A Canadian Conundrum

By David Dittman • May 9, 2014 • In Brief

Editor’s Note: What follows is the executive summary of the May 2014 issue of Canadian Edge. Thanks for reading.

Canadian stocks, as represented by the S&P/Toronto Stock Exchange Composite Index, have put together a great performance during the first five months of 2014, with a 7.8 percent total return in local currency terms through May 9.

Even accounting for the 2.5 percent decline in the value of the Canadian dollar versus the US dollar from USD0.9414 on Dec. 31, 2013, to USD0.9174 on May 9, the main Canadian equity benchmark is up 5.1 percent from a US-based investor’s perspective.

That beats the 2.4 percent year-to-date total returns for the S&P 500 Index, which is 2.4 percent to the positive, and the MSCI World Index, which is also up 2.4 percent including dividends.

The turnaround after several years’ underperformance versus major global equity indexes has been led, as we note in this month’s In Focus feature, by Canada’s energy sector, specifically its oil and gas exploration and production companies.

Crude oil price differentials have narrowed as producers and transports have found new ways to get output to market, specifically railcars. Demand for Canadian oil from US refiners is on the rise.

Natural gas markets could finish 2014 at their highest levels in years as producers struggle to refill inventories that were depleted during the frigid winter that hit most of the continent. Canadian natural gas producers benefitted from a 62 percent increase in AECO natural gas pricing during the first quarter.

And because oil is denominated in US dollars, the exchange rate gives Canadian producers more Canadian dollars for every barrel they sell, boosting their profits in their home currency.

Strangely, in an historical context, the loonie continues to weaken despite the strength of commodity prices.

Other pressures have combined to more than offset the effect of stronger commodity prices on the loonie, a dynamic that will persist at least through the second quarter.

As the currency reaction to today’s jobs report from Statistics Canada indicates–the Canadian dollar sank from an intraday high of USD0.9245 just before news hit the wire to as low as USD0.9161 in the immediate aftermath–larger macro forces are in play.

That Canada lost 28,900 jobs in April versus a consensus expectation of 14,200 additions is being read as a sign that the Bank of Canada could still cut its benchmark overnight cash rate from 1 percent–where it’s been since September 2010, the longest stretch without a change in the BoC’s history–before it embarks on any tightening of monetary policy.

This dovish divergence from the emerging “tightening” bias from the US Federal Reserve is driving the loonie’s weakness versus the buck.

But higher Canadian oil prices may have helped the loonie stabilize in a range above recent lows versus the buck.

There are other, longer-term factors supporting a new, higher permanent range for the Canadian dollar, including the efforts by global central banks to diversify their currency reserves. These efforts have largely concentrated on the addition of Canadian dollar- and Australian dollar-denominated assets.

At a fundamental level, Canada is one of the few developed economies expected to generate a budget surplus by 2015, meaning that it can soon afford to bolster economic growth with tax cuts

Shorter-term factors are mixed.

Although the April jobs report from Statistics Canada was unquestionably loonie-negative, this downside surprise followed the equally unquestionably loonie-positive upside employment surprise for March.

It appears that, like the US, Canada is suffering a two-steps-forward-one-step-back, jagged and sluggish recovery from the Great Recession.

Statistics Canada reported April 17 that the consumer price index increased at an annual rate of 1.5 percent in March, up from 1.1 percent in February but still well within the BoC’s target range.

But it’s tied for the highest the rate has been since April 2012. And inflation accelerated to a 3 percent annual rate over the three months ended Feb. 28, 2014. The comparable trend in October when the BoC turned dovish was 0 percent.

The Bank of Canada’s Spring Business Outlook Survey, which was released on April 7, 2014, revealed bullish attitudes among executives who make hiring, firing and investment decisions at Canadian companies.

Inflation data such as these and anecdotal evidence, to which BoC Governor Stephen Poloz is paying particular attention, such as the Business Outlook Survey, make it difficult to see how the BoC will continue in its dovish posture.

The risk that the US will start hiking rates before Canada looks far less likely in light of Federal Reserve Chair Janet Yellen’s very dovish public remarks in recent weeks. StatsCan’s April employment figures raised the specter of an emerging “rate differential,” but the balance of the evidence suggests that the monetary status quo–at least as far as official interest rate benchmarks are concerned–will persist well into 2015.

And Canadian equities continue to attract foreign investors.

It looks to me that a bottoming out process is in play. It could last awhile, but scaling into the loonie via dividend-paying Canadian stocks, even amid further currency weakness, is likely to prove profitable in the short to medium term.

A Note on China

Stephen Roach, former chairman of Morgan Stanley Asia now stationed at Yale’s Jackson Institute for Global Affairs, is a notably influential, insightful voice on China.

Mr. Roach is the author of Unbalanced: The Codependency of America and China, in which he argues that both the US and China need to find new ways to manage their economies.

Mr. Roach recently answered questions posed by The Wall Street Journal’s China RealTime blog about his book, including his views on Americans’ view on China, challenges facing the Middle Kingdom, China’s centralized system and concomitant economic advantages and disadvantages, the need for more savings in the US and the need for a “social safety net” in China.

