Canadian General Investments — Adding to positive long-term performance record

CGI is the second oldest closed-end fund in North America and offers a broad range of quality Canadian equities, along with up to 25% of the portfolio in US businesses that may not be available in Canada. Exhibit 1 shows CGI’s long-term admirable outperformance versus its benchmark. It also illustrates the benefit of compounding and having a long-term approach.

While Canadian stocks have not kept pace with the world market over the last decade (partly due to the strong performance of US large-cap technology stocks), they have delivered annual total returns of 7.2%, with compares favourably with returns on other asset classes such as bonds and cash. In aggregate, Canadian stocks continue to look attractively valued on a forward P/E basis versus the US and world markets and versus their history, and offer a notably higher dividend yield (as shown by Datastream indices in the right-hand side of Exhibit 2).

Performance of the Canadian market, by sector, is shown in Exhibit 3. The benefit of having a diversified portfolio is probably illustrated most clearly by looking at the energy sector, which in recent years has been either one of the best or one of the worst performing sectors. While Canada may have been traditionally associated with financial and commodity stocks, it should be noted that 43% of the companies, representing c 40% by market cap of the S&P/TSX Composite Index, lie outside of the financials, energy and materials sectors.

Eckel suggests that is there is a 50:50 chance that the Bank of Canada will reduce interest rates soon. It is taking a cautious approach and observing how both the Canadian and US economies are progressing, particularly as a recent US inflation data point was higher than expected, thereby pushing out consensus expectations for a US interest rate reduction. The manager notes that the Canadian economy is weaker than in the US as higher Canadian interest rates are starting to have a negative economic effect. Retail customers are trading down, which is benefiting the discount retailers, such as portfolio company Dollarama, and there has been a reduction in consumer discretionary spending, evidenced by lower volumes at recreational vehicle company BRP, which is another of CGI’s investments.

Highlighting specific areas of the Canadian economy, Eckel says that the housing market remains tight, although in hot markets, while prices have held up, the number of transactions is declining. Canada has a long history of welcoming immigrants; however, this government policy has been toned down since COVID-19, as a rising population is exacerbating the Canadian housing shortage. The Canadian energy sector is benefiting from robust commodity prices, which are partly supported by Middle East conflicts. There has been a greater appreciation of the sector’s modest valuation, suggests the manager. He says the major Canadian energy companies are increasing cash returns to shareholders. Although annual production growth is a relatively low 3–5%, adding in share repurchases and dividends increases total returns to double-digit levels, while there is potential for multiple expansion given low sector valuations.

At the end of April 2024, CGI’s top 10 positions made up 37.8% of the fund, which was lower than 40.1% a year earlier; nine positions were common to both periods. The manager’s willingness to seek opportunities outside of Canada is shown by the fact that four of the top 10 holdings, including the largest, are US companies. There is a soft limit of a maximum 5% of the portfolio in a single holding, above which Eckel must regularly discuss the position with the board, while there is a hard maximum limit of 10% in a single holding.

CGI’s sector breakdown is shown in Exhibit 5. Notable changes in the 12 months to the end of April 2024 are a lower allocation to materials (-6.0pp) with higher weightings in financials (+3.4pp) and energy (+3.0pp). Compared with the benchmark, CGI has a structural underweight position in financial stocks (-17.2pp), with notable overweight allocations to technology (+12.7pp) and industrial stocks (+9.4pp).

Discussing CGI’s technology exposure, Eckel says it is a volatile sector that rallied strongly in 2023 based on the growth potential in artificial intelligence (AI). While IT stocks could be due for a pause, the manager suggests that this is also true for other parts of the market, and the large-cap technology companies are generating good cash flow unlike during the dot.com bubble. Eckel notes that NVIDIA has been a standout performer; it entered the portfolio in 2016 and since then until the end of last year, the manager has realised US$96m in profits, including US$44m in 2023. NVIDIA was purchased when its business was more cyclical, as semiconductors were not as widely used. Eckel says the company has a very strong management team and a competitive edge, having transitioned from being a leading supplier to the cryptocurrency and autonomous vehicles companies into the high-growth gaming, data warehousing and AI industries.

