Download the PDF Version of this report
2013 Market Outlook
Expect 2013 to be very similar to 2012 – modest returns and potentially high volatility.
With 2012 in the books, now is a great time to take a look at what we expect for the coming year and offer up some ideas on how to position your portfolio.
Looking at the economic and investment environment, we expect that 2013 will look a lot like 2012. Many of the key issues of 2012 remain in play this year. For example, Central Banks in Canada and the U.S. are expected to keep interest rates on hold for most, if not all of 2013. With interest rates basically on hold, we don’t expect to see much in the way of return from fixed income investments. On December 31, the Bank of Canada reported that Government of Canada 10 year bond was yielding 1.80% while the two year was yielding 1.14%. Corporate bonds offer a better yield, with the DEX All Corporate Bond Index yielding approximately 2.85%. Back out fees and the outlook for fixed income for 2013 is flat to slightly positive, comparable to the returns generated in 2012.
For equities, the picture is considerably more complicated. Much of the headline risk that affected markets in 2012 continues to weigh on sentiment. While the bulk of the fiscal cliff in the U.S. may have been averted, the focus now shifts to handling the nation’s overwhelming debt load and there is no doubt that the negotiations to raise the debt ceiling will wreak havoc in the markets. There are signs emerging that the housing market is on the rebound and the economy is creating jobs, but we are still a long way from a robust recovery.
Europe continues to be Europe. While many steps have been made to address the debt crisis, it is far from being solved. Further complicating matters, the wealthy countries continue to call for deeper cuts from the heavily indebted nations, which is having the unintended consequence of stifling any level of economic growth. Until this conundrum is remedied, we expect continued negative returns and high volatility in the region.
Within the emerging markets and China, which have been struggling of late, early signs indicate that the worst may be in the past and a rebound is under way. If this turns out to be the case, we expect that market should rebound. This will also have the additional benefit of providing some support to commodities, which will help to move the Canadian equity markets higher.
On balance, we are cautiously optimistic for 2013. We are expecting modest gains from North American and emerging market equities as modest economic growth continues. For fixed income, with interest rates likely on hold, we expect low single digit returns, and we expect Europe to be volatile with continued risks to the downside. We continue to favour equities over fixed income. Within the equities, we slightly favour the U.S. over Canada and large caps over small caps. We will continue to focus on funds that invest in high quality, well-managed companies that generate strong free cash flows. For fixed income investments, we favour low cost, actively managed funds that have higher exposure to corporate bonds which are expected to provide higher returns to investors in the coming year.
Please send your comments to feedback@paterson-associates.ca.
Funds You Asked For
Bissett Canadian Dividend Fund – For the past few quarters, the Bissett Canadian Dividend Fund has been one of our favourites in the category. Unfortunately, it was announced that Juliette John, one of the co-managers of the fund had left the company in early December.
Ryan Crowther, a co-manager on the fund remains. Mr. Crowther has been with the firm since 2008 and has been co-manager on the fund since mid 2011. Les Stelmach, who has been a part of the Bissett organization since 2006, will join him on the fund. Mr. Stelmach has been involved with the management of other Bissett funds including the Bissett Strategic Income Fund and the Bissett Energy Fund.
While any manager change is tough to assess, we don’t envision significant changes as a result of this departure. First, Mr. Crowther has had a hand in managing the fund for the past year and a half. Second, both of the current co-managers have extensive experience within the firm and are well indoctrinated in the Bissett way of managing money.
The fund will remain a concentrated portfolio of Canadian dividend paying stocks. They will continue to build the portfolio on a bottom up basis, using a “growth at a reasonable price” approach that looks for high quality companies with a history of repeatable and sustainable growth, that are trading at a discount to its growth prospects.
The fund will likely remain concentrated, holding in the neighbourhood of 35 names. As of September 30, the top ten holdings made up approximately 45% of the fund. Portfolio turnover has been modest, averaging less than 20% per year. However, in periods of high volatility, for example 2008 and 2009, the managers are not afraid to be very active, using the volatility as an opportunity to improve the quality of the portfolio.
Performance has been decent, approximately matching that of the S&P/TSX Composite Index. A notable exception was 2011, when the fund dramatically outperformed the index. Volatility of the fund is typically lower than both the index and the category average.
