Winnipeg Free Press

Winnipeg Free Press (Newspaper) - February 13, 2014, Winnipeg, Manitoba C M Y K PAGE A18 A 18 WINNIPEG FREE PRESS, THURSDAY, FEBRUARY 13, 2014 winnipegfreepress. com FINANCIAL POST B Y J O N AT H A N R AT N E R T he strength in North American equities over the past two years is presenting some challenges for income- oriented investors such as Venator Capital Management's Brandon Osten and Stephen Andersons. Higher valuations make it more difficult to find attractive entry points, but they also produce lower dividend yields. As a result, the Venator Income Fund portfolio managers have made a slight shift to Canadian convertible bonds from equities and U. S. high- yield bonds. " Once you start dipping below a 5% dividend yield, you better really like the stock. And once it falls below 3%, it provides much less margin of safety," Osten said. " You're not getting enough of a head start with the income to expect making a bit of money in a bad environment." Returns in the high- yield bond space are a far cry from the 12% levels seen a few years ago, but the managers still see opportunities with yields ranging from 5% to 8% at the upper end. " If you keep the duration short at three or four years, unlike a stock where the multiple can go down, at least with a bond you'll very likely get your money back," Osten said. Two- thirds of the portfolio is in bonds with the remainder in stocks. " We're looking for dependable businesses that are not cyclical, and you can count on the income stream without the company sacrificing its ability to grow," Andersons said. One play the managers are avoiding are the small- to- mid- cap oil and gas dividend payers formed through some sort of capital reorganization. Osten noted these companies are paying out dividends sourced from equity and/ or debt issues. " Both of those are really dangerous because these companies in Alberta have never been managed for free cash flow after capex," Osten said. " Free cash flow is what is important, not operating cash flow when you're looking at yield. I just think these things are all a disaster waiting to happen." Financial Post jratner@ nationalpost. com Income harder to find these days TYLER ANDERSON / NATIONAL POST Portfolio managers Stephen Andersons, left, and Brandon Osten say income is often easier to find in convertible bonds than high- yield bonds these days. MUTUAL FUND MARKETING M I C H A E L N A I R N E M utual fund marketers must be licking their chops in anticipation of attracting assets in 2014. Boosted by the tailwind of a falling Canadian dollar, the S& P 500 delivered a stunning 41.3% return in 2013, the most impressive annual performance in over half a century. International stock markets finished a strong second with the MSCI EAFE up 31.6%, its best performance since 1993 and seventh best showing in more than 40 years. Even the resource- burdened S& P/ TSX Composite managed to pull off a double- digit 13.0% return. Hence, you can expect fund marketing materials to feature some mouthwatering one- year returns this year. Of course, regulators are well aware of the danger of investors focusing on a single year of returns. They therefore require any sales communications to also include annual returns for three, five and 10- year periods, as applicable, as well as since the inception of the fund. A twist of timing will likely result in some very attractive double- digit returns for the past three- year period. First, the U. S. and EAFE 2013 returns are so extraordinary that they will boost the average. Second, stocks corrected sharply in mid- 2011 and then recovered in 2012 so, provided 2014 returns don't suffer a similar correction, the threeyear numbers later this year will benefit from the additional " hidden" lift to the three- year average return resulting from the depressed 2011 starting base. The five- year returns are going to appear particularly healthy in RRSP season. The catastrophic bear market of the Great Recession ended in February 2009 creating an absolute low point from which the subsequent five- year returns of the bull market will be measured. Consider that the five- year average annual returns for the Canadian, U. S., international and emerging stock markets as of December 31, 2013 are already 11.9%, 14.5%, 9.6% and 11.7%, respectively. These returns are only going to get better in January and February as long as performance in 2014 in these months exceeds the deep losses of 2009 in the same months - a pretty safe bet. Unfortunately, many an investor in 2014 will be tempted to cast aside their thoughtfully constructed longterm asset mix ( should they even have