For Love of the Loonie

By David Dittman • October 4, 2013 • In Brief

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

US investors who are long Canadian equities are also long the Canadian dollar. Movements in the loonie vis-à-vis the US dollar are reflected in prices of the stocks we hold in our portfolios as well as in the dividends we’re paid in respect of those holdings.

For much of the past year that’s been an unenviable proposition. From a 12-month high of USD1.0236 established Oct. 8, 2012, the loonie has alighted to USD0.9711 as of Oct. 4, 2013, a decline of 5.1 percent.

The Canadian dollar has closed as low as USD0.9450 on July 5, 2013, a top-to-bottom turn within our reference points of 7.7 percent.

The third quarter was clearly a good one for the loonie, as it was for Canadian stocks.

Our focus, however, is on building wealth over the long term, though the news here is strictly positive as well: As we’re going long Canadian stocks and the Canadian dollar, the world’s central banks are loading up on loonies too.

According to the International Monetary Fund (IMF), central banks increased their holdings of Canadian dollars to USD108.9 billion as of June 30, 2013, up from USD94.9 billion at the end of the first quarter and USD90.1 billion at the end of 2012.

International desire for the loonie was underscored by an August 2012 report from the IMF that suggested the Canadian currency, along with the Australian dollar, be included among the basket of currencies–including the US dollar, the British pound sterling, the euro, the Japanese yen and the Swiss franc–listed in the IMF’s quarterly Currency Composition of Official Foreign Exchange Reserves (COFER).

A March 2013 report in The Wall Street Journal indicated this would happen by June 30, 2013.

“The IMF is expanding the list of currencies separately identified in the COFER template,” an IMF spokeswoman told the WSJ. “The implementation of the revised COFER Report Form, with separate identification of the Australian dollar and Canadian dollar, is scheduled for the first half of 2013.”

The COFER report for the second quarter of 2013 marks the first time central bank holdings of the loonie and the aussie have been broken out on their own line. They had previously been lumped in the “other” category.

It should be noted that the IMF is merely catching up to the curve here, as central banks have been diversifying into alternative currencies in earnest since the September 2008 crackup of Lehman Brothers signaled the serious stage of the Great Financial Crisis.

The “big five” still command the lion’s share of central bank foreign currency holdings. But the trend toward the loonie and the aussie–which share in common underlying economies focused on resource production and export as well as supporting governments with relatively low levels of debt–is clear.

“Claims in other currencies” surpassed the Japanese yen to take fourth place during the fourth quarter of 2009 and leapt over the British pound for third place in the third quarter of 2010.

“Other’s” share has grown substantially in the 21st century, from 1.49 percent of allocated reserves at the end of 2000 to 5.49 percent in 2011 to above 6 percent as of Dec. 31, 2012.

It’s important to note that the IMF’s listing the loonie on its own should have no substantive impact, as it’s an after-the-fact accounting of actions central banks have already taken.

Although the increase in Canadian dollar holdings probably reflects more a desire among central banks to diversify holdings, it is also, at least in some small part, recognition of the country’s relatively strong fiscal position.

A new line-item doesn’t make the currency any more or less fundamentally attractive. But it does acknowledge the fact that the Canadian dollar has achieved a certain critical point in the eyes of central banks around the world.

A Shutdown Note

We’re just four days into a US government shutdown that’s earned a lot of headlines and cable TV news time. But unless it merges with the Oct. 17 deadline for extending the US federal borrowing limit there are unlikely to be significant consequences for Canada.

Some businesses that serve or supply US government departments or rely on the civil service to have permits or visa applications approved might be slightly affected. But generally speaking the effect of even two weeks of a government shutdown would barely show up in Canada’s economic indicators.

Royal Bank of Canada (TSX: RY, NYSE: RY) has estimated that a month-long shutdown would reduce Canada’s fourth-quarter gross domestic product (GDP) by 0.25 percent.

The outlook could change if the shutdown continues and investors begin to suspect that it will cause the U.S. Federal Reserve to delay its phasing out of economic stimulus measures.

Failure to raise the debt ceiling, however, would require the US government to essentially slash USD600 billion of its annual spending. That’s 4 percent of GDP, and it’s enough to push the US economy into recession.

If a debt-limit increase isn’t approved, the US government might have to miss interest payments on loans, or fail to pay social security or default on US Treasury securities. The latter are the gold standard as far as bank collateral is concerned, so a large chunk of banks’ assets would also essentially be in default.