It pays a monthly distribution of $0.025 per unit, which at current prices works out to an annualized yield of approximately 2.7%. Looking at the yield of the underlying holdings and the expected return profile, it is our expectation that this level of distribution is sustainable going forward. It is also available in a T-Series, which pays out an annualized yield of approximately 8%. At this level, we do expect some degree of capital erosion over time.
While we don’t expect to see substantial changes as a result of this manager departure, there may be some. We will continue to monitor it to see if we notice any level of erosion to the risk reward profile of the fund.
TD Latin American Growth Fund – As interest in the emerging markets continues to grow, it’s not surprising that some investors may way want to add additional exposure to particular developing regions such as China and Latin America. This fund is one of only a handful that is focused on Latin America.
It invests in companies that are located in Mexico, Central America and South America. As of December 31, it was 54% in Brazil, 26% in Mexico and 10% in Chile. Christina Piedrahita and Gaite Ali of Morgan Stanley manage it. When considering a company for inclusion in the fund, the look for those with sustainable competitive advantages and compelling long term growth opportunities.
Their approach is fairly patient, with portfolio turnover averaging a very modest 40% for the past five years. The portfolio is well diversified, holding 55 names with the top ten making up just over 40% of the fund.
Performance has been largely uninspiring, with a five year annualized loss of 2.4% as of December 31, which is middle of the pack for the other Latin America focused funds. Like other geographically focused funds, it is significantly more volatile than the broader equity markets. In fact, it is about 1.5 times more volatile than the MSCI EAFE Index.
While we understand the appeal of a fund like this, it is our opinion that most investors are best served using a more broadly focused emerging markets fund. These funds provide the managers with considerably more leeway in managing the funds. But, for those looking for pure Latin American exposure, this isn’t a bad option.
Considering the volatility profile, it is our opinion that this is only suitable for those investors with a very high-risk tolerance and who are comfortable with the risk of a big drawdown.
Sprott Silver Bullion Fund – This fund does just what you expect it to do – it holds unencumbered, fully allocated silver bullion and silver certificates. All for an MER of 1.71%.
Many investors view silver in a similar way to gold in that it helps to provide some protection against currency devaluation and inflation. Unlike gold however, silver does have a number of uses in many industrial applications, which can help to underpin its value. Despite this, it has been quite volatile since its launch.
While there may only be a handful of options available for those looking for exposure to silver bullion, it is our opinion that there may be better options available. Given that the fund is a buy and hold vehicle, we feel that the 1.71% MER is too expensive. Instead, we would suggest that investors look at a couple of ETFs which will provide similar exposure at a much lower cost – iShares Silver Bullion Fund (TSX:SVR) or the Horizons COMEX Silver ETF (TSX:HUZ).
Brandes Global Small Cap Equity Fund – Managed by the Brandes Investment Committee using a bottom up, Graham and Dodd, value focused approach, this global focused small / mid cap fund is looking to build a diversified portfolio of businesses that are trading below their estimate of true value. As of September 30, the fund held 73 names with the top ten making up just under 30% of the fund.
Given the fact that the portfolio is built on a stock-by-stock basis, sector weights are the by-product of stock selection, which means that the portfolio will quite often look dramatically different from its benchmark index. That does not mean that there aren’t risk controls in place, quite the contrary. For example, the maximum weight of any one security in the portfolio will be capped at 5%, and sector weights cannot exceed the great of 20% of the fund or 150% of the index. It can also invest up to 20% of the fund in emerging markets.
Performance has been very strong, gaining 34% in 2012 and has an annualized five-year return of 4.1%, handily outpacing the benchmark and most of the peer group. A drawback is that it is more volatile than the category average and the benchmark. As a result, it is susceptible to big drawdowns in falling markets as evidenced by performance in 2011, 2008 and 2007 when it underperformed the index.
This is not a fund for everybody. In our opinion, it is only suitable those able to accept the higher volatility of this fund. However, we believe that it has the potential to earn strong risk adjusted returns over the long term.
Bissett Microcap Fund – Like the name suggests, this fund invests in those very small companies which have a market capitalization of less than $350 million. In reviewing potential investments for the portfolio, the management team uses a bottom up, growth at a reasonable price process that looks for companies that have strong balance sheets, low valuation risk, and a profitability profile that is better than the index.
