Is the Recovery Finally For Real?

By David Dittman • December 6, 2013 • In Brief

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

The more data we see, the closer we seem to get to the “tapering” of the US Federal Reserve’s USD85 billion per month bond-buying program.

Except this time, on this Friday, the market’s reaction to news–in this case the Bureau of Labor Statistics’ report that the US added 203,000 jobs in November and that unemployment rate declined to 7 percent–wasn’t about “tapering.”

Rather, US equity indexes approached new all-time highs because there’s cause to believe that this economic recovery is finally for real.

The unemployment rate is now lower than it’s been in five years.

Although the holiday shopping season seems to have gotten off to a mixed start, the retail sector added 22,000 jobs last month. Manufacturers, which are closely watched as a bellwether for the broader economy, hired 27,000 workers.

And the seasonally adjusted labor force participation rate ticked up from 62.8 percent in October to 63 percent in November, an indication the unemployment rate fell because more people found jobs, not because they got discouraged and dropped out of the workforce.

Employment Friday followed the Thursday report from the US Dept of Commerce that gross domestic product (GDP) grew at a 3.6 percent annual rate during the third quarter rather than the 2.8 percent pace reported a month ago. That beat expectations of revised 3.1 percent.

And it qualifies as the fifth-best quarter for economic growth in the last 30 quarters.

The employment trend is generally positive. The growth trend is generally positive. But it’s still too early to call this anything more than a modest recovery. And it’s still too early to predict with any certainty when the Fed will roll back its purchases of long-dated mortgage-backed securities.

In 2009, when the unemployment rate hit 10 percent, a higher percentage of working-age Americans was in the labor force then than now, even though the nominal unemployment rate is three full percentage points lower.

In other words, participation in the workforce is at a four-decade low. If the labor participation rate right now were at the average level for the past 10 years, the unemployment rate would be closer to 11 percent.

The number of people who now have jobs is still 1.8 million people below where it was when the recession officially started in December 2007. At the current pace of job gains, it will be nine more months before that measure returns to pre-recession levels.

And though GDP posted its biggest gain since the first quarter of 2012, inventories accounted for almost half of the increase in growth.

The headline figure obscured a more subdued picture of domestic consumption. As that third-quarter inventory build-up is worked off, growth is likely to be softer in the fourth quarter.

Businesses accumulated UD116.5 billion worth of inventories during the quarter, the most since the first quarter of 1998.

The big build-up suggested firms were surprised by a lack of demand. Domestic demand rose at just a 1.8 percent rate, instead of the 2.1 percent the government reported last month.

According to the Commerce Dept new orders for factory goods declined by 0.9 percent in October after rising by 1.8 percent in September, as demand for aircraft and capital goods weakened, suggesting some cooling in manufacturing.

Fourth-quarter growth estimates are already on the low side, with a 16-day shutdown of the government in October expected to shave off as much as half a percentage point from GDP.

Growth in consumer spending, which accounts for more than two-thirds of US economic activity, was revised down to a 1.4 percent rate, the lowest since the fourth quarter of 2009.

That sluggish start to the holiday shopping season is reason for caution on the economy’s near-term prospects.

The future direction of interest rates is a complex forecast. Set it–and speculation about the Fed and “tapering”–aside.

By focusing primarily on high-quality stocks that pay dividends, the CE Portfolio provides investors the opportunity to participate in the growth of underlying businesses. And that includes the potential to benefit from rising dividends.

Our focus is on the long term, meaning we want to populate our Portfolio with companies capable of surviving and thriving throughout interest-rate as well as economic cycles and market volatility.

Notable too is the fact that monetary policymakers also haven’t abandoned “easy” policy; the Fed is simply contemplating removing or altering one of its methods of keeping interest rates low.

The fed funds rate is still parked near the “zero bound,” and policymakers have strongly suggested it will remain there until at least 2015 or when the US unemployment rate will approach the key goal of 6.5 percent.