It’s hard to estimate the impact on global financial markets of this degree of failure of the US political system.

It’s another reminder of the relative tranquility and stability found north of the border, where there is no equivalent to a “debt ceiling.” When a federal budget that includes spending and taxes is passed in the approval for the borrowing that’s required goes along with it.

The US political system builds in the opportunity to vote to approve spending but also, against all logic but to the benefit of gerrymander-protected members of Congress, the opportunity to vote to oppose the increase in borrowing that that spending necessitates.

For better or worse, Canada’s economic fortunes are tied to those of the US: The greater the impact the shutdown/debt ceiling conflict has in the US, the greater will be the spillover effect in Canada.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

A certain group of high-yielding equities has managed to avoid the carnage visited upon real estate investment trusts (REIT), utilities and other stocks associated with outsized payouts: Canadian oil and gas exploration and production companies.

Our top five Canadian oil and gas producers–ARC Resources Ltd (TSX: ARX, OTC: AETUF), Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF), Enerplus Resources Corp (TSX: ERF, NYSE: ERF), Peyto Exploration and Development Corp (TSX: PEY, OTC: PEYUF) and Vermilion Energy Inc (TSX: VET, NYSE: VET)–have outperformed sector and broad-based indexes, with an average total return from May 2 through Oct. 2 of 8.1 percent in US dollar terms and 10.79 percent in Canadian dollar terms.

Even factoring in the laggard Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF), which is off 10.94 percent in US terms and 8.72 percent in Canadian terms, leaves the six-stock average total return of 4.93 percent in US terms, 7.54 percent in local terms, still far better than the yield-focused sector benchmarks but slightly behind the broader market indexes.

We discuss the factors behind this outperformance in this month’s Portfolio Update.

We also have results from the last Portfolio Holding to post financial and operating results for the recently concluding reporting cycle, Student Transportation Inc (TSX: STB, NSDQ: STB). Numbers were solid, as the full-year payout ratio declined again, and management looks forward to another solid year for fiscal 2014.

Portfolio Update has all that as well as updates from Holdings with developments of particular note during the past month.

Best Buys

Both companies’ names begin with the letter “N.” Beyond that superficial similarity, however, lies a key common factor for this month’s Best Buys: Energy and industrial waste recovery specialist Newalta Corp (TSX: NAL, OTC: NWLTF) and real estate investment trust Northern Property REIT (TSX: NPR-U, OTC: NPRUF) offer secondary but stable ways to play the build-out of oil and gas infrastructure and production in Western Canada.

Newalta’s capital investment plan for 2013 is on budget–about CAD190 million, with 80 percent earmarked for growth initiatives, with 70 percent levered to oilfield services–and the company’s strong balance sheet and operational track record make a solid foundation for continuing growth into 2014. Newalta is a buy under USD17.50.

REITs are not popular right now. And that means it’s probably a good time for new money to establish positions in those with high-quality portfolios concentrated in growing economies.

Northern Property REIT generated 37.1 percent of its 2012 revenue from Canada’s growth-engine provincial economies, Alberta and British Columbia, where oil and gas development and production promise to support more growth in coming years.

Northern Property, along with second-quarter results, announced a 3.3 percent increase to its monthly distribution rate. That’s a sure sign of management confidence in the sustainability as well as the growth trajectory for its operations. Northern Property is a buy under USD30.

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

In Focus

Canada’s role in the global build-out of liquefied natural gas (LNG) capacity won’t be a major one. Note, however, that Marlon Brando won an Oscar for about 12 minutes of screen-time in the 1989 film A Dry White Season.

Key to Canada’s success in this burgeoning energy market will be its ability to move gas from British Columbia across the Pacific Ocean to Asian customers. But infrastructure requirements are immense, regulatory hurdles are high, and competition, particularly from the US, is intensifying.

We favor companies with existing operations in the oil and gas and industrial spaces that will see a significant step-up in revenue, earnings and cash flow based on the realization of at least part of Canada’s LNG export potential but whose dividends can be supported by existing operations.

Oilfield services is a solid way to play Canadian LNG because of the changing nature of the typical consumer: It’s getting much, much bigger, capable of supporting longer-term engagements, generating repeat business and driving margin expansion as well as earnings and cash flow growth.

In Focus discusses the obstacles that must be overcome for Canada to become a significant player in the global LNG export market, and it explains the potential rewards for oilfield services companies.