Their approach is fairly patient, with portfolio turnover averaging 25% for the past five years. They can also be somewhat opportunistic with the
fund, using periods of market weakness as an opportunity to strengthen the portfolio.
Previously capped, the fund was reopened in October 2012. Performance of the fund has been strong, gaining 25% in 2012. During this period, a portion of the gains the fund realized were the result of a number of the fund holdings being taken over by larger rivals. For the five years ending December 31, the fund gained 8.4%, outpacing much of its peer group.
Despite the strong longer term performance numbers, this fund is not for everybody. First, this fund has been volatile. It has a standard deviation that is nearly 1.5 times that of the broader S&P/TSX Composite Index. In 2008, it was hit hard, dropping nearly 50%. After that drop it rebounded in 2009 and 2010, gaining 55% and 54% respectively. Given the risk profile of the smaller cap funds it invests in, we don’t expect that volatility will decline substantially as we move forward.
Another drawback to the fund is that it is expensive. The MER is listed at 3.78%, which is more than 120 basis points higher than the category average. While returns have made up for this above average cost, should we hit a period of modest returns, it is a big hurdle for the managers to clear.
While we like this fund, it is our opinion that it is best suited for investors who have a very high risk tolerance that are looking for above average gains over the long term. Given the high levels of volatility, portfolio exposure should be limited for most investors. Those with lower risk tolerances looking for small cap exposure should take a look at Sentry Small Mid Cap Income Fund, Beutel Goodman Small Cap or the BMO Guardian Enterprise Fund. All will offer small cap exposure at a lower cost and less volatility risk.
CI Signature High Income Fund – Managed by Eric Bushell and his Signature Team, the fund has the objective of generating a high level of income and long-term capital growth. This is a fund that has excelled at both. It pays investors a monthly distribution of $0.07 per unit, which works out to an annualized yield of approximately 6.1% at current prices. Investors have also been rewarded with strong first quartile performance from the fund since its inception.
The fund invests in a balanced portfolio of high yielding equity securities and a mix of Canadian fixed income, the bulk of which will be corporate bonds. The approach used is very collaborative and style agnostic. When reviewing any investment candidate, the Signature team reviews the entire capital structure of a company to get a more complete view of the company. They also pay attention to many qualitative aspects of the company such as management, disclosure and governance. The team also develops a comprehensive outlook for economic growth, interest rates, capital market conditions and geopolitical tensions which helps identify the asset classes and sectors which are most likely to benefit.
As of December 31, the fund held nearly 60% in cash and fixed income and 30% in high yielding Canadian securities such as REITs and energy trusts. On the surface, this appears to be a fairly conservative mix. However, looking at the makeup of the fixed income sleeve, there is a significant weighting in corporate and some high yield exposure. While this mix will outperform in a flat or rising rate environment, the lack of government bond exposure could result in bigger drawdowns, similar to what happened to the fund in 2008.
The fund carries a low MER of 1.61%. This is a great fund for most investors, as it is relatively conservative yet offers a high income yield and strong growth potential.
Considering this, it is our opinion that this may be a good fund for investors who are looking for a fund that can deliver a decent yield and solid risk adjusted returns over the long term. However, investors should be aware that this fund might be prone to periods of higher volatility.
Is there a fund you would like us to review?? Please send any requests for fund reviews to feedback@paterson-associates.ca.
January’s Top Funds
PH&N Total Return Bond Fund
| Fund Company | Phillips, Hager & North Investment Management |
| Fund Type | Canadian Bond |
| Rating | N/A |
| Style | Multiple |
| Risk Level | Low |
| Load Status | No Load / Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | P&N Fixed Income Team since July 2000 |
| MER | 0.60% |
| Code | PHN 340 – No Load Units PHN 6340 – Front End Units |
| Minimum Investment | $5,000 |
Analysis: While interest rates are likely on hold for the near to medium term, the fact remains that interest rates will be moving higher at some point in the future. Knowing this, many investors may be tempted to move out of fixed income and into even safer investments such as cash. In our opinion, this is not a wise move as we believe that fixed income investments should form a cornerstone of most investment portfolios.
