The philosophy driving Goodreid’s Canadian Equity Portfolio is easy to grasp: find great quality companies with strong management teams and growing profitability at a reasonable price. Yet in reality, it’s much more challenging to execute consistently over the long-term. This is the revitalized investment philosophy for managing Canadian equities at Goodreid Investment Counsel and is the hallmark of some of the world’s most respected investors, Warren Buffett among them.
Goodreid’s Portfolio Manager for Canadian Equities is Robert Gill, an industry veteran who recently took over the lead for this critical piece of client portfolios. He notes that “soaring inflation, rising interest rates and an increasingly uncertain economic landscape have led to very high volatility across equity markets.” These conditions favour investors with a consistent, high-conviction strategy who construct a portfolio of companies with strong balance sheets, histories of providing high returns on equity, and the prospect of continued growth due to several factors. In the end, Goodreid seeks to identify companies with defining characteristics where quality and value intersect.
Goodreid’s value-based philosophy aims to find high-quality companies to add to the portfolio at the right price. “That said, quality is always more important than valuation,” Gill points out. After all, a company’s share price may appear attractively valued relative to its earnings. For example, its price to earnings ratio, measuring how much investors are willing to pay for every dollar of earnings generated, may suggest it is a bargain purchase. Like countless other valuation metrics, price-to-earnings is informative, but it can be misleading when examined in isolation. A stock can appear to be on sale at a certain price, but its price may actually reflect a change for the worse in its prospects, which the market has recognized. Often referred to as ‘value traps,’ these seemingly bargain stocks are likely to fall even further in price because their business is actually deteriorating, impacting earnings and future growth. Goodreid’s bottom-up approach to uncover companies with sustainable business franchises and strong balance sheets is a proven methodology to avoid value traps. The analysis considers a close examination of financial fundamentals such as profitability, cash flow and debt.
Mr. Gill’s equity selection strategy consists of combing through the Canadian equity universe of more than 4,000 publicly traded companies in order to build a portfolio of about two dozen stock positions. As a rule, only Canadian companies with a track record of five years and market capitalizations of $200 million or more make the initial cut, leading to a pool of about 400 stocks. “Then we look over each of these, separating good quality companies from bad ones – the good being profitable companies with strong market positions and great prospects for future growth along with reasonable debt on the balance sheet,” he says. “By the time we apply that quality filter, we are down to our ‘Working List’ of about 120 companies.” The next step is looking among these quality companies to find those whose share price is attractively valued relative to their fundamentals.
Through this analysis, the companies on the Working List can be plotted on a Quality / Valuation Matrix. This quadrant is broken up into four categories: Avoid – poor quality companies at expensive valuations / poor quality companies at at-tractive valuations; Monitor – high quality companies at expensive valuations; and Purchase – high quality companies at attractive valuations with a ‘margin of safety’. This ‘margin of safety’ means a company’s purchase price is below their intrinsic value.
By the time this process is complete, Goodreid’s Canadian portfolio is whittled down to about two dozen companies.
Included among the holdings today are three well-known Canadian brands: cheesemaker Saputo Inc. (SAP-TSX), Canadian National Railway Co. (CNR-TSX) and Restaurant Brands International (QSR-TSX). All illustrate Goodreid’s investment philosophy aimed at consistently strong profitability. This can result in a portfolio that can look quite different from the S&P/TSX Composite Index – the benchmark often used to measure the performance of Canadian equity strategies. Indeed, having a portfolio that is different from the index is critical to success going forward, amid current conditions with a recession looming and growth likely to be constrained. That’s especially so when that portfolio consists of great companies that are more likely to remain profitable and add performance to the portfolio.
Mr. Gill points to Restaurants Brands International as embodying this approach. Tim Hortons represents approximately 60 per cent of QSR’s revenue, but Restaurant Brands International’s portfolio of companies also includes Burger King, Popeyes Louisiana Kitchen and Firehouse Subs, which have larger footprints in the U.S. That said, QSR has a growing international footprint with Tim Hortons locations in the U.S, emerging markets (China included) and the UK among other European nations. Yet Tim Hortons dominant position in Canada provides QSR with a foundation of consistently growing earnings. “Tim Hortons is arguably one of the strongest brands in Canada, with an extremely loyal following” Gill says. “It has strong recurring revenue with many customers going there four or five times a week.”
These attributes provide QSR with a strong “economic moat.” This is a key characteristic sought for Goodreid’s portfolio. Having a competitive advantage in an industry in which continued profitability is notoriously difficult to achieve is essential, he adds. “Restaurants are a very difficult business.” Costs can be high, and consumers can be fickle. Yet Restaurant Brands International has a unique strategy to derive revenue compared with competitors. It does not own and operate each location. It franchises them, earning royalties from ongoing operations, while providing franchisees use of marketing and access to its distribution network and supplies. “For the most part, the company is receiving cheques, and it’s a darn good business,” Gill says.
