Middlefield Canadian Income — Exposure to high-yielding North American equities

Exhibit 2 (LHS) shows the performance of Canadian indices in sterling terms over the last 10 years. Returns during 2016 were boosted by the weakness of sterling, which depreciated by c 23% versus the Canadian dollar. As shown in Exhibit 2 (RHS), Canadian stock market returns in 2016 were led by materials, energy, financials and industrials. During Q117, market leadership has broadened out, and as at-end March 2017, nine sectors had outperformed year-to-date; the exceptions were energy (which had been affected by a pullback in the oil price) and healthcare (a tiny sector dominated by the troubled Valeant Pharmaceuticals). There is the potential for this broader leadership to continue for the balance of the year.

Following the significant share price appreciation of Canadian equities in 2016, some valuation measures are looking high relative to history (Exhibit 3, LHS). On a forward earnings basis, using the Datastream Canadian Index as a proxy, Canadian equities are trading towards the top end of their 10-year range and 14% higher than the 10-year average. However, a benign economic environment could provide support to company earnings. In its April 2017 World Economic Outlook, the International Monetary Fund forecasts 2016-21 average annual economic growth for Canada of 1.86%, which is broadly similar to the US and modestly above the growth expected in both the UK and Europe. For investors seeking exposure to North America, a fund invested broadly across the Canadian stock market (and selectively in the US), with a focus on companies generating an attractive level of income and the potential for long-term capital growth, may appeal.

Middlefield Canadian Income – GBP PC (MCT) is the initial (sole) protected cell of Middlefield Canadian Income PCC (protected cell company). It is managed by the Middlefield Group, an investment company with c C$4.0bn of assets under management, with offices in Toronto, Calgary, San Francisco and London (UK). MCT is incorporated in Jersey and its shares are traded on the Main Market of the London Stock Exchange. It aims to provide shareholders with a high level of dividends and long-term capital growth from a diversified portfolio of primarily Canadian and US equities. Investments are focused on companies with good fundamentals, proven management teams, strong balance sheets and sustainable dividends. The portfolio typically contains 40-50 holdings; there are currently 47, including six debt instruments. Since fund inception, MCT has been managed by Dean Orrico; Rob Lauzon replaced the previous co-manager in May 2016. The trust is benchmarked against the S&P/TSX Composite High Dividend Index.

In February 2015, the investment limit for securities listed outside a Canadian exchange was increased from 20% to 40% and a new condition was introduced, allowing 10% of the fund to be invested in securities listed outside Canada and the US. These new rules allow the manager greater freedom to invest in sectors that are underrepresented in Canada, which could lead to higher total shareholder returns. MCT may invest up to 10% in a single issuer, the top 10 holdings may comprise 50% of the portfolio and up to 10% may be invested in unquoted securities (although none are held due to lack of liquidity). Currency exposure is not hedged. Gearing up to 25% of gross assets is permitted; it is typically in a range of 0% to 20%.

From a macro perspective, co-lead manager Orrico considers that both Canadian and US economic data is relatively positive, with unemployment, purchasing manager indices and general economic activity all moving in the right direction. The manager suggests that the US economy has had more momentum than Canada, and this may continue if President Trump is able to follow through on his proposed policies. Orrico explains that Canada has come out of a difficult two-year period, where softness in the oil price and other resources weighed on the economy, but now commodity prices have improved. He suggests the improving economic outlook provides a good backdrop for the performance of North American equities. Corporate earnings have been improving since Q316, which the manager argues should support equities, given elevated valuation multiples.

The manager comments that interest-rate sensitive sectors such as real estate have been affected by higher US rate expectations over the last few months, but real estate is an industry where, in the longer term, he expects rental growth and improved occupancy to outweigh higher borrowing costs. (At more than 20%, real estate is MCT’s second largest sector exposure.) Orrico believes that if comments from the Federal Reserve Board are constructive on economic activity, there are likely to be another two US interest rate rises in 2017, but the outlook for rate rises in 2018 is too difficult to call. He suggests that 10-year US government bond yields are likely to stay in a 2.5-3.0% range and that stock markets will start to discount this. Canada has not seen interest rate rises unlike in the US; hence the manager continues to prefer Canadian commercial real estate rather than US REITs. He says that these companies have good fundamentals, solid balance sheets, good payout ratios and are selectively increasing their annual dividends.

Managers Dean Orrico and Rob Lauzon take account of the prevailing macro environment to select high-yielding, primarily Canadian companies, which have the potential to increase their dividends. The managers aim to outperform the benchmark S&P/TSX Composite High Dividend Index. When selecting stocks on a bottom-up basis, screens are used extensively, including dividend yield, payout ratios and valuation metrics, and meeting company managements is a key element of the investment process. Third-party resources are used to provide research into areas, such as energy and healthcare, that are considered too specialist for a generalist fund manager. The healthcare research is led by SSR, which is led by Dr Richard Evans. Currently, c 15% of MCT’s portfolio is invested primarily in the US to provide exposure to sectors unavailable in Canada, such as healthcare where there are a large number of listed companies available. A small percentage of the portfolio (c 6%) is held in fixed income securities. All of MCT’s equity holdings pay a dividend; the manager has analysed MCT’s portfolio and found that eight out of 41 equity holdings raised their dividends during Q416 and c 70% of current equity holdings have increased their dividends during the last three years (by an average of c 13%). The manager suggests that investing in dividend-paying companies results in a better total return with lower risk, as well as helping to fund MCT’s dividend.