one) to chase alluring shortterm returns. One study of mutual funds in the U. S. found that inflowing investment jumps when funds display improving one, three or five- year annual returns - even when these increased returns stemmed solely from the mechanical process of historic poor monthly returns rolling over in favour of comparatively better ones as time marched on. Of course, one, three or five- year averages that soar simply from the swings of the overall market really don't provide any insight into the performance capabilities of a particular manager or the long- term return likely to be realized. But these artificial increases can influence investor behaviour. The authors of the above study have aptly labelled this " chasing false returns." They also found evidence that U. S. fund advertising is often designed to capitalize on this " false return chasing." Fund marketers are only too aware of how the idiosyncrasies of timing can create eye- catching returns for a particular period, and are quite happy to let the sizzle sell the steak. These tantalizing double- digit returns obscure the long- term reality of equity returns. Over the past 20 years, Canadian and U. S. stocks have delivered annual returns of 8.3% and 8.0%, respectively. In fact, at today's valuation levels and growth rates, some investment strategists believe annual returns going forward will be even less appetizing - in the 5% to 7% range. Investors need to craft their financial plans on these hard facts, not the heady returns they'll be enticed with in 2014. Michael Nairne is the president of Tacita Capital Inc., a private family office and investment counselling firm in Toronto. tacitacapital. com. A N A L Y S I S Don't be fooled by one- year returns B U Y & S E L L BIG- PICTURE VIEWS, CURRENT ISSUES, OUTLOOK AND PICKS. K BRO LINEN INC. ( KBL/ TSX) The position Long- term holding Why do you like it? This laundry and linen services provider has been a big winner for the fund, in part due to its top- notch but understated management team. " It's a very defensive business, but really hasn't received any credit for its growth," Osten said. " It's only now and then that they win a new contract." K Bro may not grow at 7% every year, but he suggests it may grow 15% once every two years. Biggest risk Valuation is near its high end. GRANITE REIT ( GRT/ TSX) The position Added in past six months Why do you like it? The managers haven't liked the REIT sector for the past year, but they did see an opportunity in Granite REIT, which owns and manages predominantly industrial properties. " They've been doing a good job of locking down and extending leases for some of the larger properties," Osten said. " They are also relatively debt free, which is unusual in the sector. As long as Granite offers a comparable yield to other REITs, they have an easier path to growth than those with more leverage." Biggest risk Majority of revenue comes from one tenant ( Magna International). SUPERIOR PLUS CORP. ( SPB/ TSX) The position Top holding ( owns stock and convertible bonds) Why do you like it? This energy services, specialty chemicals and construction products company would likely be worth more if it was split into parts, but the Venator managers are comfortable with the plan Superior Plus has in place. " They've been able to implement some operational changes in terms of streamlining the business, which has led to higher margins," Andersons said. " They are also expanding their business, while not sacrificing growth to pay out and increase the dividend." Biggest risk Warmer weather reduces chemical demand. B U Y S E L L Tantalizing double- digit returns obscure the long- term reality of equity returns Managers Brandon Osten and Stephen Andersons, Venator Capital Management Fund Venator Income Fund Description North American income strategy focused on yield and capital appreciation AUM $ 60- million ( fund); $ 225- million ( firm) Performance 1- year: 15%; 3- year 12.8%; 5- year: 18.8% ( annualized, as of Jan. 31, 2014) Fees Management 2% ( Class A), 1% ( Class F); Performance 10% ( 5% threshold) M A N A G E R P R O F I L E AUTOCANADA INC. ( ACQ/ TSX) The position Sold in past year Why don't you like it? The managers remain very fond of this auto dealership, but exited the position because its dividend yield fell below 3%. " It didn't hit our income criteria," Andersons said. " As well, while it's a great growth story with continued opportunities to remain a leading player in the Canadian automotive industry, its valuation had grown to the point that exceeded its U. S. peers." 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