Equity

Did someone say conviction?

Conviction is one word that’s hard to come by during these uncertain times.
July 2020

Lutz Zeitler

Managing Director & Portfolio Manager, Head of Canadian Fundamental Equities, BMO Global Asset Management

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Conviction is one word that’s hard to come by during these uncertain times. Lutz Zeitler, Head of Canadian Fundamental Equities, BMO Global Asset Management, discusses his group’s active platform approach to generate long-term success, starting with a narrow focus on true quality and value – providing the confidence and assurance institutional investors need right now.

Avoiding short-termism by focusing on quality

While there is no denying the oil shock impact on the Canadian market, it has created a golden opportunity for long-term, actively managed strategies that can provide the necessary downside protection – and potential for upside – at the same time. Asset managers who select high-quality, sustainable business models have the ability to choose not to invest in companies that are driven by the volatility of underlying commodities. What has become all too clear is that the majority of energy and resource stocks are unable to manage operations in this type of uncertain environment, and are therefore not suitable for an investment style predicated on preserving value.

Our Canadian Fundamental Equities team uses a bottom-up, long-term approach as a shared, platform strategy across the funds we manage – from small-cap to the larger-cap focused BMO Dividend Strategy. In the truest sense of the word “long”, we seek quality companies that can compound earnings for the next 5-10 years, with the tools to withstand market downturns. It’s a disciplined process that’s defined by our confidence in our holdings over that extended timeframe, because quite frankly, we cannot predict the short term, and the Coronavirus crisis is the perfect example.

No one could have anticipated this eruption, and all that came with it, including the supply chain effects in China and slower consumer demand. These events – and their subsequent consequences – fall under the category of “short-termism”, which aside from unexpected macro problems, can also include any company-specific concern. We work to eliminate this market noise by avoiding a focus on near-term earnings that ensures institutional investors are chasing markets, rather than concentrating on the fundamentals and true business value longer term.

Our process: Business value vs. valuation

How do we assess business value?

A principle tenet to the process is our belief in the difference between business value vs. valuation, the latter of which, to most, involves a combination of near-term earnings prospects and the price to earnings ratio. However, the true quality of the business – and its compounding nature – is not reflected in near-term multiples. For example, Shopify has performed phenomenally well this year, and many are focused on the steep multiple at which it’s trading, but if you incorporate the company’s ability to grow at high rates of return over 5-10 years, one could argue the stock is rather inexpensive. It’s that sort of deeper analysis that we execute in our strategies to understand a company’s potential – from economic moat and recurring revenues to profitable, well-financed growth profiles and strong leaders with a clear vision that have a history of value creation.

Part of our “growth algorithm” assessment all relates back to the integral (yet underappreciated) culture of a business, which we think ultimately drives its quality, and mirrors the way we operate our own team. We’re strong believers in collaboration and accountability: our idea generation, strategy discussions and decision-making include all of our research analysts – even if they’re covering different sectors than the company in question – because of the diversity of thought that including everybody brings to the conversation. Assumptions are challenged at every meeting; this team-based culture is ingrained in our investment process, and facilitates our ability to generate superior risk-adjusted returns – just like it does at the businesses in which we choose to invest. Our interviews with management are an essential piece of our ability to forecast longer-term cash flows, and the company’s competitive dynamics. In fact, for the BMO Dividend Strategy in particular, we view the ability to generate sustainable dividend growth as an indication of the leaders’ discipline, alignment and culture of success.

ESG, or environmental, social and governance, analysis is also at the heart of our platform process. It’s not just a tag-on consideration, because it affects a company’s future prospects, which has become all the more evident in light of the COVID-19 crash and recent shareholder scrutiny. Does management care about the health and safety of its employees? Do they care about environmental impact? Does the company’s board reflect diversity? Aside from the fact that responsible investing (RI) is the right course of action as stewards of capital, all of these issues have a material impact on long-term shareholder value, and ignoring them can have a serious detrimental effect on investment returns. For example, prior to the Coronavirus, many service companies may not have appreciated the risk that employee health and safety poses to their long-term business model.

