Davis Rea Buys U.S., Trims RBC on Economy Risk
The threat of a Canadian recession is prompting John O’Connell, who co-founded a private wealth management firm at Royal Bank of Canada (RY), to trim shares in the bank and sell Barrick Gold Corp. (ABX) and Imperial Oil Ltd. (IMO) at his new firm.
O’Connell, 50, says Canada is facing a consumer and housing-led slump and is reducing equities at Toronto-based Davis Rea Ltd. while acquiring U.S. dollars to deploy in consumer stocks such as Home Depot Inc. (HD)
“Our choice right now is cash and American versus Canada,” said O’Connell, chief executive officer at Davis Rea, which runs about C$575 million ($588 million). O’Connell bought the investment firm two years ago after leaving RBC’s The Harbour Group, which he helped build into assets under management of $2.8 billion when he left in 2010.
While Canada may have survived the 2008 financial crisis in relatively good condition, growth since has been fueled by consumer debt and a housing bubble that looks set to burst, he said in an interview in Bloomberg’s Toronto office on Oct. 5.
“Look at the gross debt consumer levels and the amount of spending in Canada, they’re all flashing major warning signs,” O’Connell said. “Much of our employment growth has been construction fueled by credit, and government employment. You have to wonder how much longer this can go on. The unemployment level is vulnerable to both.”
Davis Rea runs four pooled funds or trusts and accounts for individuals with a minimum C$1 million to invest. The Davis Rea Equity Pooled Fund holds about 35 percent cash, compared with 24 percent at the end of the first quarter this year.
At the end of the second quarter, it had advanced 4.3 percent in the previous 12 months, beating the Standard & Poor’s/TSX Composite Index which retreated 13 percent in the same period. Its balanced, fixed-income and partners funds each beat their benchmarks in the past 12 months.
Canada’s household debt burden rose to a record high of 154.3 percent in the first quarter, Statistics Canada said in June. The Bank of Canada has warned household debts are the economy’s biggest domestic risk and likely to continue rising.
John Johnston, chief strategist for Davis Rea and a former chief economist at Harbour Group, said the global economy is in the midst of the “third great depression of the industrial age” and headed for a recession.
“Europe is in a canoe and the mist is coming up from the falls,” he said. “Canada thinks it’s different, Canada thinks it’s exceptional, but it’s not.”
Johnston said he expects Canadian house prices to drop an average 20 percent, while Toronto and Vancouver markets could fall more. Average house prices surged 85 percent to C$465,412 in the past decade in Toronto.
Economists do not see a contraction in Canadian gross domestic product this quarter or the next four, though growth probably dipped to a low of 1.7 percent in the third quarter, according to a survey by Bloomberg.
With the proceeds of his Canadian sales, O’Connell is building up U.S. dollars, which he will deploy into the U.S. market when conditions turn more favorable.
“Right now is the time to focus on retention of capital, not return on capital for our clients,” O’Connell said.
Davis Rea is also looking at shares of U.S. consumer discretionary and health-care equipment suppliers, although O’Connell hasn’t settled on specific targets yet. Prospects look brighter for the U.S. housing market, making home improvement retailers intriguing investments as well, he said.
Mark Wisniewski, a fixed-income manager hired by Davis Rea earlier this October, said he’s looking forward to buying shorter-term duration debt products and finding ideas that have “fallen through the cracks” such as so-called crossover corporate debt. That’s debt rated between investment grade and high yield bonds, Wisniewski said.
“High-yield guys say it doesn’t yield enough and investment-grade guys say they can’t buy it, but I like crossovers,” he said.
One example is the debt of Fairfax Financial Holdings Ltd. (FFH), the Canadian financial services company run by Prem Watsa, Wisniewski said. The company’s most recent issue of C$200 million in 10-year senior unsecured debt, with a coupon of 5.84 percent, was rated BBB- by Standard & Poor’s Ratings Services yesterday.
O’Connell’s Canadian sells also include Husky Energy Inc. (HSE), while he’s reducing Canadian Natural Resources Ltd. (CNQ) Within his Canadian equity holdings O’Connell owns Morguard North American Residential REIT (MRG-U) as it is buying residential properties in both Canada and the U.S. The stock, which began trading in April, has risen 17 percent this year.
He also owns Tourmaline Oil Corp. (TOU), calling it the best oil and gas company in Canada with strong management, large resources and a solid balance sheet. The stock is up 13 percent this year.
“It’s exceptionally attractive to a foreign or domestic acquirer,” O’Connell said.
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