Manager Insight

Duncan Anderson prefers to view portfolio building as akin to constructing a conglomerate.
By Michael Ryval | 19/07/18

Many Canadian investors have adopted a passive approach to equity investing based on the premise that the benchmark S&P/TSX Composite Index has served them well during the recent bull market. But while they may also be assuming that the traditional dividend-paying stocks that underpin the index are safe, investors are taking on too much risk, argues Duncan Anderson, senior managing director at Toronto-based Manulife Asset Management.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

Anderson, who is part of a team that oversees about $21 billion in assets, says it is far better to adopt a bottom-up approach to stock-investing. "A passive approach in different markets can have different effects. More specifically, we think the S&P/TSX Composite Index is a 'bad' or riskier index. The risks embedded in it are much higher than, say, the S&P 500 Index," says Anderson, whose mandate includes the 5-star rated $1-billion Manulife Dividend Income Plus.

The key reason, he notes, is that the financials, energy and materials sectors, in aggregate, account for 66% of the benchmark. "Those three large sectors are all cyclical, and as we enter this final phase [in the bull market] they are outperforming. It's been the pattern for the last year, as we have seen interest rates move up."

Active managers such as Anderson and his team, who make no attempt to replicate indices, face more challenging markets since they have little exposure to the three dominant sectors. "But what most people forget about a market-weighted index is that by its nature it is a momentum-based strategy. The stocks that do well tend to garner a larger weight in the index, which then attracts more dollar-flow, which goes into these stocks. It becomes a virtuous circle."

The risk is that this can work the other way, too, and as money flows out, it can turn into a vicious circle on the way down. "Now the selling will be aimed at the big names, which puts pressure on the index and causes more people to sell out of the index, which in turn puts pressure on those names," says Anderson, a 19-year industry veteran who joined Manulife Asset Management in 2002 after a stint in mutual fund sales and earning a BA in economics from York University in 1999.

Investors have profited by owning large, dividend-paying stocks, which have delivered year after year as interest rates kept falling for several decades. "Most people have only experienced declining rates. But we could be entering a new phase as interest rates start to rise. The conventional thinking around dividend-paying stocks being 'less volatile and more safe' will be questioned. A passive approach, of simply buying and holding these stocks, may not be the best approach going forward."

For his part, Anderson argues that being an active investor is especially critical at this point in the cycle, when there is so much uncertainty about the effect of rate-tightening by central banks and when, and how, the cycle may end. "We are not macro investors. For us, it's not about predicting where markets are going, but about properly risking our portfolio," says Anderson. "Instead of having to predict where short-term and long-term rates will be, and determining the potential impact, we stand back and ask, 'How do we try to be conservative and protect ourselves if interest rates rise?' In our valuation work, we've developed a methodology for doing that."

The key is flexibility, which is reflected in the "plus" in the fund's name. "We have the ability to add non-dividend payers to our portfolio. At certain times, there is a risk to focusing only on yield. It's particularly risky now, with defensive names such as  Enbridge (ENB), which has come under pressure in the last year because rates have been rising." Instead Anderson is focusing on companies that are reinvesting their earnings rather than paying out dividends. "These companies that can grow will be less interest-rate sensitive. They will be able to grow at a higher rate than the implied discount rate that is going up."

Running a portfolio of 62 companies, Anderson describes the process as building a very large conglomerate with scores of diverse businesses. "We ask ourselves, 'What in aggregate do we want that large company to look like?'" says Anderson, adding that the conglomerate concept arose out of the team's need to think about portfolio construction in the absence of an index. Significantly, the fund has a global focus, as only 55% of the portfolio is Canadian, with 23% in the United States, 3% in international markets and 19% in a mixture of cash and convertible debentures.

"The reason we believe this approach is effective is because we are creating a portfolio that looks so different from the benchmark," Anderson continues. "We can't start with a benchmark, as traditional managers do. We need to think about how we can out-perform and how can we de-risk our portfolio. We want our conglomerate to have the attributes of what we believe are some of the best-performing wealth-creators."

One representative name is  Alimentation Couche-Tard (ATD.B), one of the world's largest operators of convenience stores and gas stations. The firm, which has a market cap of $33 billion, is in a negative light because of the expectation that the growth of electric vehicles will severely impact gas sales. "There is a view that not only are combustion engines going to die, but that there will be massive reclamation costs as Couche-Tard will have to clean up their properties."

Yet Anderson is positive on the stock and believes there is 65% upside. "We have an opportunity to own a non-cyclical, and its valuation is cheap because of this overhang," says Anderson, adding that Couche-Tard has demonstrated 8% annual revenue growth.

Although it's a smaller weight, Fevertree Drinks is also favoured, mainly for diversification and re-investment purposes and because the UK-based soft drinks maker is attracting consumers willing to pay for its premium-priced products. "They are focused on lower consumption, but a higher-priced quality product. And they are taking share globally."

Fevertree, which had revenue last year of 170 million pounds sterling, has been growing at 200% annually for the last three years. "Can they achieve those growth rates forever? Obviously it's impossible. That's why it's a smaller weight. But as long as those type of growth rates continue, it has more than 300% upside."

Looking ahead, Anderson argues that an approach based on fundamentals will prove itself over the longer run. "But when prices move absent the fundamentals [in the short term], that's when it becomes a little more difficult."

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