Dividend Watch List

There were zero dividend cuts by members of the How They Rate coverage universe last month, which is a good thing. At the same time, Encana Corp (TSX: ECA, NYSE: ECA), Canada’s largest producer of natural gas, has made its way onto the list following comments by new CEO Doug Suttles at a recent analyst conference.

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

Canadian Currents

Although policymakers see exports as key to the resurgence of the country’s economy, near-term challenges remain, explains CE Associate Editor Ari Charney in this month’s Canadian Currents.

Bay Street Beat–Reporting season is over; long live reporting season. Next month Portfolio Update will summarize the first set of third-quarter earnings reports from our top recommendations. Here’s how Bay Street analysts stand on our favorites heading into the next earnings cycle.

How They Rate Update

Coverage Changes

Oilfield services firms are seeing new growth from old wells. As volumes of waste and completion fluids rise in mature Western Canada plays, Secure Energy Services (TSX: SES, OTC: SECYF), which we’re adding to How They Rate coverage this month, is growing by helping customers find environmentally friendly ways to dispose of it.

Secure claims 13 percent of the Western Canadian Sedimentary Basin treatment and disposal business and sees that as a primary growth market. We initiate coverage of Secure Energy with a hold rating.

We’re in the process of evaluating members of the coverage universe based on a combination of low market capitalization, low daily trading volume on the Toronto Stock Exchange and in the US and, most importantly, for those that aren’t paying a dividend at present, whether there’s a reasonable likelihood of ever doing so in the near future.

This is part of an effort to streamline our focus on companies with a realistic opportunity to build wealth for investors for the long term, keeping in mind too that part of the rationale for building a coverage universe is to provide context and comparison.

With all this in mind, barring any objections from readers, which you can express via our “Stock Talk” feature at www.CanadianEdge.com, we will begin paring the ranks next month.

Early candidates for removal from How They Rate coverage include:

Armtec Infrastructure Inc (TSX: ARF, OTC: AIIFF) pays no dividend and has a market capitalization of just CAD56.3 million.
Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF) discontinued its dividend in March 2011 and has a market capitalization of just CAD79.8 million.
Lanesborough REIT (TSX: LRT-U, OTC: LRTEF) hasn’t paid a dividend since March 2009, and its market cap is just CAD12.1 million.
Tree Island Steel Ltd (TSX: TSL, OTC: TWIRF) pays no dividend and has a market cap of CAD15.5 million.
Tuckamore Capital Management Inc (TSX: TX, OTC: NWPIF) pays no dividend and has a market cap of CAD19.3 million.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF) shareholders approved the CAD10.75 per share buyout of the company by LifeLabs Ontario, and the Ontario Superior Court of Justice has issued a final order approving the plan of arrangement.

Will all necessary approvals in, the transaction has closed. Shareholders should by now have received CAD10.75 per share in cash. CML has de-listed from the Toronto Stock Exchange.

CML will be removed from How They Rate effective with the November 2013 issue.

Advice Changes

Canadian Utilities (TSX: CU, OTC: CDUAF)–From Hold to Buy < 36. A selloff since late April has brought the share price down to attractive levels at 15.11 times earnings. Solid dividend growth and a good regulated earnings base augmented by reasonable non-regulated growth prospects make it a solid way to play Canadian essential services.

Encana Corp (TSX: ECA, NYSE: ECA)–From Hold to Buy < 19. Management has announced a significant strategic revamp that could include a 50 percent reduction in the company’s current dividend rate. Nevertheless, a solid portfolio of producing assets and a proven track record of execution will likely be acknowledged in the market once focus and capital management issues are worked out. This is for aggressive investors with risk capital ready for speculative allocation.

H&R REIT (TSX: HR, OTC: HRUFF)–From Hold to Buy < 22. The REIT is trading at an attractive valuation after a brutal selloff that’s afflicted all of its kind since May. Solid financial and operating results for the second quarter also support the upgrade. A relatively high debt level keeps it from the ranks of our favorite Portfolio REIT holdings. But it will benefit over the long term as investors recognize fundamental quality.

LeisureWorld Senior Care Corp (TSX: LW, OTC: LWSCF)–From Hold to Buy < 11. This health care play posted solid operating and financial results for the second quarter, and the share price has come well down from its 2013 highs above CAD13.

Rating Changes

There are no Safety Rating changes for How They Rate companies this month. Activity on this front will likely pick up as third-quarter earnings reports begin to flow in late October. Look for changes in the November issue.

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

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