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.
The rally in US equities last year was once again led by the ‘magnificent seven’ tech stocks. Research from investment bank Goldman Sachs indicates that close to 80% of the returns delivered by the S&P 500 last year were attributable to those seven companies.
As we head into 2024, it’s plausible that performance will start to be distributed more evenly. Returns in the rest of the US index have arguably been held back by rate hikes and recessionary fears. We aren’t out of the woods yet, but with inflation coming down without a commensurate increase in unemployment, it’s plausible the US economy may ultimately achieve that much-vaunted soft landing or at least fare much better than previously expected.
Assuming that’s the case and we also start to see rate cuts this year, a more interesting way to play any bounce in North American equities may be via Canada. Unsurprisingly, given how intertwined the two countries’ economies are, research from Morningstar indicates that Canadian equity funds tend to have a high correlation of 0.8 with US equity markets.
A key difference today is that Canadian stocks trade at much lower valuations than their US peers. The TSX now trades at the lowest valuation levels relative to the S&P 500 that we’ve seen over the last three decades.
Similarly, the MSCI Canada Index trades at a nearly 40% discount to the equivalent US index on a forward price-to-earnings basis. On a price-to-book basis the figure is 60%. Even if you exclude the impact that big tech has this remains true. The MSCI Canada Index is still trading at close to 25% below the equivalent levels of the US index on a forward price-to-earnings basis, with those mega cap tech stocks excluded.
This dislocation and the potential for valuations to converge again means there is a rare opportunity for investors to take advantage of in Canada. For Middlefield Canadian Income (MCT) these lower valuations are also exacerbated by the nearly 16% discount that the trust’s shares trade at today, which is close to 60% wider than its own 10-year historical average. This also doesn’t capture the discounts that many of the trust’s own holdings are trading at across the real estate, financials and energy sectors.
MCT is one of the only trusts listed on the London Stock Exchange today that provides investors with dedicated exposure to Canadian stocks. As its name suggests, the trust’s managers aim to provide investors with a high level of dividends, as well as long-term capital growth.
Currently the portfolio is heavily overweight REITs, which constitute approximately 25% of the portfolio, compared to around 5% in the S&P/TSX High Dividend Composite Index. Other key holdings are in financials and energy.
With regard to real estate, performance has been hit over the last two years because of interest rate hikes. However, the sector has been supported by the huge population growth that Canada has experienced over the last three years via immigration.
Assuming the government’s migration targets are hit, there should be a near 5% population increase via immigration alone in from 2022 though to 2025. As MCT manager Dean Orrico noted when we spoke in August 2023, this has been beneficial for both commercial and residential real estate, with landlords able to mark up rates in excess of inflation and not have to worry about a lack of tenants.
Dean has also argued that Canada is now at the end of the rate hiking cycle and will likely start to see cuts in 2024. This is plausible given that Canada pre-empted the U.S. in raising interest rates and is now seeing some of the lowest inflation prints among the world's major economies, with the latest CPI coming in at 3.1%.
Dean maintains that the fundamentals in the Canadian real estate sector are very attractive with very limited supply and solid demand. Moreover, MCT’s REIT holdings are trading at a discount to NAV of approximately 15% on average, relative to trading at premiums to NAV historically. As a result, REITs are well positioned to outperform in 2024, assuming rates decline and investors looking for stable and growing income come back into the REIT market.
Financials and energy have been afflicted by similar problems, with investors fearful of the impact that a recession would have on both. However, as with real estate, the fundamentals for both sectors look strong. As we noted at the end of last year, Canadian energy companies are seeing strong earnings growth and continue to produce high levels of cash, which is translating into rising dividends and more share buyback programmes.
Indeed, over the last five years, companies in the MCT portfolio have averaged annual dividend growth of 8%. We see the knock on effect of this in the MCT portfolio, as the trust has just announced another increase to its annual dividend.
MCT sits at an interesting juncture as a result. Markets are ultimately forward-looking and many of the problems that MCT’s holdings were expected to face have not really come to pass. However, investors have aggressively priced them in, particularly in real estate where we see those extremely wide REIT discounts.
Rate cuts in the months ahead may ultimately result in a reversing of this negative sentiment. But the driving force may prove to be those stronger earnings and the dividend growth we see in the underlying portfolio. Assuming MCT’s holdings continue to deliver in this regard then it’s plausible 2024 will see stronger performance and a commensurate tightening of that discount
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