economic growth is an inexact science at best, the current trends suggest a hard landing is an increasingly likely event.

As the third quarter drew to a close, we saw the Canadian and U.S. equity markets falter, investor sentiment at low levels and volatility increase. What are your current thoughts on the direction of the Canadian equity market?

• We are cautious on the market, as we recognize the risks to equities given the trajectory of inflation, interest rates and the growing risk of a recession. In a typical recession, there is a significant contraction in corporate earnings and P/E multiples decline. Accordingly, our view is that the next year in equity markets will likely be treacherous.
• Notwithstanding this view, given the pronounced weakness in equities and current investor sentiment, we are now seeing better valuations and believe equities have a good chance of staging a rally over the next few months, as the coming earnings season and economic data releases may result in “less bad” news – and “less bad” would be good for equities. Countertrend rallies are often witnessed during bear markets.
• We will look to take advantage of opportunities in anticipation of a short-term reprieve in the market, but to be clear, the positioning of the Fund is geared to benefit, on a relative basis, from a weaker market environment in the coming quarters.

Let’s now cover some of the more meaningful activity in the Fund during the third quarter. You added to the Fund’s already sizable position in Open Text.

• During the quarter, Open Text announced the acquisition of UK-based software company Micro Focus, effectively doubling the size of the Company.
• The market reacted unfavourably, as Micro Focus posts negative organic growth and Open Text will have to take on meaningful debt to fund the transaction.
• However, we viewed the share price reaction as an even further disconnect from the intrinsic value of the business. Open Text has a proven track record of opportunistic and accretive M&A and we are confident in their ability to successfully integrate Micro Focus and reduce their financial leverage over time.  

Towards the end of the quarter, you added to SNC Lavalin and reintroduced CAE – can you please explain your rationale?

• While these purchases were contrary to our recent Fund actions which have generally reduced market risk and economic cyclicality, our rationale was twofold.
• One, as I stated earlier the equity market weakened precipitously in September and investor sentiment became quite negative.
• Two, while both SNC Lavalin and CAE have some near-term challenges, we are constructive on the long-term outlook for both businesses and we were able to add to the names at what we consider to be significant discounts to their intrinsic value.
• SNC Lavalin was introduced to the Fund in the fall of 2021 and we have been slowly building our position.
• CAE was similarly added to the Fund last fall but was eliminated this summer at $33/share. In late September we reintroduced CAE to the Fund below $22/share, so we viewed it as an opportunistic purchase.

Energy was the best performing sector to start the year but has struggled since June. Given your views on the likelihood of a recession, what are your thoughts on the Energy sector?

• The Canadian energy sector has declined since June in sympathy with lower crude oil and natural gas prices.
• The War in Ukraine initially drove global crude oil prices higher on account of supply concerns given Russia’s significant role in global production. As well, subsequent events in Russia and Europe saw dramatically reduced natural gas flows from Russia into Europe, which caused natural gas prices to spike higher in many areas of the world.
• More recently, however, the growing risk of a recession has pressured crude oil and global natural gas prices; with a moderate counterbalance provided by the recent hawkish posture of OPEC+.
• Over the past three quarters, we modesty trimmed the Fund’s Energy exposure as we viewed valuations as getting less attractive – effectively, stock prices were discounting increasingly favourable long term commodity prices.
• It is uncertain how geopolitical events may influence oil and gas prices in the coming months, but there is clearly a risk that the geopolitical influence, which has supported prices, subsides. In this scenario, there is downside risk to energy prices given the weakening economic backdrop.
• We have emphasized quality within the Energy sector – quality in terms of management teams, balance sheets and assets. We think the risk-reward for our Energy holdings, at current prices, is acceptable, but will likely need to see a different environment (in terms of commodity prices and/or equity prices) to pivot to want to either aggressively be buying or selling the sector.

Thanks Garey. Can you discuss the overall positioning of the FBCEF?

• Our consistent focus is on high quality businesses, with visible free cash flow profiles and clear pathways to surfacing shareholder value.
• Risk management is a key aspect of our investment approach, and we target a beta of 0.8 to 0.9. The Fund’s beta is currently in our target range.
• We are comfortable with our Fund’s ex ante beta in the middle of the historical range, as it provides us with optionality to pivot, whether the market meaningfully strengthens or weakens. Having said that, our expectation is that there will be more meaningful opportunities to reposition the Fund from defence to offence in future quarters.
• At quarter end, the Fund was overweight sectors that have less economic sensitivity –  Consumer Staples, Utilities and Communication Services, and underweight more cyclical sectors such as Energy, Materials, Industrials and Consumer Discretionary.
• We currently see three differentiating features of the Fund – quality, valuations and ESG profile. We believe that the Fund’s holdings have meaningfully better long-term businesses profiles than the overall benchmark. As well, free cash flow-based valuation work is integral to our approach, and we continue to position the Fund with better valuations than the Index. Finally, our integrated ESG approach and engagement efforts translates into a differentiated ESG profile for the Fund.

What is your long-term outlook for the Fund?

• Notwithstanding the near-term concerns confronting the market, this is part of the typical economic and investment cycle. We’ve seen many different environments while managing the Fund, but we don’t deviate from our investment strategy.
• In fact, volatile markets have historically provided us with opportunities to reposition the Fund and ultimately differentiate our results from our competitors.
• Since the Fund’s inception in 1983, and when looking at rolling ten-year returns, our annualized gross of fee return has never fallen below 4.7%, and the annualized return since inception is 11.5%.
• When observing the rolling ten-year gross of fee returns, the Fund’s return was at least 10% (64% of the time) whereas the Index only posted a return of 10% or more 20% of the time.
• We believe the value proposition of the Fund for long term-oriented unitholders is excellent and remain confident in our ability to deliver on our return and risk objectives.