ClearBridge Canadian Dividend Strategy Q2 2024 Commentary

By Ryan Crowther, CFA & Les E. Stelmach, CFA

Divergence in Canadian and U.S. Equities Opens Opportunities

Market Overview

Although it reached new all-time highs in the middle of the quarter, the S&P/TSX Composite Total Return Index (‘TRI’) declined in June to finish down 0.53% in the second quarter (in Canadian dollars). Without the strength of AI-driven and Magnificent Seven returns available to the U.S. market, Canadian equities performed more in line with the “S&P 493.” Benchmark 10-year interest rates in Canada and the U.S. ended the second quarter roughly flat at 3.50% and 4.40%, respectively. Although below their October 2023 highs, around the time of the Fed’s dovish pivot, 10-year rates remained at heights not seen since the Global Financial Crisis. Consensus expectations for Fed rate cuts in 2024 tempered further in the second quarter, with futures markets now pushing out most cuts to late 2024/2025, as opposed to the six cuts expected at the beginning of this year.

Returns across sectors diverged, but were generally weak, with seven of 11 sectors in negative territory. Health care, real estate, information technology (‘IT’), industrials and communication services were the poorest performing sectors. In contrast, materials was buoyed by strong copper and gold prices. Energy stocks eked out a gain, as crude oil prices were supportive. There was considerable bifurcation in North American natural gas prices, with U.S. reference gas prices increasing 47.5% to US$2.60/mmbtu (‘NYMEX’), while local Alberta (‘AECO’) prices languished. Noteworthy for the Canadian Energy sector, the long-awaited Trans Mountain Pipeline expansion is complete, and with LNG Canada expected to start exporting liquified natural gas in 2025, prospects have improved for regional crude oil and natural gas prices for Western Canadian producers.

Against this backdrop, the ClearBridge Canadian Dividend Strategy trailed the S&P/TSX Composite TRI benchmark in the second quarter. The most significant positive relative contributors to performance included our meaningful overweight in the outperforming Agnico Eagle Mines (AEM). Agnico Eagle shares benefited from strong operational execution and robust gold prices. The company recently hosted a site visit at its long-life Detour property in Northeastern Ontario. Detour is the largest gold-producing mine in Canada with production expected to increase to one million ounces annually by 2030 from a current run rate of approximately 700k ounces. Across all its operations in Canada, Australia, Finland and Mexico, with solid production guidance, project and reserve updates, and better than expected cost control, the company has performed well.

Also on a relative basis, avoiding IT sector heavyweight Shopify (SHOP) materially aided performance, as the large benchmark constituent delivered disappointing quarterly results. Not owning retail chain Dollarama (OTCPK:DLMAF) detracted from relative returns, given that stock’s robust second quarter return (+21.2%).

The main absolute and relative detractor in the second quarter was Open Text (OTEX) in IT. Open Text shares declined following its fiscal third-quarter results, largely due to increased investments in AI capabilities within its software solutions, further marketing spend to grow the cloud business as well as a change in acquisition strategy. Alongside recent divestitures, near-term margin and operating leverage improvements have been pushed out. That said, the base business is still showing areas of fundamental improvement, with continued increases in cloud bookings, ongoing deleveraging, stabilization of its recent Micro Focus acquisition and overall organic growth.

Portfolio Positioning

In materials, we trimmed our position in Agnico Eagle Mines on strength and initiated positions in two royalty/streaming businesses, Wheaton Precious Metals (WPM) and Franco-Nevada (FNV). Having been shareholders of both these companies in the past, we have spent ample time contemplating and analyzing the business models of royalty and streaming companies versus conventional miners, and we have had years to interact with and observe the management approach of each. In the precious metals subsector, we have tended to favor the royalty/streaming business model when valuations align. Once a novel business model, over past decades royalty/streamers have become a conventional source of financing for miners, complementing the traditional capital structure. Wheaton Precious Metals has demonstrated constructive portfolio growth over the past couple of years, while challenges at Franco-Nevada and related share price weakness present an attractive opportunity. On the latter, Franco-Nevada’s largest single royalty/streaming agreement, with Cobre Panama (a partnership with First Quantum in Panama), was fully written off following the local government’s forced closure of the mine. Significant subsequent weakness in Franco-Nevada’s shares priced in residual risk, and leaves restart optionality should local conditions improve.

“We remain mindful of the risks as investors re-acclimate to an environment of non-zero interest rates.”

The underperformance of communication services was notable as wireless and wireline competitive pressures remain heightened in Canada post the Rogers (RCI) acquisition of Shaw, with Quebecor (OTCPK:QBCRF), now the fourth national wireless operator, leveraging its newfound competitive offerings from Freedom Mobile to gain wireless market share. With these concerns, as well as lingering regulatory and macro fears, valuations have significantly rerated for incumbents such as BCE (BCE). While undoubtedly challenged in the short term, BCE has been pursuing cost efficiencies to help navigate a tougher near-term revenue environment. We expect the company’s free cash flow profile to improve in the coming years as it de-levers, moderates its capital expenditure and leverages its respective fiber footprint and overall asset base.

We eliminated our longstanding position in Loblaw during the period. Improved execution and free cash flow growth in the business have been consistent with our thesis over the past few years; however, the stock price in our view now reflects these characteristics as well as a continued robust outlook. We continue to have a positive outlook for the business, but our emphasis on valuation keeps us at bay for the time being.

Outlook

In our view, differences in the composition of Canadian and U.S. equity markets have led to significant divergence in performance in recent years, to the point where the resulting capital flows and market concentration are creating overlooked opportunities elsewhere. Notwithstanding the Bank of Canada’s “go-it-alone” interest rate cut in June, rate cut expectations in Canada and the U.S. have been tempered from where they were at the start of the year. We remain mindful of the inherent risks in equities as investors re-acclimate to a non-ZIRP (zero interest rate policy) environment. We believe that our portfolio offers superior predictability and downside protection — at a reasonable price — and that this defensive characteristic not only provides ballast in more challenging market environments, but also presents us with considerable dry powder when better risk/reward opportunities arise.

Although the Strategy emphasizes dividends, our focus is on risk-adjusted total return and not merely “income.” Valuation is the primary driver of our portfolio decision making, but embedded in our assessment of valuation are core attributes we seek: secular growth, profitability and durability of the business, management teams with diligent approaches to capital allocation and capital structures that align with the predictability of cash flows and cyclical exposures. We use this approach to design a portfolio with an attractive but not overly ambitious dividend yield, and one that seeks to optimize the risk-adjusted return potential of the Strategy.

Portfolio Highlights

The ClearBridge Canadian Dividend Strategy underperformed its S&P/TSX Composite TRI benchmark during the second quarter. On an absolute basis, the Strategy generated gains across three of the nine sectors in which it was invested (out of 11 sectors total). Contributors to total return came from materials, consumer staples and energy while the primary detractors were in IT and industrials. Avoiding health care and consumer discretionary stocks aided absolute performance.

On a relative basis, while sector allocation provided a positive effect due primarily to an IT underweight, it was more than offset by negative security selection, in particular selection in the IT and industrials sectors.

In terms of individual securities, the top contributors to absolute returns were Royal Bank of Canada (RY), Agnico Eagle Mines, TMX (OTCPK:TMXXF), Keyera (OTCPK:KEYUF) and Brookfield Renewable (BEP). The main absolute detractors were Open Text, Bank of Montreal (BMO), Canadian National Railway (CNI), Canadian Pacific Kansas City (CP) and Bank of Nova Scotia (BNS).

Ryan Crowther, CFA, Portfolio Manager

Les E. Stelmach, CFA, Portfolio Manager

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