In H223, the manager initiated a position in Cameco, which is the world’s largest publicly traded uranium company. It produces very high-grade uranium from its flagship McArthur River and Cigar Lake mines in the Athabasca Basin in northern Saskatchewan. The uranium industry has a complicated and checkered past in terms of success, which has deterred some investors. However, increased demand for nuclear fuels in an environment of decarbonisation and energy security may lead to a change in perception. Governments are reassessing their countries’ nuclear energy capabilities in terms of extending plant lifespans, restarting idled capacity or considering new builds. This higher demand could lead to a uranium demand/supply imbalance in coming years, especially as an extended period of lacklustre uranium pricing has deterred investment in new industry capacity. Eckel considers that with rising geopolitical tensions and a favourable uranium industry outlook, Cameco looks very well positioned either as an ongoing enterprise or as an acquisition candidate. Another uranium company, NexGen Energy, was added to CGI’s portfolio in 2024. The company has a major, very low-cost resource, which is the highest grade in the world; production is scheduled to start in 2029.

There are two other relatively new positions in CGI’s portfolio, Builders FirstSource and Stantec. Builders FirstSource is a major player in the fragmented US building supplies industry, which provides opportunities for acquisitions as well as organic growth. The company is moving into higher-margin products such as prefabricated roof trusses and windows. Stantec is a Canadian supplier of engineering services that has moved its exposure away from the oil and gas industry and made a timely move into infrastructure and water sectors. More than 50% of the company’s revenues are generated in the US and, like Builders FirstSource, it has good growth opportunities from both internally generated and acquired growth.

Two of CGI holdings were sold, CCL Industries (Canadian label company) and Pool Corp (US provider of swimming pool supplies), not because the manager had lost confidence in these businesses; rather they were used as sources of funds to fund higher-conviction positions.

CGI is one of seven companies in the AIC North America sector (Exhibit 6) and one of two Canadian specialists. Comparing CGI to the whole sector, its NAV total returns are average over the last five years and modestly above average over the last 10 years, ranking second out of five funds. On 1 May, it had the largest discount in the sector, where only one fund was trading at a small premium. CGI has the second-largest ongoing charges and level of gearing. Its dividend yield is in line with the mean, ranking fourth and only surpassed by the three funds in the sector with an income bias.

Middlefield Canadian Income (MCT) is the only other Canadian fund in the AIC North America sector. However, the companies follow different strategies, with MCT’s income focus understandingly generating a higher dividend yield. Both companies can invest in US equities, but MCT has a much smaller (c 3%) allocation to these stocks. CGI has superior NAV total returns over all periods shown in Exhibit 6 and significantly so over the last five and 10 years. Its discount is much wider than MCT’s, which is perhaps due to its limited free float, and CGI has a slightly higher fee structure.

In FY23, CGI’s NAV and share price total returns of +17.4% and +9.5% compared with the benchmark’s +11.8% total return. The company benefited from its above-benchmark technology weighting, as the sector performed very well, with positive contributors including NVIDIA (share price +229%), Shopify (+119%) and Constellation Software (+58%). Other stocks that added to CGI’s performance included Amazon.com (consumer discretionary, +76%), TFI International (industrials, +34%) and goeasy (financials, +52%).

Conversely, stocks that detracted from CGI’s performance included First Quantum Minerals (-61%) as late in 2023, its major asset, a copper mine in Panama was ordered to shut down by the Panamanian government. Franco Nevada (-19%) was also negatively affected as it has a royalty stream on this mine.