At BMO Global Asset Management, we have the benefit of a dedicated, in-house RI team of 19 specialists that we use as consultants for our portfolio decisions. When we analyze an industry, or a company within, we will meet with these experts to gain a better understanding of the sector-specific issues, and what types of questions we need to consider when we’re conducting due diligence. As part of our active ownership commitment, we then log their answers, allowing us to fully engage with management teams on their progress the next time we meet with the company’s C-suite. In doing so, we’re influencing positive change, which not only improves society, but the quality of our investment as well.

Keeping it concentrated: High conviction leads to higher exposures

Our in-depth, rigorous investment process allows us to gain the confidence and conviction we need to create – and manage – concentrated portfolios. As active managers, we feel that at a certain level, further diversification no longer generates incremental benefits and only dilutes a manager’s ability to generate added value through active exposures. Every single holding that we own is based on its investment merit alone. Importantly, investors should think about their portfolio holdings as real estate. When you buy marginal quality stocks for benchmark purposes, you’re wasting valuable real estate within the portfolio that could be allocated toward higher conviction, differentiated companies that deliver robust returns, and can thrive regardless of economic environment.

Number of holdings

Number of holdings

Source: BMO Investment Strategy Group, unweighted. As at March 31, 2020 (analysis begins in January 1990).

BMO Dividend Strategy: Our stats

  • 17.9% expected portfolio ROE
  • 5.4 years weighted average holding period
  • 10% gross one year dividend growth rate
  • 39 names in the portfolio
  • 93%/78% five year upside/downside capture 

 

Source: BMO Global Asset Management, Bloomberg, May 2020.

Risk management is inherent in our process

To maintain a high-quality, concentrated approach, ongoing monitoring, and consistent dialogue between management, and our portfolio managers and analysts is required. Since Coronavirus came onto the scene in March, we have connected with all of our holdings to better understand the strength and depth of their investment moat during these unprecedented times, and we’ve only made slight weight changes to the portfolio after analyzing risk/return profiles with a new lens. For example, we’ve added to our multi-residential REIT exposure, such as Killam Apartment Real Estate, because we think these stocks have been unduly punished by the crisis due to fear of unemployment resulting in residents not being able to pay rent. However, taking a long-term perspective, we know that the economy will inevitably recover, while immigration is another strong tailwind for these properties over the next 5-10 years, despite the current, temporary slowdown. All of our holdings represent themes that we believe are relevant going forward, from renewable energy and global infrastructure to a cashless society and the mobile consumer. For us, it’s not about what’s performing now, or even over the next 1-2 years; while gold stocks may be rising, we will still not invest because of their inability to differentiate themselves from the competition, and the volatility of the commodity price. They simply do not fit our investment criteria, and as a result, we’re comfortable avoiding these low-quality rallies in favour of long-term success. Similarly, despite the negative rhetoric on Canadian banks, we’re bullish on these stocks because they’re well-capitalized assets proven to provide income stability, growth and resilient dividends, which they did even during the 2008 Financial Crisis. Focusing on the bigger picture, they offer predictability of earnings in an oligopoly environment, which is attractive, especially in light of where they’re valued currently.

As diligent as we are in our purchases, we exert the same skill and expertise in our sale decisions. We’re constantly reassessing our portfolio and determining whether companies have that critical ability to protect their business from the competition, and by doing so, are able to grow at above-market rates. If we believe there is permanent structural impairment, we will make changes to assure our portfolios are positioned for long-term value creation. Case in point: we invested in Cineplex at its IPO in 2003, and held our position until 3 years ago because the company had a long-standing monopoly of Canada’s theatres, which we thought secured its economic moat even through the advent of home entertainment and surround sound speakers in the early 2000s. When Netflix and other streaming services appeared, however, the story quickly changed with the production of high-quality, direct-to-consumer content, and the competition began to reflect in theatre attendance. That’s when we decided we were no longer confident in the sustainability of the business model, and by extension, its value proposition. It’s an ideal example of how a company can offer differentiated products and services for a long period of time only to have new competition quickly alter its moat.

