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

Let’s start this quarter’s Q&A with how would you characterize the final quarter of 2022 for the Canadian equity market?

The Canadian equity market finished the year with a strong quarter, despite ongoing concerns about rising interest rates, sticky inflation and the growing risk of a recession. The S&P/TSX Composite Total Return Index posted a gain of 6.0% in the fourth quarter; however, the gains were made in the first two months of the quarter as the Index was down 4.9% in December.

Overall, in the fourth quarter, the market witnessed a bounce following a poor finish to the third quarter on hopes that interest rate hikes are drawing to a close. The market’s gains came from equities of all stripes, from value and growth equities to cyclical and non-cyclical equities. After three consecutive negative quarters, the Information Technology sector turned positive, and was the best performing sector in the fourth quarter with a total return of 13%. Only two sectors posted negative total returns – Health Care was down 11% and Utilities were down 7%.

How did the Franklin Bissett Canadian Equity Fund fare during the fourth quarter?

Series F of the Fund returned 4.8%, net of fees, which lagged the benchmark’s total return of 6.0%.  The Fund’s relative contribution from its positioning in Financials, Communication Services, Information Technology and Consumer Discretionary was a detractor and was driven by negative security selection. This was partially offset by a positive contribution from the Utilities sector, where security selection was positive.

Let’s discuss the year as a whole for the Canadian equity market.

The S&P/TSX Composite TRI declined 5.8% last year. Seven of the 11 GICS sectors posted negative returns. For the second consecutive year, Energy was the best performing sector, with a gain of 30% in 2022. The second-best performing sector was Consumer Staples, which exhibits classic defensive characteristics, can pass through inflation and generally the equities have moderate leverage. The largest weighted sector, namely Financials, was down 9% last year given the challenging macro backdrop.

Somewhat surprisingly, the Utilities sector, which is generally considered a defensive sector, posted poor returns for the year. Two drivers for the poor performance include regulatory threats facing the sector (as regulators are increasingly focused on protecting consumers from price inflation) as well as relatively high leverage, which is presenting a growing risk given the step up in interest rates.

Real Estate also fared poorly in 2022 and was down 22% given higher interest rates and the residual impacts from the pandemic.

One theme in 2022, in both Canada and the U.S., was significant weakness in concept stocks and highly valued growth stocks, particularly as it related to businesses with marginal profitability. In Canada, the Health Care sector was down 62% and the Information Technology sector fell 52%.

What were the drivers of performance for the Fund in 2022?

The Fund advanced 1.9%, net of fees, for the year, which resulted in 770 bps of outperformance versus the benchmark. The Fund’s focus on superior fundamentals and valuations were rewarded by the market in 2022.

Regarding sector contributions, the biggest driver was Information Technology, where our return’s decline was much better than the sector’s decline, and in Consumer Staples, where the Fund was both overweight the outperforming sector and our returns where better than the sector.

You touched on the weakness in highly valued, and in many cases, unprofitable, growth stocks. Perhaps you can elaborate on this and reference Shopify, given its prominence in the Canadian marketplace.

I think Shopify typifies what we’ve witnessed in “so called” growth stocks over the past five quarters. At one point in 2021, Shopify became the largest weight in the S&P/TSX Composite Index, reaching a peak Index weight of 8.0% on July 23^rd, 2021. Since its all-time high in November 2021, the stock was down 78% to the end of 2022.

I call it a “so-called” growth stock, because like many of these businesses, it may have been posting revenue growth, but there hasn’t been much focus on the business’s ability to generate earnings or free cash flow. Now that even revenue growth has disappointed, and sentiment has turned negative, people are starting to question the investment merits of these stocks. Notwithstanding the big declines we’ve seen since the fall of 2021, many of these businesses such as Shopify still have an uncertain profile as it relates to generating profits and free cash flow, so they remain speculative in nature, rather than fundamental investments.

I take it you don’t own names like Shopify in your Fund?

Yes, that’s correct. We’ve never owned Shopify. Not owning these types of names curtailed our relative performance, particularly in the 2017-2020 period, but we stayed true to our investment style and the subsequent unwind in these high-flying stocks has allowed the Fund to more than regain that period of underperformance.

For the past few quarters, we’ve discussed inflation, given its recent magnified influence on capital markets. What are your current views?

