Canadian General Investments — Update 19 September 2016

Exhibit 2 (left-hand side) shows the performance of the S&P/TSX Composite and FTSE World indices over the last 10 years. Canadian stocks have lagged global markets over this period, but there have been significant periods of outperformance such as following the global financial crisis, between mid-2013 and Q314 and since January 2016.

The recent period of Canadian stock price outperformance has been narrow. As shown in Exhibit 2 (right-hand side), materials is by far the best-performing sector year to date with a total return to the end of August of 46.8% versus the S&P/TSX Composite index performance of 14.5%. In a period of global stock market volatility, gold stocks have performed particularly well; within the index there are 51 materials stocks, of which 25 have more than doubled in price since the start of 2016. Energy, which was a significant underperforming sector in 2015, is now the second best performing sector year-to-date following a partial recovery in the oil price.

It would not be unreasonable to expect the performance of the Canadian stock market to be more broadly based in future, which may appeal to investors wishing to have exposure to a fund invested widely across sectors within the country, along with selected investments in the US, covering businesses that are generally not available in Canada.

CGI was established in 1930 and is North America’s second-oldest closed-end fund. Since 1956, it has been managed by Morgan Meighen & Associates (MMA), which has more than C$1.6bn assets under management. CGI is listed on the Toronto Stock Exchange (since 1962) and the London Stock Exchange (since 1995) and invests over the medium to long term in a broad selection of primarily Canadian equities, aiming to generate a total return higher than the benchmark S&P/TSX Composite index. CGI is designated as an investment corporation under the Income Tax Act (Canada), which eliminates a layer of taxation as capital gains are only taxed at the shareholder level and enables CGI’s capital gains to be paid as dividends to shareholders. However, to maintain investment corporation status, CGI is unable to repurchase its shares to help manage the share price discount to net asset value. In addition, not more than 25% of its gross revenue may be from interest income and at least 85% of gross revenue must be from Canadian sources. More than 50% of CGI’s shares are held by related parties, which ensures that management’s and shareholders’ interests are aligned. The five-year average portfolio turnover is 18.6%; it is currently running in the low- to mid-20% range as a result of selected repositioning within the portfolio.

The manager comments that the Canadian economy is far from homogenous. The west is a resource-based economy and has been affected by the low oil price and recent wildfires in Alberta. The Prairies are in a better position as the region is not so energy dependent and the agriculture environment is in reasonable shape. In Central Canada (Ontario and Quebec), although there has not been a pickup in exports, there has been an upturn in the financial, manufacturing and service industries.

Reflecting on the current oil price, the manager suggests that it appears well supported in the low $40s and that over the longer term the trend is likely to be for a higher rather than a lower oil price. CGI has been underweight energy since 2011, and in anticipation of an improving commodity price, the manager started to increase exposure early in 2016, acknowledging that stock prices move ahead of industry fundamentals. He believed that there would be shifts in the supply/demand balance for oil. The oil price has been weak due to the emergence of North American shale production, the magnitude of which means that this region has overtaken Saudi Arabia as the industry’s swing producer. Iranian production has come back on stream and OPEC members have continued to pump oil, so the manager wonders how much more oil can possibly come on stream. In North America, there have been some supply cutbacks as a low oil price makes production uneconomic, plus there have been supply disruptions elsewhere, such as in Nigeria.

The manager suggests there could be a period of volatility in global stock markets. Investors have issues to consider in coming months, including the magnitude and timing of US interest rate rises and the US election. Typically, in September, portfolio managers reassess their positioning for the balance of the year. If there is a pullback in the market, the manager will likely use the opportunity to further increase CGI’s energy exposure. He considers that at current levels the Canadian stock market is fairly valued; neither too expensive nor too cheap, and that investors have to accept that the environment is one of slow growth both in Canada and the US and around the world.

CGI invests primarily on a bottom-up basis, while being mindful of the macroeconomic environment. The majority of the portfolio comprises Canadian equities. However, up to 20% may be invested in US stocks, to gain exposure to areas of investment unavailable in Canada such as major internet retailer Amazon, which has the valuable Amazon Web Service cloud computing operation. US is the only non-domestic exposure permitted. The manager invests for the medium to long term, focusing on companies with positive fundamentals and good management teams generating consistency of performance that can grow their businesses over the long term. He seeks businesses with strong franchises, preferably companies with market-leading positions or that have a unique product offering. Portfolio companies generally have strong cash flow, solid balance sheets and attractive valuations. The manager is prepared to follow good management teams as companies transition. For example, top 10 position Franco-Nevada’s IPO was in 1983, before being taken over by Newmont Mining in 2002 and subsequently spun-off in 2007. Franco-Nevada has had a consistent management team throughout the changes in ownership and CGI invested in the latest IPO in 2007. CGI also invests in turnaround situations such as Canadian Pacific. Following shareholder activism and a change in the board, industry veteran Hunter Harrison was brought in as CEO. Canadian Pacific’s operating ratio has gone from being the worst to the best in the North American railroad industry; CGI has fully participated in the company’s turnaround. To enable payment of dividends, some higher-yielding stocks are held, including Bank of Montreal and oil/gas pipeline companies Enbridge and TransCanada. Despite the long-term nature of many of CGI’s investments, portfolio positions are continually assessed to ensure that their current exposure remains appropriate.

At the end of August 2016, the top 10 positions represented 34.2% of the portfolio, a slight reduction from 35.8% in the prior year. Six positions were common to both periods including Dollarama, the largest holding. It is the dominant dollar store in Canada and is many times larger than its biggest competitor. The manager considers the company has a lot of earnings growth ahead of it; same store sales are robust, margins are high and benefits are accruing from investment in technology upgrades. This is an example of a very long-term holding in the CGI portfolio, which has generated returns of nearly 10 times the original investment.