When interest rates do move higher, the value of a fixed income investment will fall. But, not all fixed income funds are created equally. For example, those funds with more exposure to corporate bonds are expected to hold their value better. This is because corporate bonds typically pay a higher rate of interest than government bonds, which reduces their sensitivity to rising rates. Also, funds that have a shorter term to maturity are also expected to hold their value better when rates move higher.
The PH&N Total Return Bond Fund both of those covered. As of December 31, it has significant exposure to corporate bonds, holding 43% of the fund in corporates and 6% in Government of Canada bonds. The fund also has a healthy 32% exposure to provincial bonds, which offer high yields than Canada’s and should outperform in a rising rate environment. It has a shorter average term to maturity than the benchmark DEX Bond Universe, and nearly half the fund is in bonds with maturities of less than 5 years. It is a very high quality portfolio, with nearly 85% rated “A” or better.
The fund is managed in a very similar fashion to the PH&N Bond Fund, but can use a number of nontraditional strategies including the use of high yield bonds, mortgages and derivatives. Because of this, it has outpaced the PH&N Bond Fund of late and we expect that trend to continue in the near to medium term. This opinion is based on two key factors. First, the managers have a number of different strategies in their toolbox that will allow them additional flexibility to add yield and protect capital. Second, it has a smaller asset base, which should allow the managers to be more nimble in managing the fund.
We believe that this fund is a great core holding for most investors. It exhibits relatively low levels of volatility and has shown low to negative correlation to the major equity asset classes. This will allow it to help reduce the overall volatility of your portfolio and help provide better downside protection in volatile markets.
RBC North American Value Fund
| Fund Company | RBC Global Asset Management |
| Fund Type | Canadian Focused Equity |
| Rating | B |
| Style | Large Cap Blend |
| Risk Level | Medium |
| Load Status | No Load / Optional |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Stuart Kedwell since May 2005 Doug Raymond since May 2005 |
| MER | 2.10% |
| Code | RBF 554 – No Load Units RBF 766 – Front End Units |
| Minimum Investment | $500 |
Analysis: The team of Stuart Kedwell and Doug Raymond use a multi stage portfolio construction process that incorporates both quantitative screening and fundamental, bottom up analysis.
The first stage in their process is a series of quantitative screens that weed out the undesirable companies in their selection universe. Then the team conducts a fundamental analysis on each of the companies and conducts a series of scenario analysis, looking at a wide range of possible outcomes for each stock. Stocks are also evaluated using a 2 Factor Matrix Model that evaluates earnings projections relative to valuation. They are looking for companies that are attractively valued, are fundamentally sound, and offer above average returns on capital.
The fund can invest up to 49% in non-Canadian stocks. They look at both Canadian and U.S. stocks, with the country allocation being a by-product of the stock selection process. The fund’s cash position will be determined by two main factors; the availability of quality opportunities and the team’s macro call on the markets. As a policy, half of the fund’s foreign currency exposure is hedged.
The portfolio tends to be fairly well diversified holding more than 100 names, with the top 10 making up 22% of the fund. The managers do tend to be active, with high levels of portfolio turnover.
The fund has performed very well of late, outpacing the S&P/TSX Composite and its peer group, posting solid first quartile performance. Volatility of the fund has also trended lower than both the broader market and the Canadian equity category average.
In recent months, the managers have been increasing their exposure to the U.S. market. As of November 30, the fund was 43% in Canadian equities, 45% in U.S. equities, 3% in international equities and 9% in cash. The three main sectors are financials, energy and consumer discretionary, which combined make up 58% of the fund.
We like the fund for a number of reasons including the management team and process, a reasonable 2.10% MER, the volatility profile of the fund, and the fact that the fund is still small enough at $654 million to allow the managers to implement their process. Asset growth has been strong, adding more than $200 million in 2012. We will want to monitor this to ensure that the fund doesn’t get too large, however, given the ability to invest up to 49% outside of Canada, the managers do have a great deal of flexibility which should enable them to implement their process for some time.
