Canadian General Investments — Update 2 December 2015

Over the 18 months to end November, the Canadian market (S&P/TSX Composite) produced a modestly negative total return (-3.6%) while the ex-resources version of the index was actually more than 11% ahead (see Exhibit 2, left-hand chart). The primarily oil-price related difference highlights the main challenge faced in the Canadian economy over the last year, while the positive performance of the non-resource segment of the market is a reminder that other parts of the market have been more than resilient.

Looking ahead and turning to GDP growth figures, the second chart in Exhibit 2 shows how GDP shrank modestly in the first half of 2015 as slowing capital expenditure in the oil industry took effect. However, growth is expected (Bank of Canada estimates) to bounce back into positive territory in the second half and beyond. There are risks to these estimates, including oil/commodity price assumptions and whether the US economy (Canada’s main export market) maintains its current relatively positive progression. There are also worries expressed by some observers over the level of Canadian household debt that could interact unfavourably with a rise in interest rates or slower US/global growth. However, household debt is well collateralised and business sentiment while described as tepid is more positive on forward-looking indicators (Bank of Canada Autumn Business Outlook Survey), suggesting the risks should not be overstated.

From a valuation perspective the market is trading on a forward P/E of just under 15x, only modestly above its 10-year average and therefore not giving a strong signal in either direction. Given the market has already moved to factor in the impact of the oil price, a fund aiming to invest more broadly in this relatively stable economy, closely tied to the US, could be of interest to investors who find US market valuations too full (forward P/E c.17x, 120% of 10-year average).

Canadian General Investments was established in 1930, in part by a former prime minister of Canada, Arthur Meighen. It is now North America’s second oldest closed-end fund and has been managed by Morgan Meighen & Associates (MMA) since 1956. The company is TSX- and LSE-listed and is majority-owned by directors of MMA, suggesting there should be close alignment of interests between managers and other shareholders. D Greg Eckel, senior vice president of MMA, is responsible for managing CGI’s investment portfolio. The fund focuses on medium- to long-term investments in Canadian corporations aiming to provide better than average returns to investors by selecting companies using a primarily bottom-up approach. While performance is compared with the S&P/TSX Composite Index this is not treated as a benchmark for asset allocation and the intention is to give investors broad Canadian exposure; currently the portfolio has lower weightings in the financial and energy sectors than the benchmark. Structural gearing is employed in the form of preference shares, currently equivalent to a net 20.9%.

Greg Eckel acknowledges the commodity exposure of the Canadian economy but highlights that exports are much more diverse than Australia, for example (commodities c 30% of exports versus 58% for Australia, 2010-14 average). Prospectively, the Trans-Pacific Partnership, once ratified, should encourage increased trade, particularly with Japan. Canada’s debt to GDP is relatively low at less than 40% compared with the G7 average of more than 80%, while employment growth has been relatively strong leaving unemployment at a moderate, sub-7%, level.

On the political background the manager notes that the change in government in October was not a surprise for the market, although the scale of the Liberal party victory was. Liberal policies are seen as a negative for the oil sector and pipeline companies, but proposed spending on needed infrastructure improvements should be helpful directly and indirectly. Eckel observes that the party’s substantial historical experience in office may well act as a moderating influence, so outside the oil sector, the change in government is probably not a major factor for the market.

Commenting on three of the current top 10 holdings (at 20 November 2015), Eckel sees Dollarama as a unique retailer with the potential to deliver further medium-term growth through continued store openings. The shares have performed strongly delivering an 8-9x multiple on CGI’s original investment at the time of the IPO in 2009. As the size of the company has grown in tandem with earnings it has entered the target universe of a wider range of investors potentially contributing to the share price performance. The manager has trimmed the holding over time to limit exposure: at end-September it accounted for 8.7% of the portfolio and on 20 November 6.1%. CCL Industries is a global speciality packaging business and is the largest label company in the world employing technology to provide solutions for products, including those in the consumer and healthcare sectors. The manager sees it as a very successful acquirer of businesses (including Avery in 2013) and, as the market has begun to recognise its potential, the shares have performed particularly well over the last year. Finally, Gildan Activewear supplies T-shirts, fleece, underwear and socks. Eckel sees the broadening of the product range from the manufacture of undecorated garments for wholesale to print shops, including the development of own-branded garments and international expansion, as sources of significant additional growth over time.

The manager follows an investment process that is weighted to bottom-up stock selection criteria looking for companies that have market share leadership, are in some sense unique, have a low cost structure, are consistent and have strong management. Broader macro and growth trends are also considered; where suitable companies to play these themes are not available on the Canadian market, foreign equities (mainly US) may be held in the portfolio, subject to the objective that the portfolio provides a proxy for the wider Canadian economy and the formal restriction that CGI’s status as an investment corporation depends on it deriving at least 85% of its gross revenues from Canada. The main reason for the sale of a holding is when the fundamental rationale for a purchase no longer applies.

The manager seeks to mitigate risk through diversification with new holdings typically representing 1.0-1.5% of the portfolio. Larger holdings reflect investment gains, often on companies that have been in the portfolio for a number of years, such as Dollarama. This illustrates a willingness to take significant active positions compared with the benchmark and to adopt a long-term view to harvest the potential of portfolio holdings. Portfolio turnover in the first half to June 2015 was 14.1% annualised and averaged just over 20% per year over the previous five years (implying an average five-year holding period). CGI can pay dividends from capital gains meaning that the focus of investment policy can be on total returns rather than yield.

