Encounter

Michael O'Brien adds to his holdings in railways, energy.
By Sonita Horvitch | 15/03/17

Michael O'Brien, managing director and head of the core Canadian equity team at TD Asset Management Inc., is tilting his big-cap Canadian equity portfolio toward those sectors and companies which tend to do better in a stronger global economic environment.

About the Author
Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

"The industrials, notably the rails, and energy companies stand to gain from the current reflationary climate," he says. Then, the financial-services sector, the banks and insurers, do well when interest rates bottom and start to rise gradually. "I think that we are finally at this inflection point in interest rates, after a number of false starts."

O'Brien reports that he has been adding to his weightings in the railways, energy and the insurers. "We have also kept our overweight position in the Canadian banks," he says. "They represented significant value at the beginning of 2016, but this is less the case now."

He has underweight positions in the defensive sectors, "but there are sufficient uncertainties to warrant caution and I will continue to maintain a position here." He has changed the composition of his defensive holdings. "I am moving away from high dividend-paying, more mature companies, such as telecommunications services, which could face headwinds from rising interest rates."

Instead, he is targeting those companies that have stable businesses combined with reasonable earnings and dividend growth, though he cautions that "those dividends are growing from a low base." Here he is "finding candidates in the consumer-staples sector, for example, among the grocers." Pipeline stocks, he says, are also part of his defensive play. "These companies are growing their dividends and this should help to offset the impact of rising rates."

Looking at the macro picture, O'Brien notes that economic data point to a major turnaround in the global economy. "It is broader than just a strong showing from the United States." A key indicator of this, he says, is the strength of the benchmark core commodity-price index, which bottomed in May 2016, "when it moved out of bear-market territory."

Of this commodity index's constituents, oil bottomed in February 2016, he notes, and copper in the late summer/fall of last year. In general, he says, the positive economic data was evident before Donald Trump's U.S. election win on Nov. 8. "The new U.S. administration is committed to boosting the U.S. economy through a variety of measures, some better than others, but all of which are likely to have a reflationary bias."

Michael O'Brien
Michael O'Brien

At TD Asset Management, O'Brien is responsible for some $7.6 billion in assets. He is lead manager of TD Canadian Equity, his flagship fund, which has assets of $5.1 billion. Benchmarked against the S&P/TSX Composite Index, the fund is permitted to have foreign content of up to 20%. It is currently 11% foreign.

In keeping with his greater emphasis on companies that will benefit from the improved North American and global economic outlook, O'Brien has been increasing his overall exposure to the railways. In the last quarter of 2016, he started building a position in  Canadian Pacific Ltd. (CP). "Given the upsurge in the demand for commodities, CP will benefit from the fact that it has a big bulk-commodity business." Also, he notes that CP has become more efficient due to the intervention of shareholder activist William (Bill) Ackman's hedge-fund company, Pershing Square Capital Management L.P., in late 2011.

There was a subsequent change in CP's top management and its governance, and the stock took off, says O'Brien, "to the point where its valuation left little room for disappointment." Last August, Pershing Square sold the remainder of its shares in CP. "Since then, CP shares have retreated to more attractive valuations." The stock, says O'Brien, recently traded at 17.4 times earnings-per-share estimates for 2017 versus the median P/E ratio over the past decade of 17.1. "While the forward P/E ratio is in line with the historic valuation, it is a much improved company."

The TD fund, O'Brien says, has for some time had a significant position in  Canadian National Railway Co. (CNR). The company "continues to be an outstanding operator." But he notes that its price/earnings multiple, at 19.5 times 2017 estimates, is above CNR's median P/E ratio over the last decade. "The company, as is its style, has issued conservative estimates for its outlook for 2017, but the equity market considers that there is upside to the estimates."

A U.S. railway stock in the portfolio is  Union Pacific Corp. (UNP). "It operates in the western United States and has a high-quality franchise," O'Brien says. "Like CNR and CP, Union Pacific will benefit from the improvement in U.S. economic growth."

Canadian National
Railway Co.
Canadian Pacific Ltd.
Mar. 13 close$97.83$199.37
52-week high/low$98.23-$72.78$209.12-$156.01
Market cap$74.2 billion$29.1 billion
Total % return 1Y*24.415.2
Total % return 3Y*17.66.0
Total % return 5Y*21.621.9
*As of Mar. 13, 2017
Source: Morningstar

Turning to energy, O'Brien is optimistic about the outlook for the fundamentals and the price. "But until inventories both in North America and globally are drawn down consistently, investors will not believe that the supply/demand equation is balanced."

An immediate cloud on the horizon for Canadian energy producers is the possibility of a U.S. border-adjustment tax, he says. "There is a question as to how this will affect imports of Canadian energy into the United States." One possible political deterrent to the U.S. administration, says O'Brien, is that the imposition of such a tax could raise the cost of gasoline to Americans at the pump.

Canadian energy stocks have been among the poorest performing sectors of the S&P/TSX Composite Index so far this year, O'Brien notes. "I used this retreat to add to holdings of energy producers in recent months." This includes additions to the fund's largest three energy weights:  Suncor Energy Inc. (SU),  Canadian Natural Resources Ltd. (CNQ) and  Cenovus Energy Inc. (CVE).

Reinforcing O'Brien's positive outlook for Canadian energy producers is the move by the federal Liberal government last November to approve two pipeline projects, the TransMountain Expansion Project of  Kinder Morgan Inc. (KMI) and the Line 3 Replacement Program of  Enbridge Inc. (ENB). It is still unclear, he says, under what conditions President Trump will approve the Keystone XL Pipeline project of  TransCanada Corp. (TRP). "But the move by Ottawa to give the green light to the two projects is an important step toward substantially enhancing the market for Canadian energy producers."

At the end of February, Enbridge and TransCanada were among the top-10 holdings in TD Canadian Equity. "Both pipeline companies have made transformative acquisitions in the United States and will deliver strong dividend growth over the next five to 10 years."

In the financial-services sector, O'Brien reports that he has taken some money off the table in Canadian bank stocks, "but they still represent 28% of the portfolio." These stocks performed well in 2016 after a hesitant start, he says, and "they are now trading at valuations toward the high end of their historic range." He deployed the proceeds in the fund's existing holdings of insurers, "as these stocks had pulled back." This included additions to  Manulife Financial Corp. (MFC) and  Power Financial Corp. (PWF), the parent of insurer  Great-West Lifeco Inc. (GWO).

In keeping with his strategy for the defensive portion of TD Canadian Equity, O'Brien reports that he has been selling down his position in the telecom-services company,  BCE Inc. (BCE). "This reduces the portfolio's exposure to names that are likely to be adversely affected by rising interest rates."

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