Stubbornly high inflation levels have been the dominant focus of markets. Although inflation rates appear to have peaked in mid-2022 and have since declined in the past few months, it remains to be seen how inflation will evolve; this is a critical issue for equity markets.

Fixed income markets rallied from their weakest levels of the fourth quarter, given the recent trends in inflation and the expectation that central banks will hike to their terminal, or maximum, short-term interest rate by mid-2023.  Accordingly, the 10-year U.S. Treasury yield reached a peak of 4.24% during the fourth quarter but finished the year at 3.87% while the 10-year Government of Canada bond yield topped out at 3.67% and declined to 3.30% by the end of the year.

The downside risk to equity markets is that inflation rates are slow in their descent in the coming months, and that central banks are forced to raise rates more than currently anticipated by the market (“higher for longer”).

Do you still think we will experience a recession?

While the avoidance of a recession remains a possibility, we continue to believe that a recession is the likely outcome of the furious pace of interest rate increases. In fact, a hard landing is a realistic outcome given the extent of the monetary tightening we’ve witnessed and what may still be ahead of us.  It has been quite some time since economies have faced interest rates at these levels, let alone the shock from the recent velocity of increases, so it is a new era for governments, corporations and consumers.

Accordingly, we expect that coincident economic indicators will progressively weaken in the coming months. Forward earnings expectations appear too high and will likely undergo downward revisions.

What is your current outlook for the Canadian equity market?

We remain cautious on the market in the nearer term.  At the same time, we recognize the counterpoints to a bearish view on equities, which include the weakness we’ve already experienced in equity markets over the past year, the prevailing bearish sentiment and the possibility that central banks are near the end of their hiking cycle (“higher for shorter”). Effectively, the reasons to be bullish are that equity markets have already discounted the challenging environment, the economy will skirt a recession and/or we will soon transition from a phase of interest rate hikes to a phase of interest rate cuts.   

From our perspective, however, we think it is possible that economic growth and earnings will be even worse than consensus estimates. For us to be more constructive on equities, we would want to see better equity valuations given our assessment of the economic and market environment as we start 2023.

Let’s now cover the activity in the Fund during the fourth quarter.

We did see an elevated level of trading in the Fund during the fourth quarter. There were some noteworthy trades in the quarter, including a large purchase of Brookfield Asset Management prior to the spinoff of the asset manager, which has assumed the name Brookfield Asset Management. We continue to have a high conviction in the new publicly traded asset manager as well as Brookfield Corporation. We added FirstService to the Fund, which is a high-quality growth business we have followed for quite some time and is a legacy position in Franklin Bissett Small Cap Fund. We also added 100 bps to Bank of Nova Scotia as the stock has been a significant underperformer, and we continue to like the long-term fundamentals of the business.

In terms of sales, the top sales made in the Fund included the elimination of First Capital REIT, as we replaced it with FirstService, additional trimming in Metro given the strength in the stock price as well as Manulife Financial.

We’ve discussed the Energy sector in our past few discussions. Energy was the best performing sector in 2022. What have you been doing in the Energy sector and what are your current views?

The Energy sector posted a strong fourth quarter despite crude oil and natural gas prices generally remaining under pressure.

As we discussed last quarter, the risk of a recession has pressured crude oil and global natural gas prices in recent months. Following the initial fears that the War in Ukraine would lead to severe supply issues for both crude oil and natural gas, the globe has remained sufficiently supplied and demand from China has been muted.

Since last spring, we have modestly trimmed the Fund’s Energy exposure as we viewed valuations as getting less attractive – effectively, stock prices were discounting stronger for longer commodity prices. During the fourth quarter, we trimmed our weight in PrairieSky Royalty, Suncor Energy and Tourmaline Oil.

Notwithstanding the correction in energy prices over the past few quarters, we believe there remains downside risk to energy prices given the weakening economic backdrop.

Over the course of 2022, the Fund transitioned from an overweight stance to an underweight stance in the Energy sector as compared to the benchmark. As I stated last quarter, we will likely need to see a different environment (in terms of commodity prices and/or equity prices) to pivot to want to either be aggressively buying or selling the sector.

You were cautious on the market. Why haven’t you aggressively tilted the Fund to more defensive, less economically sensitive equities and sectors?

