Editor’s Note: What follows is the executive summary of the July 2013 issue of Canadian Edge. Thanks for reading.

We’ve been following Canada since the summer of 2004, before word of the “miracle” up north went viral.

Of course Canadian income trusts and their high distributions attracted considerable interest from an investing public hungry for yield.

Over the long term–and we’re now well into year three of the post-income trust era–the main differentiators among economies and markets are fundamentals.

And, despite the fact that Canadian growth has slowed and the fact that the S&P/Toronto Stock Exchange Composite Index has underperformed the entire G-7 and even Spain’s and Greece’s benchmarks, Canada’s fundamentals remain strong.

To wit, housing starts increased by 14 percent in May to an annualized rate of 200,178, beating market expectations, and building permits surged by 35 percent in April. Industrial production expanded by 0.7 percent in March, while real gross domestic product was better by 0.2 percent and retail sales increased by 0.7 percent.

The Canadian economy shed far fewer jobs than expected in June after posting the second-biggest monthly gain on record in May, according to Statistics Canada. The number of net new jobs created fell by just 400, the first decline in three months and a tiny payback following the addition of a whopping 95,000 positions in May. That left Canada’s unemployment rate unchanged at 7.1 percent.

The consensus call was for a loss of 7,500 jobs and a steady jobless rate in June.

Job growth averaged 14,000 a month in the first half of 2013. That’s roughly half the average of 27,000 in the second half of 2012, a more modest pace that will likely lead the Bank of Canada to keep its overnight interest rate at 1 percent at least through 2013.

The BoC will meet July 17 for its first interest rate decision under Governor Stephen Poloz, who has succeeded Mark Carney. Mr. Carney is now Governor of the Bank of England, a title he earned largely on his and Canada’s performance during and after the Great Recession.

It must be noted, however, that the “before” part of the equation involves many Canadian decision-makers, including Mr. Flaherty, notorious for killing the income trust but an otherwise capable steward of his policy portfolio.

It also includes Julie Dickson, Superintendent of the Office of the Superintendent of Financial Institutions, Canada’s top banking regulator.

If Mr. Carney has ridden the reputation of Canadian banking’s “safest in the world” reputation to the Bank of England, it must also be noted that this reputation is rooted, like Canada’s generally strong public finances, in decisions made in the 1990s.

In 1998, Royal Bank of Canada (TSX: RY, NYSE: RY) and Bank of Montreal (TSX: BMO, NYSE: BMO), two of Canada’s Big Five banks, wanted to merge. So did Toronto-Dominion Bank (TSX: TD, NYSE: TD) and Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM).  

That would have left three institutions, including our favorite, Bank of Nova Scotia (TSX: BNS, NYSE: BNS), two of them gigantic. And those institutions would likely have taken the road travelled by their US brethren, expanding in search of global scale, taking on more risk and likely getting exposed to the US subprime market.

The decision by then-Prime Minister Jean Chretien and then-Finance Minister Paul Martin to block the mergers involved not a little local political consideration: The mergers would have resulted in job losses across Canada, as consolidating banks closed branches in small towns.

In addition to having little positive impact on average Canadians, Mr. Martin had in mind the failures of two banks in western Canada in the mid-1980s and of a major trust company and an insurance company in the 1990s.

There’s no question that Canada’s Big Five are systemically important. But they aren’t so interconnected that problems at one will inevitably poison another. Two gigantic Canadian banks would inevitably have ventured south in search of growth, likely snapping up an American institution deeply involved in subprime lending and bringing that famous crisis north of the border.

It was a prudent decision by Mr. Chretien and Mr. Martin that reverberates today.

The Canadian banks have been well managed, and they’re regulator has required them to have higher capital ratios than banks elsewhere around the world. Limited competition has allowed them to make big profits from domestic retail banking, while significant deposit bases have provided stable sources of funding.

On top of mortgage regulations that are now even stricter than in the US after Mr. Flaherty’s recent efforts to slow a lending boom, the decision to keep them simply big as opposed to Citigroup (NYSE: C) or JPMorgan Chase & Co (NYSE: JPM) style gigantic is the foundation for Canada’s sound financial system.

Canada’s economy posted growth of just 0.1 percent from March to April, and it’s likely that Alberta flooding will take a bite out of growth in June. BMO Capital Markets estimates that about CAD2 billion, or one-tenth of one percentage point, could be wiped out when the monthly GDP report is released.

Much of southern Alberta has been under a state of emergency after record water levels on the Bow River steamrolled through municipalities and downtown Calgary. Alberta accounts for about 6.5 percent of Canadian GDP, according to BMO Capital Markets, and preliminary damage estimates range from CAD3 billion to CAD5 billion.

But consumers will have to replace a lot of stuff damaged by the flooding, and that will provide an uplift later in the summer.

And the US has been more resilient than anticipated in the early months of 2013, improving Canada’s trade balance. Stronger demand for autos, houses and industrial machinery from the US will help sustain the lift in export growth that Canada experienced so far this year for the remainder of 2013.

Company balance sheets are also healthy and will allow Canadian firms to invest in growth at an accelerating rate.

The US will likely outpace Canada in terms of GDP growth, but much of that is due to pent-up demand being released. But what’s good for the US is good for the other side of what’s still the largest bilateral trade relationship in the world.

We have more on How They Rate companies and Portfolio Holdings poised to benefit from improving US economic conditions in this month’s In Focus feature. This month’s Best Buy selections are also tied to economic growth beyond Canada.

At the end of the day, company-level fundamentals matter more to dividend-focused investors than global- or country-level macro conditions. But context is important. A negative context has dragged on Canadian equity valuations. Understanding it will help identify strong companies priced at bargain levels.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

Through the first six months of 2013 the 18 stocks that comprise the Canadian Edge Portfolio Conservative Holdings posted an average total return in US dollar terms of negative 1.64 percent.

The Aggressive Holdings, meanwhile, were off by an average of 15.14 percent. This includes significant losses incurred by Colabor Group Inc (TSX: GCL, OTC: COLFF) and Just Energy Group Inc (TSX: JE, NYSE: JE), which we sold in the June issue, and IBI Group Inc (TSX: IBG, OTC: IBIBF), which we sold in a May 17 Flash Alert.

The 15 stocks that remain in the Aggressive Holdings posted an average total return in US dollar terms of negative 7.23 percent.

The S&P/Toronto Stock Exchange Composite Index was off by 6.32 percent in US dollar terms, though just 0.88 percent in local currency terms. The S&P 500 Index, meanwhile, returned 13.83 percent, the MSCI World Index 8.82 percent.

It’s been a strong year for developed-world equity markets–everywhere, it seems, but Canada, where lower commodity prices and the perception that the economy is slowing or will slow due to a housing-market correction have brought out the bearishness in the broad investment community.

Portfolio Update has more, including the first-of-the-season earnings report and an update on other Holdings that have struggled.

Best Buys

Between AltaGas Ltd (TSX: ALA, OTC: ATGFF) and fellow July Best Buy Vermilion Energy Inc (TSX: VET, NYSE: VET) there’s just a single dividend cut, one that came in the aftermath of the 2008-09 global financial, economic and market meltdown and in direct consequence of the Canadian government’s imposition of an entity-level tax on so-called specified investment flow-throughs, or SIFTs.

Aggressive Holding Vermilion Energy has been a member of the CE Portfolio since August 2004, or the second issue of the advisory. Conservative Holding AltaGas is only slightly later to the party, having joined the Portfolio in the February 2005 issue.

Both are trading at attractive levels based on recent dividend and asset growth.

Best Buys has more on the Portfolio Holdings that represent our top ideas for new money in July.

In Focus

Sentiment on Canada, at least as measured by the decline in the Canadian dollar, is cooling. The loonie is near a three-year low at USD0.9458 as of Friday afternoon.

But economic fundamentals up north remain solid.

Despite widespread worry and a prevailing sense that a US-style debacle is in the works, the Canadian housing market is not imploding.

The financial system is sound, with Canadian banks boasting solid return on equity figures and complying with stricter Basel III capital requirements.

The Bank of Canada is under new leadership, as Mark Carney has left for his new gig with the Bank of England. New governor Stephen Poloz is maintaining the old monetary policy.

Slower Chinese growth will impact Canada’s resource-intensive economy, but this impact has largely been priced in. It should be noted too that metals account for just 12 percent of Canada’s exports, while energy commodities–where prices are relatively stable–account for about 25 percent.

Another combined 22 percent of exports are wood products and autos, which are both linked to two parts of the US economy that have stabilized in the aftermath of the Great Recession and are showing solid if unspectacular growth, housing and motor vehicles.

At the same time, several stocks in the How They Rate coverage universe–including one new addition–are not specifically tied to Canadian economic fortunes. In some cases their stories are more continental, in others more global.

But at these levels, due in part to the fact that Canada has fallen out of fashion, they represent good value.

Dividend Watch List

There was just one dividend cut in the How They Rate coverage universe last month, by closed-end fund Precious Metals & Mining Trust (TSX: MMP-U, OTC: PMMTF). And Barrick Gold Corp (TSX: ABX, NYSE: ABX) joins the List this month.

Dividend Watch List has the details on members of the How They Rate coverage universe whose current dividend rates are in jeopardy.

Canadian Currents

After Canada’s gross domestic product grew at a stronger-than-expected pace during the first quarter, the economy settled into a more sluggish trend in April, writes CE Associate Editor Charney.

Canadian Currents has more on how and why Canada’s economy is in a holding pattern.

How They Rate Update

Coverage Changes

Auto parts and systems designer and manufacturer Magna International Inc (TSX: MG, NYSE: MGA) is new to How They Rate coverage this month, under Business Trusts. We have more on Magna in this month’s In Focus feature. Buy under USD80.