In a concentrated portfolio – like our BMO Dividend Strategy – all of the holdings are at risk of being replaced by a new, and better idea, and that is the opportunity cost of owning a smaller group of 35-40 high-quality names, with high returns on capital. That is why we continually review our assumptions, ensuring only the best investment opportunities reside in our portfolio. While there are many mediocre, or even good, businesses, there aren’t many great businesses that inspire the highest conviction.

An inside look into 3 high conviction names:

WSP Global – International engineering company that we believe is poised to benefit from the massive infrastructure demand globally, and that is already set to take advantage of remote working capabilities, ideally positioning them for the post-COVID-19 economy.

Northland Power – With a long-term view, the runway for growth for this global renewable energy company is tremendous given the eventual reckoning we expect from an environmental standpoint, as the need to replace hydrocarbon fuel increases.

Brookfield Infrastructure Partners – A pure play on global infrastructure, benefitting from Brookfield Asset Management sponsorship, and a strong history of shareholder returns. We believe the company’s organic growth is underappreciated, with growing free cash flows to support above average dividends.

BMO Dividend Strategy: Confident in the long term

Managers that think long term – and invest long term – will naturally gravitate toward the highest quality business models, because it is these companies that can withstand the “short-termisms”, and come out the other side. It’s no coincidence that one-fifth of the S&P 500’s market cap in April was accounted for by 5 big tech companies, including Apple, Microsoft and Amazon.1 Whether it’s through strength of brand, scale, industry knowledge, or customer relationships, the ability to protect from the competition, grow dividends and compound earnings is vital in terms of reducing volatility, and securing returns for institutional investors through any economic climate. That’s why our portfolios have been performing as expected, reflecting our ability to choose companies that can responsibly and sustainably add significant value over the next several years.

Ultimately, we’re investors for the long haul, and this has created tremendous opportunity because even though some of our holdings have experienced instability, we’re confident that stock prices will inevitably follow fundamentals. And we have the track record to support our bedrock beliefs, with significant outperformance relative to representative benchmarks and peers (see below). It’s this unwavering commitment to our process – even during these chaotic times – that differentiates us the most, and has resonated with all of our investors since our funds’ inceptions.

BMO Dividend Fund - Trailing Returns

Trailing Returns 1-Day 1-Week 1-Month 3-Month YTD 1-Year 3-Year 5-Year 10-Year 15-Year Since Inception

Total Return %

2.99

-0.97

8.63

-16.11

-12.86

-6.16

3.33

4.07

7.01

N/A

7.55

+/- Category

-0.18

-0.57

-1.31

3.49

4.55

7.34

5.17

3.44

2.25

N/A

N/A

+/- Index

-0.32

-2.33

-5.00

1.36

2.12

4.19

3.18

2.36

2.19

N/A

N/A

Morningstar Rating

N/A

N/A

N/A

N/A

N/A

N/A

4 stars

4 stars

4 stars

N/A

N/A

Quartile Rank

Third Quartile

Third Quartile

Fourth Quartile

First Quartile

First Quartile

First Quartile

First Quartile

First Quartile

First Quartile

N/A

N/A

Percentile Rank

63

74

83

22

21

13

3

8

8

N/A

N/A

Number of Funds in Category

534

534

534

534

534

523

435

345

184

55

N/A

Fund return as of April 17, 2020. Morningstar Rating as of March 31, 2020. Category: Canadian Dividend and Income Equity as of April 17, 2020. Index: S&P/TSX Composite TR as of April 17, 2020. Inception date: November 3, 2008. Time periods greater than 1 year are annualized.

Disclosures

1 “Only a Handful of Stocks Are Helping the Market Rally. Why That’s a Bad Sign,” Barrons.com, April 27, 2020.

Not intended for distribution outside of Canada.

Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations.

This communication is intended for informational purposes only and is not, and should not be construed as, investment, legal or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Past performance does not guarantee future results.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

Commissions, trailing commissions, management fees and expenses may be associated with mutual fund investments. Please read the fund facts or prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

BMO Mutual Funds are offered by BMO Investments Inc., a financial services firm and separate entity from Bank of Montreal.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms.

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under licence.

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