At any point in time, there are equities that we like from a fundamental perspective, yet valuations are too rich for us to invest. A good example of this at present relates to some of these defensive equities – particularly those that are perceived to be minimally exposed to the market’s current concerns – namely economic, interest rate and inflation risk. Many of these equities reside in the Consumer Staples sector but are also found in less obvious sectors such as Materials, Industrials, Consumer Discretionary and Financials. As market participants have become more cautious on the market, there has been increased demand for defensive equities. Conversely, we’ve generally seen more economically sensitive names become more attractively valued and these equities have been what many investors have wanted to sell.

This is a good example of a situation where, paradoxically, “safer” names become riskier from a valuation perspective, and more “economically risky” names become less risky from a valuation perspective.

So, for us, we have exposure to many defensive equities in the Fund, but we have had to be selective, and not relax our need for attractive valuations. Further, this dynamic in the marketplace has allowed us to add to some strong secular growth businesses, but with some possible near-term challenges, at exciting valuations as other short-term oriented investors indiscriminately sell into this weak equity market environment.

It sounds like you’ve been buying some defensive names and some more offensive names, is that correct?

That’s correct. It is rarely as simple as us moving in one direction based on one variable. In fact, in the fourth quarter we even trimmed some of our exposure in some of our most defensive positions such as Dollarama and Metro given their valuations. Overall, however, the Fund’s buying has been skewed to moderately defensive names where valuations remain attractive, but there have been situations where we have purchased more cyclical equities at excellent valuations, such as CAE, SNC Lavalin, Bank of Nova Scotia and Brookfield. It is ultimately based on the risk-reward potential of each buy or sell decision.

Can you discuss the overall risk profile and sector positioning of the FBCEF?

Our focus is always on calibrating business fundamentals with valuations. Our consistent focus is on high quality businesses, with visible free cash flow profiles and clear pathways to surfacing shareholder value.

Risk management is integral to our investment approach. I discussed a concept last quarter that I’d like to reiterate - we target a beta of 0.8 to 0.9, and the Fund’s beta remains in the middle of our target range. We may otherwise have an even lower beta than this, but as I mentioned earlier, there is an increasingly dear price for very defensive, or low beta, equities, at present in the Canadian equity market.

As we assess this New Year, we continue to expect that there will be more meaningful opportunities to reposition the Fund from defence to offence in future quarters.

Can you spend some time talking about valuations for the Fund’s equity holdings?

With the overall weakness in equities over the past year, and highly divergent sector and stock returns, one big positive for the Fund has been our ability to make trades with valuation benefits (i.e. generally selling equities with higher valuations and buying equities with better valuations). In this respect, it was a great year, and we not only significantly outperformed the Index and our peers but we also continued to widen our advantage on a valuation basis.

I continue to believe that one of the most significant differentiating features of the Fund is its large advantage over its benchmark as it relates to valuations, which for us is based on free cash flow profiles. To roughly quantify this, we believe our Fund, on average, is trading at an approximate 30% discount to intrinsic value based on our free cash flow modelling, which is meaningfully better than our benchmark.

As a reminder, valuations remain the most significant driver of long-term returns for the Fund. Fortunately for our unitholders, there are periods like 2021 and 2022 where they are rewarded for this disciplined approach to valuation.

What is your long-term outlook for the Fund?

I recognize that my guarded near-term outlook for Canadian equities is contrary to my views over the past few years. Of course, I could be wrong and/or drivers emerge which alter the direction of equity markets.

Importantly, returns in the short term don’t have a dominant influence on what is most important to us and our unitholders – and that is the long-term risk-adjusted return profile of the Fund. Given the Fund’s valuation profile and the fundamentals of our holdings, we believe that long-term returns remain compelling.

Since the Fund’s inception in 1983, and when looking at rolling five-year returns, Series F’s annualized net of fee returns have outperformed the S&P/TSX Composite TRI gross of fee returns 60.5% of the time and the Canadian Equity Category average returns by 83.0% of the times.

Furthermore, Series F of the Fund annualized net-of-fee return since its inception, almost 40 years ago in March 1983, is 10.1%, compared to 8.6% gross-of-fee annualized return for the S&P/TSX Composite TRI and 7.8% annualized average return for the Canadian Equity Category.

The team’s focus remains on continuing to deliver results like this: