Canadian General Investments — Successful active management in Canada

Canadian equities, along with those of global companies, are currently experiencing higher levels of volatility compared to the very benign levels in 2017. Exhibit 2 (LHS) shows the average valuation of Canadian equities over the last five years. The current forward P/E multiple of 12.9x is 16.2% lower than the five-year average. In relative terms, the Canadian market is 18.3% cheaper than the US; this is much wider than the 9.5% average discount over the last five years, which may provide an opportunity for investors seeking differentiated North American equity exposure.

Exhibit 2 (RHS) shows the breakdown of the bellwether S&P/TSX Composite index. While investors may associate the Canadian stock market with financial and resource stocks, the financial, energy and materials sectors in aggregate only make up around 50% of companies in the index. This suggests that there may be a wider selection of available investment opportunities in Canada than generally understood. A key feature of the Canadian stock market during 2018 has been the wide disparity of returns in individual sectors, which means that investors could be rewarded by focusing on a fund with a long-term record of successful stock selection.

CGI was launched in January 1930. It is the second-oldest North American closed-end fund and is quoted on the Toronto Stock Exchange (since 1962) and the London Stock Exchange (since 1995). Since 1956, CGI has been managed by Morgan Meighen & Associates (MMA), a Canadian investment firm, which has c C$1.8bn assets under management. The fund’s lead manager is Greg Eckel (since 2009); he invests for the medium to long term, aiming to outperform the benchmark S&P/TSX Composite index by investing in a diverse portfolio of primarily Canadian, along with selected US equities.

The company is designated as an investment corporation under the Income Tax Act (Canada). This 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, in order to maintain this favourable tax status, the company is unable to repurchase its shares to help manage the share price discount to net asset value. No more than 25% of the company’s gross revenue may be from interest income, and at least 85% of its gross revenue must be from Canadian sources. More than 50% of CGI’s shares are held by related parties which, along with its high level of structural gearing, may contribute to its wide discount to NAV. The company has C$150m debt: C$75m Series 4, 3.75% preference shares and C$75m bank debt; at end-September 2018, net gearing was 16.0%. CGI has followed a leveraged strategy since its first issue of preference shares in 1998.

Data from MMA highlight CGI’s very long-term record of outperformance. Over the last 25 years to end-December 2017, its average annual share price total return of 10.6% is 1.6pp ahead of the benchmark. Its outperformance over 50 years is even larger, at 2.1pp pa (11.4% versus 9.3%).

Eckel notes that so far in 2018, the Canadian stock market – along with the majority of those in other regions – has lagged the performance of US shares, which have been supported by a robust domestic economy and tax cuts. He says that economic conditions in Canada are steady, with GDP growth of around 2%, and the recent breakthrough in trade negotiations with the US is positive, although this event has not been reflected by an upward move in the Canadian stock market. The manager believes that domestic economic growth should feed into corporate earnings, providing support for Canadian equity prices. He is hopeful that Q318 earnings reports will be robust; consensus expectations are for a double-digit, year-on-year increase, although Eckel says that forward guidance will be an important barometer for investor sentiment.

So far this year, CGI has benefited from overweight exposures in sectors that have outperformed, such as technology, industrials and healthcare. However, the manager notes that in aggregate, Canadian stock price performance at the individual company level has been ‘spotty’. He says that 2018 has seen a wide range of equity returns within sectors, highlighting the importance of bottom-up stock selection. Eckel describes the current investment environment as ‘difficult’, and comments that Canadian share price weakness so far in October has dragged the index into negative territory for the year to date.

Energy makes up around 20% of the benchmark, but is lagging the index so far in 2018, despite a big upward move in the oil price. Eckel says that Canadian crude prices (measured by the benchmark Western Canadian Select) are trading at a record discount to US crude prices (West Texas Intermediate), which is partly due to a lack of available transport infrastructure. He says that Canadian integrated energy company, Cenovus Energy, has recently struck a deal with a railroad to transport 200k barrels of oil a day, but this comes at a price and will squeeze margins. Eckel also notes that the timeline for a Federal government pipeline project has been pushed back due to political and environmental issues, which has also tempered investor enthusiasm for the energy sector. The manager recently attended an oil and gas conference, where he saw companies demonstrating robust fundamentals, such as volume growth and strong cash flows. However, he notes that two large Canadian pipeline companies, Enbridge and TransCanada Pipeline, are experiencing a lack of investment opportunities, despite having plenty of available capital.

Eckel aims to provide better-than-average total returns to investors via prudent stock selection and timely recognition of capital gains and losses, as well as generating an attractive level of income. He primarily invests on a bottom-up basis, while also taking the macro environment into account. The majority of the portfolio is invested in Canadian equities, while up to 25% may be invested in US companies to capitalise on businesses unavailable in Canada, such as the top 10 positions in semiconductor company NVIDIA, online retailer Amazon.com and payment processor Mastercard. The manager has a long-term investment approach, and many of CGI’s positions have multi-year holding periods, although they are continually assessed to ensure their exposures remain appropriate. He seeks companies with strong fundamentals and long-term growth potential, which are trading on reasonable valuations. There is a focus on the quality of a company’s management, and Eckel has a history of following good management teams when they transition to other companies, often as a result of mergers or acquisitions.

In early 2016, CGI’s portfolio was restructured, with changes including a higher weighting in commodities. The restructuring benefits are shown by the fund’s increased outperformance versus the benchmark (Exhibit 6). The majority of the portfolio is made up of mid- and large-cap stocks (holdings have a median market cap of c C$8bn), and less than 5% of the portfolio has a market cap below C$1bn. Some of CGI’s positions offer higher dividend yields, such as Bank of Montreal and Royal Bank of Canada, which support the fund’s own dividend payments.

At end-September 2018, CGI’s top 10 positions made up 38.2% of the portfolio, which was a higher concentration compared with 36.6% a year earlier; six positions were common to both periods. The fund had 76.6% of its portfolio (-6.9pp year-on-year) in Canadian equities, 23.0% (+6.9pp) in US equities, and 0.4% (flat versus a year earlier) in cash and equivalents. Compared with the benchmark, CGI’s structure is broadly similar to when we last published a report on the company in April 2018; exposure to each individual sector is capped at 35%. Portfolio turnover has been trending lower; it was just 1.9% in H118, which compares with 10.4% in 2017 (towards the low end of the 9-25% annual historical range) and a five-year average of 17.0%.

Canada has been in the news recently as only the second country in the world to legalise the recreational use of cannabis. CGI holds positions in two companies in the sector, Aphria and Canopy Growth. Eckel says that legislative changes are occurring faster than generally anticipated, not just in Canada, but also in the UK for medicinal use. The sector’s growth potential has not gone unnoticed, with US consumer goods company Constellation Brands recently increasing its stake in Canopy Growth from c 10% to c 40%, leading to a more than 20% upward move in the cannabis producer’s share price. There have also been indications that a US tobacco company is considering making an investment in Aphria. While these two stocks still have upside potential, Eckel acknowledges that they are also riskier than the majority of names in CGI’s portfolio, and therefore warrant a modest weighting to mitigate risk (currently c 5%).

CGI participated in the initial public offering of IPL Plastics in June 2018. Eckel says that the company has good fundamentals and is well run by a solid management team. The firm is broadening its reach in the North American packaging market, and its speciality products generate higher margins than more commodity-like offerings. Another new holding in the portfolio is payments processor Square, which is benefiting from growth in mobile billing, as this is easier and more efficient than legacy processes. The company is increasing the size of its product offering, such as advancing credit, which allows merchants to expand their businesses. Eckel believes that Square has good growth potential, both in North America and overseas markets, referring to CGI’s position as ‘a good one to be in for the long term’.

In H118 (to 30 June), CGI’s NAV and share price total returns of +9.0% and +6.8% respectively were meaningfully ahead of the benchmark’s +1.9% total return. This was a result of both positive asset allocation and good stock selection. In terms of sectors, the company had an overweight exposure in four out of the six industry groups that generated positive returns over the period (technology, industrials, consumer discretionary and materials), while being underweight in the four worst-performing sectors (utilities, telecoms, consumer staples and financials). At a stock level, positive contributors included apparel manufacturer Canada Goose (+94.7%), e-commerce company Shopify (+50.8%) and cannabis producer Canopy Growth (+29.2%).

CGI’s relative performance is highlighted in Exhibits 5 and 6. The company has outperformed the benchmark over almost all periods shown in both NAV and share price terms, with the one-year excess returns being particularly notable. CGI’s portfolio was successfully repositioned in early 2016, with changes including a higher weighting in the materials sector; since then the fund has outperformed the index by around 30pp.

CGI’s shares are currently trading at a 29.2% discount to NAV, which is broadly similar to the average discounts of the last one, three, five and 10 years (range of 26.4% to 29.4%). The discount remains persistently wide despite the company’s very long-term positive relative performance record. This may be due to the high level of insider ownership, the relatively high level of structural gearing, or a lack of investor appetite for Canadian equities. To preserve CGI’s favourable tax status, it is unable to repurchase its shares to help manage the discount.

CGI has 20.9m ordinary shares in issue and gearing of C$150m, made up of C$75m in Series 4, 3.75% preference shares and C$75m in bank debt, taken on in June 2016 before the redemption of C$75m Series 3, 3.90% preference shares. The bank debt has an interest rate of 2.28%, lowering CGI’s average cost of debt from 3.825% to 3.015%, and saving C$1.215m in annual interest costs. At end-September gross gearing was 16.4% (16.0% net of cash).

MMA is paid an annual management fee of 1.0% pa of the market value of CGI’s investments, net of cash, portfolio accounts receivable and portfolio accounts payable; no performance fee is payable. In H118, the annualised management expense ratio (including leverage costs) was 2.18% (13bp lower than in FY17), while excluding leverage costs the ratio was 1.52% (2bp lower than in FY17). The fee, excluding leverage costs, is more comparable with the ongoing charges ratio that is used in the UK.

Starting in 2014, there has been a greater emphasis on regular quarterly dividends rather than a special year-end dividend (see Exhibit 1). Given the four C$0.19 interim dividends announced for FY18 (total distribution of C$0.76, which is in line with each of the last six years), it is likely that 2018 could be the first year when no special dividend is paid. Eckel is hopeful that over time, the regular quarterly dividends will increase. Based on its current share price, CGI offers a dividend yield of 3.5%.

There are two funds in the AIC North America sector with significant Canadian exposure. While they have different investment mandates, a comparison has some relevance. CGI’s NAV total returns rank first over three, five and 10 years, and second over one year. CGI trades at a much wider discount, which may be due to reasons suggested in the Discount section of this report; it also charges higher fees. Both funds have a similar level of gearing, while CGI has a lower dividend yield, befitting its focus on total return rather than income.

There are seven directors on CGI’s board, four of whom are independent of MMA. Chairman Vanessa Morgan (president and CEO of MMA) was appointed in 1997. Jonathan Morgan (president and CEO of CGI, and executive vice president of MMA) was appointed in 2001. Michael Smedley (executive vice president and CIO of MMA) was appointed in 1989. The four independent directors and their years of appointment are Neil Raymond (2002), Richard Whittall (2004), James Billett (2005) and Michelle Lally (2015). The average tenure of the seven directors is c 16 years.