As shown in Exhibit 3, the manager’s bottom-up investment approach leads to noticeable variations from the benchmark index sector weightings. In the last year the main changes in weighting are a reduction in exposure to the energy sector (partly through market moves) and increases in the consumer discretionary sector and cash weightings. There have been more significant changes over the longer term. For example, since end-2010 the weighting in financials has risen from 14.3% to 22.7% and consumer discretionary from 9.7% to 19.4%, while the energy and materials sectors fell from over 29% each to 13.6% and 11.1% respectively at end October this year.

Looking at the current sector positions relative to the benchmark, financials are the largest underweight (-15.1 percentage points) reflecting the portfolio’s lack of exposure to Canadian banks. In the past, CGI has held banks (in the post-crisis period, for example) but currently the manager sees more potential elsewhere and wishes to avoid adopting positions that would reduce the potential for outperformance: together, the five largest banks accounted for nearly 29% of the benchmark at the end of October. Consumer discretionary, including Dollarama, is the largest overweight (+12.1 percentage points end October). These under- and overweights have been in place since 2011 while the energy sector (-6 percentage points) has been underweight since 2012.

Most of the top 10 holdings are still in place from the same time last year (see list in Exhibit 1), confirming the manager’s measured approach to changes in the portfolio.

As shown in Exhibit 4, the S&P TSX Index was in negative territory (-5.8%) over the year to end November, reflecting in particular weakness in the energy sector. The downtrend appears to have abated more recently and, for CGI both NAV and price total returns have outperformed the index over all periods shown in Exhibit 5 up to five years. The Canadian market has underperformed the FTSE World market since the second half of 2011, reflecting strength in the US market and oil price related weakness more recently. This explains the negative relative readings for CGI when compared with the World index.

Exhibit 6 shows CGI’s performance relative to its benchmark over 10 years. The period of weakness between mid-2007 and mid-2009 is ascribed primarily to an overweight position in small- and mid-caps and an underweight in potash stocks. Subsequently, there has been a generally sustained period of positive or in-line performance.

CGI shares are trading at a discount of more than 25% of NAV: while this is modestly below the one- , three- and five-year averages (between 27% and 29%) the discount does appear wide in absolute terms (see Exhibit 7). There could be the potential for the discount to narrow significantly with a more positive performance from the Canadian market, particularly if CGI is able to maintain the positive relative performance noted above. CGI is unable to implement a buyback policy without losing its advantageous tax status but the current dividend policy could be helpful in containing the discount, as the lower element of special dividends increases certainty over the level of dividend payments.

The company has 20.9m shares in issue and structural gearing in the form of C$150m nominal redeemable cumulative preference shares. The C$75m nominal, 3.90% Series 3 preference shares are redeemable at the holders’ request in June 2016. While the board has not decided on a course of action, management reports that a lack of equivalent instruments may allow the company to make a new issue on terms that are equivalent or more favourable. The Series 4, 3.75% preference shares (also C$75m nominal) are redeemable in 2023. There is no credit facility in place so gearing moves with changes in portfolio value and the net gearing also with the level of cash held. At 25 November, gearing was 27.3% gross or 20.9% net of cash of 5.0%.

Management fees are charged at the rate of 1% pa of the market value of CGI investments net of cash and portfolio accounts receivable and payable. This covers portfolio management and administration services; no performance fees are payable. CGI's officers do not receive any payment direct from the company. For the first half of 2015 the management expense ratio was an annualised 2.6% including the costs of leverage (preference dividends and finance charges) or 1.6% before these costs (more comparable with the ongoing charge figure used in the UK).

In 2014 the board changed its dividend approach from flat quarterly payments supplemented by significant special year-end dividends (see Exhibit 1 for a chart showing historical payments) to the current policy of paying steady to rising quarterly dividends where prudent. The intention is to provide investors with greater certainty over income and potentially to gain greater recognition in the share price for the income provided. Special dividends will continue to be paid but these will account for a smaller proportion of the total. The special, third and fourth quarterly payments have so far been designated as capital gains dividends, enabling the company to recoup capital gains tax. For 2015 the company has so far paid four dividends of C$0.14 (versus C$0.12 in 2014).

We have selected a small group of closed-end funds investing mainly in Canadian equities as a peer group for CGI (Exhibit 8); any comparison should be tempered by the observation that Canoe, Economic and Middlefield have only 55-58% of their portfolios in Canadian equities, while three of the companies have an explicit income remit. Ahead of its benchmark in terms of NAV total return over one, three and five years (Exhibit 5), CGI is also ahead of the selected peer average over one and three years, close to the average over five years but behind over one year. In terms of risk-adjusted return, as measured by the Sharpe ratio, CGI is ahead of the peer-average over one, three and five years. The shares trade at the widest discount to NAV within the group. The ongoing charge is above the average while the company’s structural gearing puts it at the top of the range in this peer group. The yield shown here does not include the special dividend payment and adding this would place it in line with the peer average at c 4%.

The board comprises seven directors, 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, R Neil Raymond, Richard O’C Whittall and A. Michelle Lally who joined the board in April this year; she is a partner at law firm Osler, Hoskin & Harcourt. This was the first change in board composition since 2005 and the directors’ average length of service is approximately 13 years.