Janet Yellen, President Obama’s nominee to succeed Mr. Bernanke as the top monetary policymaker in the US, has in fact said that “monetary policy is likely to remain highly accommodative long after one of the economic thresholds for the federal funds rate has been crossed.”

And if the issuance of debt by the US government continues to shrink, even if reduced the Fed’s bond-buying program could account for a proportionately larger chunk of long-dated bond inventory, which would effectively hold rates down. “Tapering” could therefore be “loosening” rather than “tightening” monetary policy.

Predicting when, why and how fast interest rates will or won’t rise is a difficult endeavor. We simplify the investing process by focusing on companies with solid histories of paying and growing dividends.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

Third-quarter reporting season has concluded, with results that are in the main satisfactory. Vermilion Energy Inc (TSX: VET, NYSE: VET) joined TransForce Inc (TSX: TFI, OTC: TFIFF) on the list of Portfolio Holdings that announced dividend increases along with financial and operating results.

Reports for the following companies are discussed this month:

Conservative Holdings

Artis REIT (TSX: AX-U, OTC: ARESF)
Bird Construction Inc (TSX: BDT, OTC: BIRDF)
EnerCare Inc (TSX: ECI, OTC: CSUWF)
RioCan REIT (TSX: REI, OTC: RIOCF)
Student Transportation Inc (TSX: STB, NSDQ: STB)

Aggressive Holdings

Ag Growth International Inc (TSX: AFN, OTC: AGGZF)
Atlantic Power Corp (TSX: ATP, NYSE: AT)
Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF)
Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF)
Enerplus Corp (TSX: ERF, NYSE: ERF)
Noranda Income Fund (TSX: NIF-U, OTC: NNDIF)
Parkland Fuel Corp (TSX: PKI, OTC: PKIUF)
Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF)
Vermilion Energy Inc (TSX: VET, NYSE: VET)

Note that third-quarter results for new Aggressive Holding Magna International Inc (TSX: MG, NYSE: MGA) are discussed in this month’s Best Buys feature. Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF), which reduced its monthly payout rate by 50 percent, is addressed in Dividend Watch List.

We’ll cover Bank of Nova Scotia’s (TSX: BNS, NYSE: BNS) fiscal 2013 fourth-quarter and full-year results in the January 2014 Portfolio Update.

Portfolio Update has details on financial and operating results for 14 Portfolio Holdings that reported after pixel time for the November 2014 issue.

Best Buys

Magna International Inc (TSX: MG, NYSE: MGA) is a leading automotive supplier with a strong financial profile based on conservative policies and solid operating results in the aftermath of the Great Recession. Conditions in the company’s North American market have remained favorable, reflecting an ongoing automotive recovery worldwide.

Magna is joining the Canadian Edge Portfolio this month based on its solid growth profile and shareholder-friendly capital management program, including regular dividend increases and robust share buybacks.

Magna International is a buy under USD90.

Longtime Conservative Holding Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF), added to the Portfolio in the December 2008 issue, is an invest-to-grow story, with every new hydroelectric, solar and wind power plant adding to cash flows that are locked in for decades by contracts at premium prices.

Customers are primarily government entities and regulated entities, virtually eliminating the risk of default no matter how bad times get.

The key variable to profitability is how quickly new projects can be brought on stream, keeping them under budget and financing them favorably.

Innergex Renewable Energy is a buy under USD10.

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

In Focus

It’s been an historically strong year for US stocks, not because of the magnitude of the gain for the world’s No. equity benchmark, the S&P 500 Index, but because of how it’s performed in the aftermath a solid double-digit gain in 2012, 16 percent on a total return basis.

What’s remarkable about 2013’s now 29 percent gain, including dividends, is that, since 1928, only four of the 16 times the market has performed as well as it did in 2012 has it followed up with a year that exceed the prior total return.

And then there’s the S&P/Toronto Stock Exchange Composite Index, which from June 30 until mid-November showed signs of getting back its 2001-11 mojo but has since fallen back again. And while most major equity indexes around the world power on toward double-digit gains for 2013 Canada’s major index is stuck at around 9 percent in local terms.