Poseidon Concepts Corp has de-listed from the TSX. Management has entered an agreement to sell its assets to Rockwater Energy Solutions. Poseidon is now operating under bankruptcy protection in the US and Canada.

There are a number of shareholder suits ongoing against the company. One US law firm participating is Howard G. Smith of Bensalem, Pennsylvania (888-638-4847).

Given how fast this one imploded, no one should get their hopes up for much restitution. But by the same token shareholders have little to lose, either.

Advice Changes

Barrick Gold Corp (TSX: ABX, NYSE: ABX)–To SELL from Buy @ 45. Gold’s fundamentals have completely broken down, and gold miners are suffering with high production costs that in many cases can’t be met at current commodity prices.

Barrick announced that it will take significant impairment charges in the second quarter and will take a hard look at its cost structure. The current dividend rate could be in jeopardy.

Baytex Energy Corp (TSX: BTE, NYSE: BTE)–To Buy @ 42 from Buy @ 55. We’ve reduced our buy-under target to a level that better reflects current market reality. Baytex closed at USD37.87 on the New York Stock Exchange on Friday, July 5.

Boyd Group Income Fund (TSX: BYD-U, OTC: BFGIF)–To Hold from Buy @ 16. The stock is pushing CAD24, or USD23 based on prevailing exchange rates, on the Toronto Stock Exchange, well above our prior buy-under target.

Management will likely announce a dividend increase in November, if prior practice is maintained. But the increase won’t be sufficient to justify the run-up in the share price. It’s a solid company with a solid growth plan, but it’s expensive at these levels.

Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF)–To Buy @ 10 from Buy @ 15. We’ve reduced our buy-under target on the stock to better reflect market reality. Lightstream closed at CAD7.70 on the TSX on July 5.

Liquor Stores NA Ltd (TSX: LIQ, OTC: LQSIF)–To Buy @18 from Hold. A selloff presents an opportunity to pick up a solid company with a stable dividend, with cash flow supported by Canada-focused growth augmented by US exposure.

MEG Energy Corp (TSX: MEG, OTC: MEGEF)–To Buy @ 32 from Buy @ 40. We’ve reduced our buy-under target on the stock to better reflect market reality. MEG close at CAD30.58 on the TSX on July 5.

Primary Energy Recycling Inc (TSX: PRI, OTC: PENGF)–To Buy @ 4.80 from Hold. The company could be a takeover target after hitting a 52-week low. First-quarter numbers were solid. This is for aggressive speculators only.

Suncor Energy Inc (TSX: SU, NYSE: SU)–To Buy @ 33 from Hold. The energy producer with significant oil sands operations earns a re-basing based on its decision to boost its dividend from CAD0.13 per share per quarter to CAD0.20.

The Keg Royalties Income Fund (TSX: KEG-U, OTC: KRIUF)–To Buy @ 14 from Hold. The chain is adding new restaurants at a solid clip, demonstrating the attractiveness of its brand. Same-store growth is better in the US than in Canada, a unique factor its domestic competitors can’t match. The selloff in the shares represents an opportunity to pick up a solid, sustainable dividend.

Ratings Changes

Canadian Natural Resources Ltd (TSX: CNQ, NYSE: CNQ)–To 4 from 3. The company earns an additional point because it has low overall debt compared to other Oil and Gas companies, two-year maturities are more than manageable and the payout ratio is relatively low and likely to remain so for the foreseeable future.

The core of my selection process is the six-point CE Safety Rating System, which awards one point for each of the following. A rating of “6” is the safest:

• Payout Ratio–A ratio below our proprietary industry baseline.
• Earnings Visibility–Earnings are predictable enough to forecast a payout ratio below our proprietary industry baseline.
• Debt-to-Assets Ratio–A ratio below our proprietary industry baseline.
• Short-Term Debt Ratio–Debt due in next two years is less than 10 percent of market capitalization.
• Business Stability–Companies that can sustain revenues during recessions are favored over more cyclical ones.
• Dividend History–No dividend cuts over the preceding five years.

Resources

The following Resources may be found in the top navigation menu at www.CanadianEdge.com:

• Ask the Editor–We will reply to your queries via email or in an upcoming article.
• Broker Guide–Comparison of brokers for purchasing Canadian investments.
• Getting Started–Tour of the Canadian Edge website and service.
• Cross-Border Tax Guide–What you need to know about taxes and Canadian investments.
• Other Websites–Links to other websites to help you get the most out of your Canadian stocks.
• Promo Stocks–Guide to the mystery stocks we tease in our promotional messages.
• CE Safety Rating System–In-depth explanation of the proprietary ratings system and how to use it effectively.
• Special Reports–The most recent reports for new subscribers. The most current advice is always in your regular issue.
• Tips on DRIPs–Details for any dividend reinvestment plan offered by Canadian Edge Portfolio Holdings.