Disclosure – Non-Independent Marketing Communication
This is a non-independent marketing communication commissioned by Middlefield Canadian Income. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Reporting season has been in full swing for much of the past month and, as you can imagine, it hasn’t been the easiest of years for the companies and funds releasing their results. Double-digit declines in valuations have been common and, although the long-term outlook may still be positive for many, it has been hard to find much to be upbeat about.
One notable exception to this was Middlefield Canadian Income (MCT). The trust is one of the only closed-ended funds on the market today that focuses solely on Canadian companies, with the managers aiming to pay shareholders a dividend on a quarterly basis. In the 12 months to the end of September, the trust was also the best performer in the AIC’s North America sector.
Canada has emerged as an attractive region for investors over the past 12 months. Energy independent and far from the war in Ukraine, the country looks much more immune from the sorts of problems countries in Europe are facing today. The country’s central bank has been more aggressive in hiking rates to deal with inflation, which is lower than in the US and has fallen for the past three consecutive months.
Its equity market was also not subject to the same sort of speculation as the US has been over the past few years, even though companies on the Toronto Stock Exchange (TSX) derive most of their revenue from the world’s largest economy.
Moreover, companies trading on the TSX skew heavily towards the sort of businesses that look better able to handle, or even benefit from, the current macroeconomic environment. For example, financials make up almost a third of the S&P/TSX Composite Index on a market cap basis, and energy close to 20%. Industrials, materials and utilities combined make up a further 30%.
These factors go some way in explaining why MCT has performed well over the past year. Indeed, the trust’s dividend policy means that it was positioned to take advantage of these tailwinds, with large weightings to the sectors that are, at least thus far, either benefiting from or proving resilient to rising prices and higher interest rates.
Energy is a prime example. Not depending on a bellicose, autocratic neighbour for your energy supplies is always likely to be a positive. Today it means that Canadians are not under threat of having their electricity shut off as we head into winter.
More importantly for MCT shareholders, energy companies in the country have been able to benefit from higher commodities prices. That was visible on a macro level in Canada’s gross domestic product (GDP), which rose by 3.3% in the second quarter of the year.
It could also be seen in MCT’s holdings. Canadian Natural Resources, an oil and gas company that’s currently MCT’s largest holding in the energy sector, saw its net income increase in the third quarter of this year by close to 126% compared to 2021. It was a similar story with Topaz Energy, another top ten holding for MCT, which saw its revenue increase by 171% year-on-year and generated a record level of free cash flow in the second quarter of this year.
Another key area of the MCT portfolio, along with financials and energy, is real estate. The trust has large holdings in different Canadian real estate investment trusts (REITs), which invest in industrial, retail, and residential properties.
As in the UK, REIT valuations have come under pressure due to a combination of factors. Rate hikes can put downward pressure on property values, as well as make any floating rate debt used to finance acquisitions more expensive. There is also the fear that inflation and an economic downturn could mean tenants struggle to pay and properties are left vacant.
These are reasonable things to be concerned about. However, there are a couple of counterpoints to consider. One is that rate hikes in Canada may be coming to an end as there are signs inflation is starting to subside. REITs are also trading at wide discounts already. The sector as a whole has an average discount of 20% but some REITs in the MCT portfolio are trading at much wider discounts. It’s worth noting that these are not factored into MCT’s own discount, meaning the trust’s ‘true’ discount is arguably wider than it appears to be.
What all of this means in simple terms is that there is a chance there won’t be further rate hikes that would dint REIT valuations. But even if there are, the wide discounts at which they’re trading at arguably already price these in, meaning they act as something of a cushion against further drawdowns.
To top this off, the economic outlook for REITs looks positive. On the industrial side, availability rates are at record lows and rents are at record highs. This is being driven in part by ‘re-shoring’ and other changes to supply chain management that have emerged after the bottlenecks produced by the pandemic.
A similar story may be playing out in the residential market. Canada has a rapidly growing population, fueled by immigration, which increased by 0.7% in the second quarter of this year alone – the highest rate of growth since the Baby Boom era. Combined with rising interest rates, that are making purchases more difficult, this is pushing up rents in the residential market and driving down vacancy rates.
It's unlikely we’ll see a quick tightening of discounts in the REIT sector given how chaotic the economic outlook is at the moment. However, it seems plausible, given the positives we’re seeing today, that the sector will hold up and drive returns over the long run.
Combined with the other strong performers in the trust’s portfolio, this means that MCT seems like one of the few trusts in the market today where there is some cause for optimism. This is not to say that the trust will be delivering massive returns in the short-term. But in a period of extreme pessimism, it looks capable of holding up well and delivering over the long term. And you can’t ask for much more than that at the moment.
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