OTEX - ClearBridge Canadian Equity Strategy Q4 2023 Portfolio Manager Commentary

2024-01-21 06:32:00 ET

Summary

• ClearBridge is a leading global asset manager committed to active management. Research-based stock selection guides our investment approach, with our strategies reflecting the highest-conviction ideas of our portfolio managers.
• Canadian equities surged in the fourth quarter, as market attention pivoted from expectations of interest rate increases to the potential for rate cuts in 2024.
• Although the Strategy generated a strong absolute return in the quarter, it underperformed its broader Canadian equity benchmark largely due to impressive performance by information technology stocks it did not own.
• We have become more constructive on defensive sectors that bore the brunt of higher interest rates for most of the past year, including communication services, utilities and real estate as well as the midstream/pipelines portion of the energy sector, and will continue to seize on opportunities in these areas as they arise.

By Garey J. Aitken, CFA and Timothy W. Caulfield, CFA

Market Overview

The S&P/TSX Composite Total Return Index returned 8.1% in the fourth quarter. Benchmark 10-year interest rates in Canada and the U.S. reached 2023 highs of 4.24% and 4.99%, respectively, in October before ultimately giving way in the final two months of the year to close at 3.11% and 3.88%. Following a U.S. Federal Reserve meeting in December that highlighted easing inflation and slowing economic growth, rates priced in a more dovish consensus.

The advance in Canadian equities was broad-based, with information technology (IT, +24.0%), financials (+12.7%) and real estate (+10.7%) leading the charge. In addition, the defensive/non-cyclical sectors of utilities (+8.2%), consumer staples (+8.1%) and communication services (+7.6%) all performed well, while energy was the only sector to decline (-1.3%). IT capped off a strong year buoyed by investor enthusiasm for the possibilities of artificial intelligence ((AI)), and as lower interest rates eased pressure on valuations of equities with longer-duration projected cash flows. Weakness in energy was driven by lower commodity prices. Crude oil prices declined despite Middle East conflicts due to inconsistent global demand indicators and sufficient supply, while natural gas price weakness reflected the generally warm winter conditions experienced to date this heating season.

Although the ClearBridge Canadian Equity Strategy generated strong absolute returns in the quarter, it underperformed its broader Canadian equity benchmark largely due to impressive performance by IT stocks in the benchmark that we did not own, primarily e-commerce enablement provider Shopify.

Portfolio Positioning

Trading activity in the fourth quarter was steady and surgical as dislocations in equity markets presented some attractive opportunities. Transactions included the participation in two secondary offerings that resulted in a drawdown in the Strategy’s cash position, which saw two new names being introduced: Pembina Pipeline ( PBA ) and Stantec ( STN ). Pembina, in the energy sector, is a leading Canadian midstream and pipeline company, operating the largest network of gathering and processing, NGL pipelines, storage, fractionation and marketing assets in the Western Canadian Sedimentary Basin and connecting the Montney/Duvernay formations to end markets. With assets located in the most productive plays, Pembina should be able to increase the utilization of existing assets, grow faster than the basin and profitably add capacity through smaller-capital, higher-return investments. Stantec, in the industrials sector, provides consulting services in engineering, architecture, interior design, environmental sciences and project management.

"We have become more constructive on defensive sectors that bore the brunt of higher interest rates for most of the past year."

A third new position was Canadian Utilities ( CDUAF ), a regulated utility providing electricity generation and distribution as well as natural gas infrastructure that is the largest asset owned by existing Strategy holding ATCO. Fourth quarter portfolio activity further added to our defensive/non-cyclical exposures in consumer staples and utilities. The Strategy also selectively added to attractive individual opportunities in more cyclical aspects of the portfolio, including in sectors with our largest underweights, such as financials and energy.

Outlook

The sharp rise in rates over the first 10 months of 2023 took a toll on the more defensive areas of the equity market. Among the 11 sectors in the S&P/TSX Composite, communication services, utilities, real estate, materials and financials were among the worst performers. The first three sectors are among the most interest-rate sensitive in the market and we believe the selling due to rate tightening has been overdone. With valuations down and the economy still fragile, we have become more constructive on these sectors as well as the midstream/pipelines portion of the energy sector. As inflation abates and growth slows, rates do not need to come down much for these companies to see a re-rating of their stock prices.

We are more bearish on cyclical sectors, including materials, energy and financials. Energy and materials are resource sectors with greater sensitivity to the global economy. With China struggling and growth sluggish in other major regions including Europe, a demand slowdown could pressure these stocks. Banks, meanwhile, which had sold off for most of the last two years before participating in the fourth quarter rebound, are trading at valuations that already discount a more challenging environment. While we expect to remain underweight these sectors relative to the benchmark, as bottom-up stock pickers we will continue to monitor these sectors for opportunistic additions.

The Strategy has successfully navigated various market conditions characterized by both strong and weak sentiment, as well as shifts in sector leadership and economic landscapes, and is well-positioned for the uncertainties of 2024. As we acknowledge the presence of risks and uncertainties, we are confident that the future will present both challenges and opportunities. We will seize on opportunities as they arise, leveraging our extensive track record of delivering superior absolute, relative, and risk-adjusted returns over the long term.

Portfolio Highlights

The ClearBridge Canadian Equity Strategy* underperformed its S&P/TSX Composite Total Return Index benchmark during the fourth quarter. On an absolute basis, the Strategy generated gains across nine of the 10 sectors in which it was invested (out of 11 sectors total). The primary contributors came from the financials, industrials and utilities sectors while the energy sector detracted.

On a relative basis, overall security selection detracted from performance but was partially offset by positive sector allocation effects. In particular, stock selection in the IT, energy and consumer staples sectors and an underweight allocation to the financials sector weighed on results. On the positive side, selection in the materials and utilities sectors and an underweight to materials contributed to performance.

On an individual stock basis, the largest contributors to relative returns were Agnico Eagle Mines ( AEM ), Open Text ( OTEX ), Allied Properties ( APYRF ), Colliers International Group ( CIGI ) and Brookfield Corporation ( BN ). Existing holdings that detracted most from relative returns were Headwater Exploration ( CDDRF ), ARC Resources ( AETUF ), Saputo ( SAPIF ), SNC-Lavalin Group ( SNCAF ) and Tourmaline Oil ( TRMLF ).

Garey J. Aitken, CFA, Head of Canadian Equities, Portfolio Manager

Timothy W. Caulfield, CFA, Director of Canadian Equities Research, Portfolio Manager

Past performance is no guarantee of future results. Copyright © 2023 ClearBridge Investments. All opinions and data included in this commentary are as of the publication date and are subject to change. The opinions and views expressed herein are of the author and may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.

Performance source: Internal. Benchmark source: Standard & Poor's.

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