CGI’s bottom-up investment process can lead to large deviations in sector weighing versus the benchmark. Looking over the last 12 months, the largest increases in exposure are to materials, which is now overweight versus the benchmark, and energy, which remains modestly underweight the index. Within materials, the manager has added exposure to gold stocks such as Kinross Gold and Tahoe Resources and sector exposure includes positions in Methanex (chemicals), and CCL (packaging), which are not strictly resource stocks but are included in the materials sector. The largest reductions in sector exposure are financials and industrials. Consumer discretionary exposure remains one of the largest positive deviations versus the benchmark and includes top position Dollarama. Global growth is one of the manager’s favoured investment themes; within the consumer discretionary sector large positions in Magna (auto parts) and Gildan (leisurewear) are viewed as beneficiaries of this trend. Illustrating the manager’s underweighting in banks (which represent a significant percentage of the index); the financial sector is one of the largest negative deviations versus the benchmark.

Currently 13% of CGI’s portfolio is invested in US companies including AutoZone, which has been a strong performer for the fund. Unlike in the US, in Canada there is no strong player in the automotive aftermarket sector. The manager considers AutoZone a very strong operator that is consolidating a fragmented market both in the do-it-yourself (DIY) segment but also in the do-it-for-me (DIFM) segment, where the company has been less developed than the industry, which offers a lot of potential future growth opportunities. The manager highlights a recent purchase of shares in US-listed NVIDIA, a semiconductor company that focuses on the production of graphic chips; it followed a meeting with company management earlier in 2016. NVIDIA is viewed as being well positioned in growth areas of the market such as gaming, virtual reality and autonomous vehicles and has less commodity exposure than competitors such as Intel and Advanced Micro Devices. The company generates high margins and has a strong balance sheet.

Year-to date, the Canadian stock market has had a meaningful rally, led by previously beaten-down resource stocks. In an environment where the stock market leadership is narrow, CGI’s diversified portfolio may underperform the market. Year-to-date ending 31 August 2016, CGI’s NAV total return of 8.1% underperformed the benchmark’s total return of 14.4%. However, in the last six months, CGI’s NAV has outperformed the benchmark by 2.1pp. It has also outperformed over three and five years. Underperformance versus the World index is primarily due to the strong performance in recent years of the US market, which now represents more than 50% of the index.

Exhibit 6 shows CGI’s NAV total return relative performance versus the benchmark over 10 years. Over five years CGI has outperformed by c 8%% (Exhibit 5). The 10-year performance record has been affected by a period of underperformance between mid-2007 and mid-2009, primarily due to an overweight position in smaller stocks and as a consequence of gearing in an extreme market downturn.

CGI’s shares are currently trading at a discount of 31.3%. This is near the top end of the 12-month range (discounts of 20.1% to 31.6%) and wider than the averages of the last one, three and five years (27.3%, 28.3% and 27.9% respectively). Contributing factors to the wide discount may include the large controlling shareholders, which could have an impact on liquidity and investor perceptions and the fact that Canada has been out of favour with global investors for some time.

A sustained period of relative outperformance by CGI or increased demand for Canadian equities could lead to a narrowing of the discount. Also, CGI’s more transparent dividend policy, where there is less emphasis on the special final dividend, could find favour with investors. Due to its investment corporation status, CGI is unable to repurchase shares without losing its tax benefits.

CGI has 20.9m ordinary shares in issue. Gearing of C$150m is split between C$75m Series 4, 3.75% preference shares and $75m bank debt. The bank debt facility was entered into in June 2016 ahead of the redemption of C$75m Series 3, 3.90% preference shares. An interest rate of 2.28% on the new debt lowers CGI’s average cost of debt from 3.825% to 3.015%, saving C$1.215m in annual gearing costs. At 6 September 2016, gross gearing was 21.4% or 20.0% net of 1.4% cash.

CGI pays an annual management fee of 1% of the market value of its investments net of cash, portfolio accounts receivable and portfolio accounts payable. No performance fee is payable. For H116, the annualised management expense ratio was 2.88% including leverage costs and 1.71% excluding leverage costs, which is more comparable with the ongoing charge figure used in the UK.

Since 2014, there has been more emphasis on regular quarterly dividends rather than a final special dividend. FY15 was the fourth consecutive year where the total annual dividend paid was C$0.76. However, the special and total quarterly dividends of C$0.20 and C$0.56 respectively compares to a special dividend of C$0.52 and C$0.24 in total quarterly dividends in 2012.

Based on the estimated quarterly dividends for 2016, the current dividend yield is 3.6%, which compares to the yield of 3.0% based on 2015 quarterly dividends.

Exhibit 8 shows CGI versus a group of selected closed-ended peers with market caps higher than c £100m, which have been chosen for their exposure to Canadian equities. However, the peers are not directly comparable as the majority of the trusts shown have income mandates. CGI’s NAV total return has outperformed the peer group average over three years. In terms of risk-adjusted returns as measured by the Sharpe ratio, CGI is below average over one year and above over three years. It has the widest discount in the group. In line with its mandate for total return rather than income, CGI ranks fifth out of seven funds in terms of dividend yield.

There are seven members on the board of CGI, four of whom are independent of the investment manager. The non-independent directors are Vanessa Morgan (chairman of CGI and president and CEO of MMA), Jonathan Morgan (president and CEO of CGI and executive vice president of MMA) and Michael Smedley (executive vice president and CIO of MMA). The independent directors are James Billett, Michelle Lally, Neil Raymond and Richard O’C Whittall. Michelle Lally is the newest member of the board; she was appointed in 2015, prior to which there had been no change in the composition of the board since 2005. The average tenure of all seven board members is approximately 14 years.