Commenting on CGI’s performance, the manager said due to the company’s underweight energy position it underperformed in 2022, when energy was by far the best performing sector. Eckel notes that CGI’s diversified portfolio structure was beneficial in 2023. He believes that stock selection rather than a focus on the macroeconomic environment should come to the fore in 2024, a backdrop that should favour his investment approach. So far this year, stocks making a positive contribution to CGI’s performance include NVIDIA, Amazon.com, The Descartes Systems Group, Enerplus (which received a bid from US-based Chord Energy) and Canadian Natural Resources. Detractors to CGI’s performance include the banks (although CGI has a major underweight position), lumber and telecom companies.

Exhibit 11 shows CGI’s upside/downside capture over the last 10 years. Its upside capture rate of 139% suggests that the company will outperform its benchmark in months when Canadian shares rise. CGI’s downside capture rate of 131% means that the company is likely to underperform its benchmark in months when the Canadian market is weak, but to a moderately lesser degree. It is unsurprising that CGI does not move in line with its benchmark given the manager’s unconstrained approach to investing as well as the company having a relatively high level of gearing.

CGI pays regular quarterly dividends in March, June, September and December. The company historically also distributed special dividends, but none have been paid since FY17. In FY23, the annual dividend of C$0.96 per share (three regular taxable dividends of C$0.24 per share and one capital gains dividend of C$0.24 per share) was 2.1% higher than C$0.92 per share in FY22 (four regular taxable dividends of C$0.23 per share). Over the last five years, CGI’s dividend has compounded at an annual rate of 4.8%. The company’s 10-year record of consecutive higher dividends means that CGI now qualifies as one of the AIC’s next-generation dividend heroes (funds with 10 years but less than 20 years of consecutive higher annual dividends).

In FY23, dividend and interest income increased by 8.4% helped by special distributions from Tourmaline Oil and Constellation Software, along with general dividend increases. The manager considers that given the company’s high level of unrealised gains (c C$0.9bn), the strategy of rising annual dividends is sustainable.

Generally, investment companies have wider-than-average discounts reflecting elevated investor aversion in an uncertain economic environment. CGI has the added consideration that it is unable to repurchase shares to help manage its discount as this would invalidate the company’s favourable Canadian investment corporation tax status. The company’s 39.3% discount is at the wider end its 20.1% to 41.8% 10-year range. It compares with the 37.3%, 33.9%, 33.0% and 30.8% average discounts over the last one, three, five and 10 years, respectively.

There have been brief periods when CGI’s shares traded at a premium to NAV; the last time was in 1998, while they traded very close to par in 2006, a period when CGI outperformed its benchmark and there was a commodities super-cycle and a rising oil price.

CGI was established in 1930 and is North America’s second-oldest closed-end fund. It has been listed on the Toronto Stock Exchange since 1962 and on the London Stock Exchange since 1995. MMA took over management of CGI in 1956; the firm has c C$3.0bn of assets under management for both private and institutional clients. Eckel has managed CGI’s portfolio since 2009, aiming to generate a better-than-average total return from a diversified portfolio of North American equities via prudent stock selection and timely recognition of capital gains and losses. While most of the fund is invested in Canadian companies, up to 25% may be held in US-listed businesses. The manager has an unconstrained approach, within the remit that a maximum 35% of the portfolio may be held in a single sector, and he invests without reference to the sector weightings of its benchmark, meaning CGI’s performance may differ meaningfully from that of the S&P/TSX Composite Index. Eckel has a medium- to long-term view, so some of the fund’s holdings have been in the portfolio for many years. The company is designated as an investment corporation under the Income Tax Act (Canada). This eliminates a layer of taxation, as capital gains are only taxed at the shareholder level, allowing them to be paid as dividends to shareholders. However, to maintain this favourable tax status, CGI is unable to repurchase its shares to help manage the share price discount to NAV. A maximum 25% of its gross revenue may come from interest income and at least 85% of gross revenue must be from Canadian sources.