As shown in Exhibit 4, over the last 12 months, MCT’s exposure to Canadian equities has increased, while US equity and fixed income exposure has been reduced. The manager argues there are plenty of Canadian companies that are attractive from a risk/reward and yield perspective.

A recent addition to the portfolio is Chorus Aviation, which provides airline services to Air Canada (90% of revenues with contracts up to 2025) and has started diversifying its operations to third-party firms. Chorus operates in three business areas: Contracted flying operations; maintenance, repair and overhaul; and regional aircraft leasing. It has been consistently profitable since its initial public offering in 2006; its current dividend yield is c 6.5%.

The manager comments that currency can be a challenge to performance; he suggests that on balance, investors prefer unhedged exposure, but currency moves can result in volatility in MCT’s reported NAV. During 2016, sterling’s 22.9% depreciation versus the Canadian dollar provided a tailwind to MCT’s absolute total returns, but this followed a five-year headwind due to sterling appreciation. Over the last 12 months, MCT’s share price and NAV total returns of 42.9% and 36.8%, respectively, are ahead of the 35.0% benchmark total return. In Q117, sterling was more stable, appreciating by 0.8% versus the Canadian dollar; however, the manager comments that developments around the UK’s exit from the EU are likely to lead to further sterling volatility.

MCT’s relative returns are shown in Exhibit 7; its NAV total return has outperformed the S&P/TSX Composite High Dividend Index over one, three and five years, while lagging over 10 years. As a reference to UK shareholders, MCT’s NAV total return has outperformed the FTSE All-Share Index over one and three years and significantly outperformed over the last 10 years.

MCT’s 5.4% current share price discount to cum-income NAV is narrower than the 13.4% average of the last 12 months (range of 5.4% to 17.9%). It compares to the averages of the last three, five and 10 years of 8.7%, 5.4% and 6.4%, respectively.

There is scope for the discount to narrow further if investor demand for Canadian equities increases or the manager continues to deliver positive relative investment performance. In should be noted that in the past there have been periods where MCT’s shares traded at a premium to NAV; the last time was in early 2015.

The authorised share capital of MCT is split between two management shares, each valued at £1, and an unlimited number of redeemable participating preference shares. The fund is able to issue or repurchase these preference shares without shareholder approval. During 2016, 1.2m redeemable participating preference shares were repurchased at an average price of 80.41p and so far in 2017, 0.5m shares have been repurchased at an average price of 104.89p (0.4% of shares outstanding at the end of 2016). There are currently 106.5m redeemable participating preference shares outstanding with a further 18.2m held in treasury, which may be sold to satisfy future demand (up to a maximum of 10% of the issued share capital at the time of the last AGM).

MCT has an on-demand credit facility agreement with the Royal Bank of Canada up to a maximum of the lesser of C$65m or 25% of its total assets. The rate of borrowing is either prime minus 0.35% or banker’s acceptances plus a stamping fee of 0.60%. MCT uses gearing strategically; it is increased when the manager considers that equities are attractively valued and paid down when valuations are unappealing. In FY16, the level of net gearing ranged from 5.6% to 17.5% and was 18.0% at end-March 2017. In recent years, the yearly average level of net gearing has increased from 4.6% in FY12 to 13.3% in FY16. Gearing is partially offset by fixed-income exposure in the portfolio, which was c 6% at end-March 2017.

Middlefield Group, the investment manager, is entitled to a management fee of 0.7% of net assets, payable quarterly in arrears. In FY16, the fees were split between capital and revenues in a ratio of 60:40. Prior to June 2013, the management fee was 0.867%. In FY16, ongoing charges of 1.02% of average NAV compared to 1.06% in the prior year.

MCT currently pays regular 1.25p quarterly dividends in April, July, October and January. Barring unforeseen circumstances, it had been the board’s intention to continue to pay an annual dividend of 5.0p, supported by dividend and interest income from MCT’s investments. However, the board discusses the level of the dividend on a regular basis; given MCT’s positive capital returns and dividend increases in the underlying portfolio, the board has proposed to increase the quarterly dividend from 1.25p to 1.275p. Based on robust Q117 income, the 2017 pro forma dividend cover is more than 120%. MCT’s current dividend yield is 4.65%, (calculated on the proposed higher quarterly dividend, its prospective yield is 4.74%).

MCT is a member of the AIC’s North America sector – in Exhibit 10 we highlight the two funds with significant exposure to Canada. MCT has the better NAV total return over five and 10 years, while lagging over one and three years. It has a significantly lower discount, a lower ongoing charge, a broadly equal level of gearing and a higher dividend than its peer.

There are five directors on the board of MCT, four of whom are independent of the manager. Chairman Nicholas Villiers, Raymond Apsey and Philip Bisson were appointed at the fund’s inception and Thomas Grose was appointed in 2012. Apart from a period between 2010 and 2012, MCT’s co-lead manager, Dean Orrico, has also been on the board since the fund’s inception.