Focus on company management when choosing stocks

Scott Lysakowski meets regularly with company management before investing in a stock.

The co-head of Canadian equity research and a portfolio manager at Phillips, Hager & North Investment (PH&N) adds finding quality management helps identify a quality company—one that has a competitive advantage, and generates and reinvests excess free cash flow.

“That’s the holy grail of what we’re looking for in terms of investment opportunities,” says Lysakowski.

When analyzing management, he and partner Doug Stadelman look at the management’s track record, and its ability to perform during ups and downs.

“You could have a really good business and a bad management team, and that could end in poor results,” he says. “You could also have a relatively poor business, but a very strong management team can help make it a bit better.”

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Lysakowski worked his way up from the trading desk at PH&N’s parent company, RBC Global Asset Management. That was more than 12 years ago. Now, he and Stadelman oversee the Canadian Equity team of analysts and associates out of their Vancouver office, with about $8 billion in AUM for institutional portfolios and retail mutual funds.

Q. Can you further outline your strategy?

We are bottom up, with a focus on fundamental research. So we’ll determine the best industries, and companies within those industries, that’ll generate strong returns. For instance, Canadian banks have a strong competitive position, since there are only six big ones in Canada, and attractive returns on equity. These are stocks we’re going to hold over the long term. There are two steps to our process.

• We study the history of the industry and company to understand business cycles. We’ll look at the drivers of inflection points over time. For instance, what is different this time and what’s the same? What’s driving a company’s success or lack thereof? Studying history also lets us identify the overall quality of a particular business. We’ll look at whether it’s generated good returns on capital over time. Does it generate and reinvest free cash flow? Does management have a track record of doing that consistently? Has that led to attractive earnings growth? This ensures we’re not overly invested in one company or aggressively invested at the top of a particular cycle, whether it’s a commodity, industry or even the overall market cycle.
• We meet with management of companies we own, as well as those we don’t, on a regular basis. We want to find out what’s happening in their businesses today, so we’ll ask how they’re positioning themselves within the industry and what opportunities they see. These types of questions help us prepare for management interviews, and we’ll document the insights we learn.

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RBC’s Canadian manufacturing index hit a 9-month high in August.

As a result of this two-pronged approach, we’re able to better understand what the market is currently discounting. From there, we build a risk/reward outcome based on various scenarios.

Q. Is there a stock that’s indicative of your strategy?

Canadian Natural Resources (CNQ) is one of our core holdings and has been a strong performing stock for us over the last 12 to 24 months. They faced significant challenges in the 2011 to 2012 time frame due to production outages at their Horizon Oil Sands mine in Fort McMurray, Alta.

We met them on a regular basis to understand what happened and what they were doing to fix it. During that time, market sentiment turned negative. But, we viewed that as an opportunity because of the history of the company. It’s been around since the 1980s and they’ve got a track record of creating shareholder value, capital discipline and strong quarterly results.Also, the management team had a proactive response. They confirmed they took the challenges they were facing very seriously, and acted quickly to remediate the issues and put processes in place. For instance, the CEO of this national company with global assets would visit the site frequently. This hands-on approach helped with employee sentiment and, ultimately, changed the market’s perception of the culture of the company. This led to strong results for the stock. For instance, during the height of challenges in September 2011, it was trading at about $29 per share. In July 2014, it was back up to around $43.

We still think there are attractive growth prospects for the company. Of course, with any oil and gas producer, you have to be prepared to ride out some near-term volatility of commodity prices. But, long term, we feel they have attractive capital reinvestment opportunities, as well as free cash flow over the medium- to long-term. They’ve also rewarded investors by increasing their dividend and instituting a larger share buyback.

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Q. How do you measure risk and reward?

We look at the best-case scenario for the stock, and the worst. What’s a likely scenario that could happen over the next two, three, or five years? What are the sets of assumptions that are being discounted to the share price? There’s no clear-cut number, but we assess a range of outcomes. For instance, a stock with 50% upside could be attractive. But, if that same stock also has 50% downside, it’s not.

Q. What should advisors tell their institutional clients right now?

Don’t get caught up on short-term market fluctuations. If you can identify a high-quality business that, for whatever reason, the market is disinterested in over a short-term period, it’s a very attractive opportunity. So focus on quality, including companies with management teams that consistently deliver strong earnings and return on capital.

Read: Canadians aren’t protecting portfolios from volatility

Companies trading at a discount

Fortis Inc.: It’s a regulated utility with diversified assets across Canada, including gas and electric distribution in Alberta, as well as gas in B.C. The firm recently expanded into the U.S., with the acquisition of CH Energy in New York. It’s also in the process of completing the acquisition of UNS Energy in Arizona. The firm has faced a number of challenges due to Canadian regulatory issues, which have impeded some of its per share earnings growth over the last couple of years. That growth went from 5% to 7% growth to 3% to 5%.

However, it’s still a buy. “We think a number of those headwinds will begin to [ease],” notes Lysakowski. “We’ll start to see some of the accretion from its acquisitions in the U.S. There’s an opportunity for Fortis to recapture some of the earnings growth in a stock that’s been underperforming the market, and has a very reasonable valuation.”

ARC Resources Ltd.: It’s a mid-sized oil and gas producer, and a high-quality business due to multiple aspects. From an asset perspective, the firm has a large land position in the heart of the region in Montney, B.C.

There’s years of drilling potential and production growth in Montney, says Lysakowski. There’s also a strong management team at ARC, who were able to go through a seamless transition with a new CEO. The firm generates excess free cash flow by producing low-cost natural gas.

ACTION STEP Don’t rule out a stock without examining company management.