Eckel’s stock selection process is primarily bottom up, although he does take the macroeconomic environment into account. The manager aims to generate an above-average total return for investors, seeking reasonably valued companies with favourable fundamentals and strong management teams; he also takes firms’ economic, social and governance credentials into account. While most of CGI’s portfolio is invested in Canadian companies, up to 25% of the fund may be held in US equities, which are primarily in niche operations or business areas that are under-represented in the Canadian market. The broad exposures at the end of April 2024 were 76% Canada, 24% US.

There are currently 58 holdings in the portfolio with a bias to large- and mid-sized stocks. Some of these are higher yielding, such as the Canadian banks, helping to support CGI’s own dividend payments. Eckel has a long-term focus – in FY23, portfolio turnover was 7.4%, which was modestly higher than the 6.8% five-year average (range of 2.1% in FY22 to 10.1% in FY20), which implies a c 14-year average holding period. However, positions are reassessed regularly to ensure they are sized correctly and investment cases are still valid. The manager has a history of successively backing good management teams that may move companies due to mergers and acquisitions.

CGI has employed a leveraged strategy since its first issue of preference shares in 1998. Since then, to the end of March 2024, its total return has averaged 6.79% per year above its cost of debt. Its C$75m 3.75% cumulative Series 4 preference shares were redeemed in June 2023 and for economic reasons, CGI increased the amount borrowed under its margin facility rather than issue new preference shares.

The company has a C$175m margin borrowing facility via a prime brokerage services agreement with a Canadian chartered bank, at a one-month Canadian dollar offer interest rate plus 0.6% per year. During FY23, the amount borrowed ranged from C$75m, which was before the preference shares were redeemed, to C$175m. The use of leverage was additive to CGI’s total returns in 2023 in a rising stock market, having detracted in 2022 when the market declined. Eckel is happy to run a relatively high level of gearing (at the end of April 2023, net gearing was 12.0%), although this is at the lower end of the historical range. There is scope for a higher level of debt if deemed appropriate.

MMA is paid a management fee that is calculated and paid monthly at 1.0% per year of the market value of CGI’s investments, adjusted for cash, portfolio accounts receivable and portfolio accounts payable; no performance fee is payable. In FY23, the annualised management expense ratio (MER) including leverage costs was 2.26%, which was 37bp higher than in FY22. Excluding leverage costs, which makes the MER more comparable with the ongoing charge figure used in the UK, in FY23 it was 1.42%, which was 4bp higher than 1.38% in FY22. Management fees in FY23 increased by 6.4% versus FY22 because of higher average portfolio assets over the period. Interest and financing charges increased by 206.1% due to higher borrowing rates and higher average borrowings compared with FY22.

CGI has 20.9m ordinary shares in issue, 52.5% of which are directly or indirectly owned by two of the company’s directors, Jonathan Morgan and Vanessa Morgan. Hence, CGI has a free float of 9.9m shares (47.5% of the total) with these holders split broadly 35:65 between Canada and international. Over the last 12 months, the company had an average daily trading volume of c 6.6k shares on the Toronto Stock Exchange and c 3.9k shares on the London Stock Exchange. Volumes have increased following a greater focus on marketing the fund via articles in the financial press and podcasts.

CGI’s board now has three non-independent and four independent directors, who collectively have an average tenure of around nine years. Vanessa Morgan is chair of CGI and president and CEO of MMA; she joined CGI’s board in 1997. Jonathan Morgan, president and CEO of CGI and executive vice-president and COO of MMA, joined the board in 2001. The four independent directors and their years of appointment are Michelle Lally (2015), Marcia Lewis Brown (2020), Michael Walke (2023) and Sanjay Nakra (2023). At CGI’s April 2024 AGM, James Billet retired from the board having been the long-time chair of the audit committee; his replacement is Michael Walke. Also, another non-independent director joined the board, Clive Robinson, who is head of MMA’s private wealth management business.