Once it has been determined that the company is a quality business, the next question at Goodreid is whether QSR is attractively valued. Already part of the portfolio, valuation is only a concern if the Goodreid team seeks to increase or de-crease the company’s position in the portfolio. “We may not buy QSR all the time, but when the stock price falls off, for example, because it misses earnings or some other negative news, we evaluate it,” Gill says. “We understand the risks and determine if the valuation is warranted based on the risks we see.” If it remains a quality company, based on underlying fundamentals, Goodreid may add more to the portfolio, given its potential upside for share price growth. Similarly, should conditions change affecting quality or valuation of a current stock holding, the team may sell a portion of the holding, or even the entire position.
Typically, Goodreid sells a company for three reasons. The first is when the quality of the company becomes impaired. It might be losing its advantage over competitors, for example, or has experienced a significant change in management that could affect future profitability. The second reason for selling a position is the team has found either a higher quality company at a similar valuation, or a more attractively priced company of a similar quality. In this case we would execute a switch. “The third reason to sell a holding is if it moves far beyond its fair market value.”
Which begs the question: What is fair market value?
Uncovering the fair value of any stock in the portfolio or under consideration for the portfolio is a key tenet of Goodreid’s investment process. Gill cites Saputo’s performance during the pandemic as one example of how Goodreid determines a stock's fair market value and whether it aligns with the portfolio.
“Saputo has a lot of great qualities: it is well managed; its balance sheet is strong, and it’s more profitable than the aver-age company on the stock market,” he notes. During COVID, however, Saputo faced several challenges, from plant shut-downs to a reduced labour supply. “Their capacity utilization pre-pandemic was generally north of 95 per cent, which is really good, but during the pandemic it dropped considerably. Gill adds these factors negatively affected near-term profitability. Compounding problems, Saputo faces high inflation and rising interest rates like many other businesses. “So there are fewer workers, higher costs for inputs—like milk—and higher interest rates making it more expensive to borrow to grow,” he says. “Everything is constrained.”
Yet Gill notes that Saputo remains a strong investment long-term due to its underlying quality. A provider of consumer staples—butter, cheese and yogurt, for instance— “a lot of things have to happen to people’s paycheques before they stop buying these items,” Gill says. This quality makes Saputo’s revenues more resilient amid high inflation when house-hold budgets are constrained.
Then comes the valuation part of the process. Besides being a high-quality company, Saputo’s share price earlier this year relative to its fundamentals made its valuation attractive. Saputo was trading at a recent high of $42 or 24X Normalized Earnings. However, its share price fell in June, and the multiple contracted to 14X. Gill says Goodreid purchased the stock when it traded at $28 a share. “We did so after assessing that its current challenges are transitory,” he says. “At some point the issues will work themselves out, and Saputo’s capacity utilization will increase, leading to superior earnings.”
In effect, Goodreid research showed the company’s share price was trading significantly below fair value, which it determined to be about $40 to $45 a share. “So by some time next year, we expect to see higher earnings and the stock price revert to the mean—which is in that price range,” Gill says. “In the meantime it pays a dividend for us to wait.”
As another example of Goodreid’s value-based philosophy, Gill points to CN Rail which offers a rail transportation service that is undoubtedly ‘mission critical’ to customers. For one, in a rising cost environment, rail is significantly more cost-effective than trucking, Gill says. What’s more, CN’s rail network is unsurpassed making it difficult for competitors to take its market share. “You can’t buy more land to roll out more track across the continent,” Gill explains. CN’s next largest competitor is CP Rail, which is on Goodreid’s watch list. Yet Gill says CN’s track footprint is superior for several reasons. CN has better access to Canada’s west and east coasts. Although CP has access at the Port of Vancouver, so does CN. Yet CN also has access at Prince Rupert, B.C., which is less congested and thereby often more efficient. In the east, CP’s rail presence ends at Montreal. In contrast, CN’s network extends much further to the Port of Halifax. Additionally, CN has access to two ports in Louisiana and Alabama, whereas CP’s U.S. network stops in the Midwest. “Long story short, CN has a better rail network than CP,” Gill says. CP is worth monitoring, particularly after it acquired Kansas City Southern in late 2021, providing it with potentially a greater U.S. footprint.
While Goodreid’s value-based philosophy is core to the portfolio, the portfolio also includes select growth names, so long as they fit the criteria of Goodreid’s overarching philosophy. “We look for strong balance sheets, for example, and management teams allocating capital well to generate high returns on that investment.” No matter the sector, a select few companies will fit this mold, among them technology companies. Generally considered growth companies with high valuations based on expected future earnings, some may fit the criteria of being high quality with attractive valuations. “One example might be a software company with a business model that generates recurring revenues, and most importantly its service is mission-critical to its customers’ operations,” Gill explains. “They can’t operate without the software.” As such, a tech company with these qualities would warrant a closer look.
Further to that point, continually watching over potential stocks for the portfolio and current holdings is a touchstone of Goodreid’s strategy. It is a particularly useful element of active management amid today’s challenging environment for stocks. Unlike the past decade where historically low interest rates broadly buoyed markets, often beneficial for passive, indexing strategies, today’s environment of higher rates and inflation requires building a targeted portfolio of select, quality companies. These are by no means easy to find, Gill adds. In fact, only a few new companies are added to the portfolio annually, given they must hit the “sweet spot” of not just being quality businesses. They must also be priced at an attractive valuation, Gill says. “That doesn’t happen often, but when you find those two characteristics together in a stock, that’s investor nirvana.”