We cover the details in this month’s In Focus feature, where we also take a sector-by-How They Rate-sector look at strong performers this year and those that are poised to generate solid returns in 2014.

Dividend Watch List

Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF) made an expected move, Data Group Inc (TSX: DGI, OTC: DGICN) made an inevitable one and Atlantic Power Corp (TSX: ATP, NYSE: AT) made its way onto the List.

Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF), meanwhile, is off the Watch List due to a positive development: The company has prevailed in its dispute with Air Canada (TSX: AC/B, OTC: AIDIF). This means no liability and no retroactive payment to Air Canada.

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

Canadian Currents

The Canadian economy has produced some strong headline numbers as of late, but the details underpinning these results are somewhat less than reassuring, explains CE Associate Editor Ari Charney in this month’s Canadian Currents.

Third-quarter reporting season has come to a close for the CE Portfolio. Discover what Bay Street analysts have had to say about the last group of holdings to post financial and operating numbers int this month’s Bay Street Beat.

How They Rate Update

Coverage Changes

Note that we’ve moved new CE Portfolio Aggressive Holding Magna International Inc (TSX: MG, NYSE: MGA) from the Business section to the Transports section of How They Rate.

CML Healthcare Inc, which was acquired by LifeLabs Medical Laboratory Services, has been removed from How They Rate.

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.

Last month we removed Tuckamore Capital Management Inc (TSX: TX, OTC: NWPIF), Lanesborough REIT (TSX: LRT-U, OTC: LRTEF) and Tree Island Steel Ltd (TSX: TSL, OTC: TWIRF) from the coverage universe.

We’re still considering our coverage of Armtec Infrastructure Inc (TSX: ARF, OTC: AIIFF), which pays no dividend and has a market capitalization of CAD36.3 million, and Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF), which discontinued its dividend in March 2011 and has a market capitalization of CAD90.8 million.

We’re also reviewing our coverage of Royal Host Inc (TSX: RYL, OTC: ROYHF), which hasn’t paid a dividend since December 2010 and is currently valued at just CAD20.5 million, and Data Group Inc (TSX: DGI, OTC: DGPIF), which last month suspended its dividend and now has a market cap of just CAD11.7 million.

Advice Changes

Atlantic Power Corp (TSX: ATP, NYSE: AT)–From Hold to SELL. As reported in a Nov. 11, 2013, Flash Alert, we’ve sold Atlantic Power from the Portfolio after management indicated that the current dividend rate, which is the result of substantial cut in February 2013, is now in jeopardy as the company strives to shape up its balance sheet while allocating resources toward projects to “optimize” its current assets. This is now either a long-term turnaround or a strip-it-down-and-sell-it story. But there are too many variables in play here.

Brookfield Asset Management Inc (TSX: BAM/A, NYSE: BAM)–From Hold to Buy < 40. This major infrastructure and resources investment firm boosted its quarterly dividend rate by 33 percent, as it reported solid financial results for the third quarter.

Chorus Aviation Inc (TSX: CHR/B, OTC: CRHVF)–From SELL to Hold. Chorus has prevailed in its arbitration dispute with Air Canada (TSX: AC/B, OTC: AIDIF). Third-quarter results were also solid.

Norbord Inc (TSX: NBD, OTC: NBDFF)–From Hold to Buy < 32. The company is poised to benefit from a continuing US housing recovery, the Canadian housing market has stabilized, there’s the potential for revenue growth via a turnaround in Europe, the yield is north of 7 percent, recent results have been solid and the valuation is attractive.

Rating Changes

Cathedral Energy Services Inc (TSX: CET, OTC CETEF)–From 2 to 3. Cathedral’s payout ratio is low relative to its Energy Services peers and is likely to remain so for the next 18 to 24 months. And it has no debt maturities before Jan. 1, 2016.

Secure Energy Services Inc (TSX: SES, OTC: SECYF)–From 2 to 3. Secure’s payout ratio is low relative to its Energy Services peers and is likely to remain so for the next 18 to 24 months. And it has no debt maturities before Jan. 1, 2016.

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.

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