MicroStockHub
By Ryan Crowther, CFA & Les E. Stelmach, CFA
Cost of Capital Critical for Stocks in New Regime
Market Overview
The Canadian equity market kicked off 2024 with a robust 6.6% first-quarter advance, building on the solid 11.8% return registered in 2023. In fact, equity market returns accelerated throughout the quarter with strength in March helping propel the S&P/TSX Composite TRI to new all-time highs. That said, gains in Canadian equities continue to pale in comparison to the ongoing boom in U.S. equities, with the S&P 500 (SP500, SPX) TRI returning 13.3% (in Canadian dollars) in the first quarter on top of 23.3% in 2023 — a large portion of these gains derived from mega cap information technology (‘IT’) and related names.
Benchmark 10-year interest rates in Canada and the U.S. ended the first quarter higher at 3.47% and 4.21%, respectively. Although below their 4.24% and 4.99% respective October 2023 peaks, around the time of the Federal Reserve’s dovish pivot, 10-year rates steadily inched back up in the first quarter and remain at levels not seen since the Global Financial Crisis. Meanwhile, consensus expectations for Fed rate cuts in 2024 tempered meaningfully — with federal-funds futures now pricing in three cuts from six just a few months ago. With peak inflation behind us, and tempered rate cut expectations ahead, we remain mindful of the potential impact on equities from a structurally higher interest rate environment. With average market interest rates proximal to earnings yields in the equity market, cost of capital implications and competing investment alternatives for stocks will remain critical considerations as investors continue to re-acclimatize to a non-ZIRP (zero interest rate policy) and non-TINA (there is no alternative) world.
The first quarter advance in Canadian equities was broad-based, with nine out of 11 sectors posting positive returns. Health care, energy and industrials were the top performers and the only three sectors to outperform the benchmark. Defensive/non-cyclical and interest-rate- sensitive sectors — utilities, communication services and real estate — were the biggest laggards. In energy, rising oil prices drove strength in exploration and production as well as integrated oil and gas companies, notwithstanding a weak natural gas market. In materials, gold bullion advanced 7.0% in the quarter to reach a new all-time high for the commodity.
The U.S. equity market saw similarly broad participation with all 11 sectors in the S&P 500 TRI in the black, led by consumer discretionary, energy, financials and IT while real estate, utilities and consumer staples lagged.
Portfolio Positioning
Crude oil and natural gas prices moved in opposite directions in the first quarter, with oil strengthening on continued OPEC production restrictions and gas weakening on warmer than expected winter temperatures. Volatility in the commodities was mirrored by volatility in the stocks, providing trading opportunities. Generally rising stock prices in the sector provided an opportunity to trim positions in ARC Resources (OTCPK:AETUF), Canadian Natural Resources (CNQ), Parkland Corporation (OTCPK:PKIUF) and Topaz Energy (OTCPK:TPZEF). We increased our weight in Tourmaline Oil (OTCPK:TRMLF) on relative weakness early in the quarter, and also established a new position in Parex Resources (OTCPK:PARXF). Parex is a Canadian company with oil and gas assets in Colombia; it is a key partner of the Colombian state oil company Ecopetrol (EC), holding a number of production sharing agreements. Parex has an established track record of generating excess free cash flow, from which it has pursued a multiyear share buyback program and, more recently, instituted an attractive dividend. Our opportunity to purchase an initial position came after the company updated its three-year business plan. Parex had built a number of contingencies into its production forecast, and the accompanying analyst forecast revisions put some pressure on the share price. We see the company as trading at an attractive discount to its intrinsic value, with its clean balance sheet (positive net cash balance) mitigating investment risk.
“Higher interest rates put pressure across the entire renewable energy space in 2023, leaving some shares well below our estimate of intrinsic value.”
We also established a position in Brookfield Renewable Corporation (BEPC) in the quarter. BEPC is the common share equivalent investment to the limited partnership units of Brookfield Renewable Partners LP (BEP), a leading global developer, owner and operator of renewable power generation facilities, and a past holding in the portfolio. 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/BEPC has access to large pools of private capital it can deploy in attractive co-investment opportunities.
Brookfield Corporation (BN) was eliminated early in the quarter. After initially underperforming Brookfield Asset Management upon being spun out, the shares appreciated significantly beginning in the latter part of 2023, and we sold the last our of holdings in January.
We exited our longstanding position in Duke Energy (DUK) during the period and replaced it with Michigan-based utility DTE Energy (DTE), in which we see superior risk-adjusted return prospects. Operating in a favorable regulatory framework that includes significant potential renewables buildouts, DTE offers a high-single-digit EPS growth trajectory at an attractive valuation, combined with a well-covered dividend. The company is also in a strong financial position with minimal equity requirements to fund its growth in the near term.
Outlook
Last year’s optimistic equity market sentiment continued uninterrupted into 2024, with the theme of AI commanding attention and driving in some cases tangible growth, in others speculative enthusiasm, into an array of securities, many of which arguably already carried very high valuations as they exited 2023. In our view, current market conditions reflect investors becoming less mindful of downside risk, and the equity market appears to discount an ideal scenario that includes not only rate cuts, but also continued economic growth and solid corporate earnings. We believe valuations of some equities are embedding uncomfortably high expectations for profitability in the year to come. Our bottom-up process and fundamental approach to valuation positions us well in this environment. We will continue to consistently adhere to our framework and to seek out opportunities for the portfolio as they present themselves.
Although the portfolio emphasizes dividends, our approach remains oriented around risk-adjusted total return and not merely income. Valuation is the primary driver of our portfolio decision making, but embedded in our assessment of valuation are core attributes we seek, such as secular growth, profitability and durability of the business, quality managements with diligent approaches to capital allocation, and capital structures that align with the predictability of cash flows and cyclical exposures. We use this approach to design a portfolio with an attractive but not overly ambitious dividend yield, and one that seeks to optimize the risk-adjusted return potential of the Strategy.
Portfolio Highlights
The ClearBridge Canadian Dividend Plus Strategy underperformed its blended benchmark* during the first quarter. From an asset allocation perspective, relative outperformance was seen in fixed income, but Canadian equities, U.S. equities and preferred shares detracted.
Thematically, the program’s higher allocations to typically defensive, but interest-rate-sensitive stocks in communication services and utilities weighed on performance.
On an individual security basis, holdings contributing the most to relative performance were JPMorgan Chase (JPM), CCL Industries (OTCPK:CCDBF), Agnico Eagle Mines (AEM), Wells Fargo (WFC) and ARC Resources. Holdings detracting the most from relative performance included Open Text (OTEX), TELUS (TU), Canadian Utilities (OTCPK:CDUAF), BCE, Fortis (FTS) and Canadian Natural Resources (CNQ). Not owning Shopify (SHOP), Tesla (TSLA) and Barrick Gold (GOLD) aided relative performance in the quarter, but conversely not owning Nvidia (NVDA), Suncor Energy (SU) and Meta Platforms (META) detracted.
Ryan Crowther, CFA, Portfolio Manager
Les E. Stelmach, CFA, Portfolio Manager
*Blended benchmark comprises 60% S&P/TSX Composite TR Index, 20% S&P 500 TR Index, 15% FTSE Canada Universe Bond Index and 5% S&P/TSX Preferred Share Index.
Past performance is no guarantee of future results. Copyright © 2024 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.
Performance source: Internal. Benchmark source: Standard & Poor’s.
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