Middlefield Canadian Income (MCT) has announced its results for the year ended 31 December 2019. During the year, MCT provided an NAV total return of 27.3%, outperforming both its Benchmark and the S&P/TSX Composite Index, which returned 26.9% and 23.9%, respectively.
Since inception in 2006, the Fund has generated a cumulative return of 155.6% which compares favourably to the Benchmark return of 121.2% and the S&P/TSX Composite Index return of 104.2%. The Fund continues to build on its solid track record and deliver attractive returns to investors on an absolute and relative basis.
Increased exposure to the US
MCT increased its exposure to US listed securities throughout 2019, as economic growth in the United States outpaced other developed nations and US consumer data remained healthy. The Fund had an average weighting of 24% in U.S. issuers in 2019 compared to 17% in 2018. Positions in AT&T, Morgan Stanley, Intel and McDonald’s were among the U.S. companies added to the portfolio.
Strong US returns driven by multiple expansion
MCT’s manager says that, during 2019, the S&P 500 and S&P/TSX Composite generated returns of 31.5% and 22.8%, respectively, driven largely by expanding price/earnings multiples. In the US, the S&P 500 earnings remained relatively flat, with the forward price/earnings ratio increased from 14.5x in January 2019 to 18.0x by the end of the year. In Canada, the S&P/TSX Composite’s forward price/earnings ratio increased from 12.7x to 14.8x over the same period. Persistently low interest rates have been an important factor behind the increase in price/earnings, in the manager’s view.
Trade negotiations between the US and China caused widespread market uncertainty and volatility during the year, but markets responded positively once a phase one deal was announced in Q4 2019, and closed out the year on a high. Markets also welcomed the signing of the USMCA, a landmark deal signed by the North American trading partners as a successor to the decades-old North American Free Trade Agreement.
Portfolio positioning
Consistent with its income objective, MCT has significant exposure to real assets with Utilities, Pipelines and Real Estate comprising collectively more than 50% of the portfolio. Companies that operate in these sectors have predictable cash flows, typically underpinned by long-term contracts and, in the manager’s view, are well-positioned to outperform over the long-term. The manager also highlights that real assets tend to have defensive qualities during periods of market turbulence – exhibiting lower volatility with smaller drawdowns than the broader market. A particular area of focus within the real asset sector is Canadian Real Estate, the Fund’s largest sector weighting. However, while real assets are the foundation of MCT’s defensive exposure, the manager has looked to US issuers to provide capital growth. Although every US listed portfolio company pays a dividend, the manager expects these to provide capital growth as the trade narrative improves and capital spending picks up. Most recently, McDonald’s was added to the portfolio following a pull back in its share price in December. The manager says that this created an attractive entry point for a company which consistently generates high free cash flow and is growing its EBITDA in the mid to high single digits.
The Fund is underweight Financials relative to the Benchmark by more than 10%. The manager’s lower for longer interest rate assumption has led it to focus on a subset of financial institutions with lower exposure to earnings derived from net interest margins. The manager says that this tactical decision paid off in 2019 through positions in Blackstone Group (+96.3%), J.P. Morgan (+47.3%) and Morgan Stanley (+32.7%). These leading global institutions accounted for c.40% of the Fund’s total U.S. exposure as at 31 December 2019.
Outlook and covid-19
Prior to the COVID-19 outbreak, MCT was defensively positioned due to the expectation of slower economic growth and high equity valuations reflected in price-earnings multiples at the higher end of their historical range. The global economy has abruptly come to a halt as a result of the global COVID-19 pandemic and market volatility has reached extreme levels. The events are causing political leaders to respond with unprecedented fiscal stimulus and policies to ensure social distancing in an effort to slow the spread of the disease. In light of the uncertainty surrounding the degree and length of the current pause in economic activity and the corresponding impact on global supply chains and consumer behaviour, MCT has made capital preservation its primary priority. Specifically, given the highly liquid nature of the Fund’s portfolio, the manager has increased the Fund’s cash position and eliminated gearing by reducing exposure to sectors like financials and select issuers that were deemed to be more economically sensitive. Although the Fund’s NAV has decreased since the beginning of March 2020, these actions have resulted in significant outperformance versus its Benchmark and the broader market since December 31, 2019.
The manager says that, in light the current economic backdrop, it is even more committed to its long-held preference for dividend paying and dividend growing equities with strong balance sheets and sustainable business models. Its focus remains on companies with predictable cash flows and real assets should serve to dampen volatility and, to date, dividends paid by portfolio companies have remained largely unchanged.