Beutel Goodman American Equity Fund
| Fund Company | Beutel Goodman Company Ltd. |
| Fund Type | U.S. Equity |
| Rating | B |
| Style | Large Cap Value |
| Risk Level | Medium |
| Load Status | No Load |
| RRSP/RRIF Suitability | Excellent |
| TFSA Suitability | Excellent |
| Manager | Gavin Ivory since February 2006 Glenn Fortin since June 1997 |
| MER | 1.43% |
| Code | BTG 774 – No Load Units |
| Minimum Investment | $5,000 |
Analysis: The Beutel Goodman American Equity Fund is managed using a highly disciplined, bottom up value approach that places a great deal of emphasis on capital preservation, with a focus on delivering absolute returns and managing risks. To achieve this, the managers look to identify high quality, well managed, dividend paying companies that have a history of generating stable cash flows and have earned a level of return that is greater than the company’s cost of capital. Put another way, the “look for companies that have shown a commitment to create shareholder value without undue financial leverage.”
Given the value bias used, any company considered for inclusion in the portfolio must not only be undervalued, but have the ability to grow their share price closer to its intrinsic value within a three year period. When evaluating a company, they pay particular attention to the price to earnings, price to cash flow and price to book ratios in the context of not only the company’s historical numbers, but also compared to the market and what the management believes to be the company’s sustainable earnings growth rate.
The result is a concentrated portfolio of U.S. based large cap companies that are leaders in their field. As of September 30, it held 29 stocks with a top ten making up 44% of the fund. It is defensively positioned with minimal exposure to commodities and deep cyclical, high beta stocks. Instead, they favour consumer and financial names, which currently make up the bulk of the portfolio.
They are patient in implementing their process, with portfolio turnover averaging 33% for the past five years. That said, they are not afraid to use periods of heightened volatility as an opportunity to improve the quality of the portfolio. This happened in 2008 and again in the first half of 2012 when several new names were added to the portfolio including Halliburton, Bemis, and JP Morgan Chase.
Performance has been impressive, generating and annualized return of 3.7% for the past five years, compared with a modest 1.6% return for the S&P 500 during the same period. It also has decent downside protection, holding up well in 2008, losing less than half of the index’s 23% drop. Overall volatility is also somewhat lower than not only the broader market but also many of its peer group.
Another positive is the relatively low MER of 1.49%, which is well below many of its competitors.
On balance, this is one of our top picks in the U.S. equity category. We believe that it will continue to deliver better than average risk adjusted returns for investors over the long term.
BMO Guardian Enterprise Fund
| Fund Company | BMO Investments Inc. |
| Fund Type | Canadian Small / Mid Cap Equity |
| Rating | B |
| Style | Small Cap Blend |
| Risk Level | Medium High |
| Load Status | Optional |
| RRSP/RRIF Suitability | Good |
| TFSA Suitability | Good |
| Manager | Martin Ferguson since August 2004 |
| MER | 2.25% Classic Units 2.75% Mutual Units |
| Code | GGF 464 – Front End Units GGF 179 – DSC Units |
| Minimum Investment | $500 |
Analysis: This Canadian small/mid cap fund is virtually identical to the highly respected Mawer New Canada Fund, which has been capped to new investors for some time. While there may be some differences between the holdings, the overwhelming majority of the fund will be the same.
Both are managed using a bottom up, “growth at a reasonable price” approach that looks for wealth creating small cap companies with the ability to grow. The investment universe is limited to only those companies that have a market cap of less than $1.2 billion. When evaluating a company, they look for those that have a sustainable competitive advantage and the ability to deliver a high return on invested capital. Any stock in the portfolio must be trading at a level that is less than their estimate of its true worth, which is determined using discounted cash flow models.
The end portfolio is concentrated, holding between 40 and 60 names. As of December 31, the top ten holdings made up 46% of the fund. While sector weights are largely the byproduct of the stock selection process, there are some limits put in place for risk management purposes. The maximum weight for any one company is capped at 6%, while the maximum sector exposure is set at 20%. Management is fairly patient in their execution, with portfolio turnover averaging less than 20% for the past five years.
Costs are reasonable to high, with an MER of 2.25% for the “Classic” units and 2.75% for the “Mutual” units.
Long-term performance has been strong, with a five year annualized return of 5.8% as of December 31. In comparison, the BMO Nesbitt Burns Small Cap index posted a loss of 0.4% during the same period.
Considering all the above, it is our opinion that investors who are looking for small / mid cap Canadian equity exposure may want to consider this fund. It is more volatile than a fund that invests in large cap stocks, and investors should consider the risks when determining the concentration within their own portfolios.