The interview is available here.

The money quote, from our perspective, is this:

The US continues to look at China through the same lens through which it sees itself. It looks at excess investment or low consumption or rising debt and concludes that China is doomed. The US misses the fact that China not only has a different system but it also is at a totally different stage in its development. It’s certainly facing some daunting problems, but moving from a producer model to a consumer model built on urbanization still requires very high investment ratios. It still requires an active government promoting state-directed infrastructure and real estate construction. We can’t rely on our own model to assess China’s progress or lack thereof.

Emphasis is mine, in support of a point we’ve made in CE and in Australian Edge, that China will still drive demand and pricing for key resources such as oil and gas and iron ore for years to come.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

It’s an earnings-heavy Portfolio Update this month, as 23 of our 38 Conservative and Aggressive Holdings posted financial and operating results over the past month.

Conservative Holdings AltaGas Ltd (TSX: ALA, OTC: ATGFF), Cineplex Inc (TSX: CGX, OTC: CPXGF), Keyera Corp (TSX: KEY, OTC: KEYUF) and Pembina Pipeline Corp (TSX: PPL, NYSE: PBA) and Aggressive Holdings Newalta Corp (TSX: NAL, OTC: NWLTF) and ShawCor Ltd (TSX: SCL, OTC: SAWLF) announced dividend increases along with first-quarter numbers.

All six posted solid first-quarter results, with outlooks and investment plans that augur more dividend growth.

And two of the five Canadian real estate investment trusts we recommend among our Conservative Holdings posted first-quarter financial and operating results this week.

Artis REIT (TSX: AX-U, OTC: ARESF) has performed well on the TSX since its Sept. 9, 2013, rising-interest-rate-fear-induced low of CAD13.45, with a total return in local terms of 25.4 percent and a US dollar return of 20 percent.

Results for the first three months of 2014 support the rally.

Dundee REIT (TSX: D-U, OTC: DRETF) hasn’t seen the same sort of unit-price pop that Artis REIT has enjoyed. But operating and financial performance remains solid.

Portfolio Update has the rundown on those Portfolio Holdings that reported first-quarter results over the past month.

Best Buys

In September 2013, when we added the CE Portfolio Aggressive Holding to the Dividend Watch List, we noted that Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF) would likely enjoy a bounce on the Toronto Stock Exchange (TSX) if management did what the market at the time appeared to be telling it to do and cut its CAD0.08 per month, CAD0.96 per year dividend.

Management did relent, stepping back from its long-held position that the CAD0.08 monthly dividend rate was a key component of its investment proposition.

Lightstream’s share price has responded well to management’s hard decision. And the company’s recent results indicate good progress is being made as the company narrows its focus, shapes up its balance sheet and continues to support cash flow with consistent production.

Having established a good trajectory as it attempts to thread the needle of fixing the balance sheet via asset sales but maintaining production and cash flow, Lightstream Resources is a buy under USD8 for aggressive investors.

A 6.5 percent yield, with the current dividend rate looking very sustainable, is solid compensation for the potential risk.

A longtime member of the CE Portfolio Conservative Holdings, specialized North American trucking and logistics outfit TransForce Inc (TSX: TFI, OTC: TFIFF) continues to add assets and grow its dividend, though the latter accomplishment is much the result of a sluggish economy that not only makes weaker competitors consumable as it consolidates a still-fragmented industry but also leads to weaker revenue and earnings growth.

Since hitting an all-time high on the TSX of CAD25.77 on Nov. 21, 2013, has bounced around but generally down, hitting a low of CAD22.71 on March 5, 2014, as concerns about the strength and durability of the North American economy have once again made their way front and center.

TransForce rallied to CAD24.78 as of April 22, but management’s report on first-quarter financial and operating results precipitated another mini-selloff. But this down-move has taken the share price to CAD23.52, or approximately USD21.72 based on prevailing exchange rates. And that’s below our buy-under target of USD23.

TransForce, which has raised its dividend three times and an aggregate 45 percent since the end of the Great Recession, is a buy under USD23.

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

In Focus

The weaker Canadian dollar has boosted profits for Canada’s energy producers, and, as other pressures combine to more than offset the effect of stronger commodity prices on the loonie, it appears the dynamic will persist at least through the second quarter.

Production, revenue, earnings and cash flow growth for our top Canadian oil and gas producers continue to impress.

They’re seeing stronger profits due to rising demand for Canadian oil from US refiners, which has raised prices for crude produced in Alberta’s oil sands region.

And share prices are rising. Canadian energy stocks are leading the way on the Toronto Stock Exchange this year and are on track to outperform US energy companies for the first time in five years.

Indeed, natural gas prices, heavy oil price spreads and the Canadian dollar-US dollar exchange rate are all in favorable ranges for the Canadian energy sector.

Market access is the key to Canadian energy producers’ success. And Keystone XL remains the big variable.

But Canada’s energy producers are finding new, cost-effective ways to get their output to market. And that’s showing up in companies’ bottom lines.

In Focus takes a look at Canadian oil and gas producers’ renaissance over the past year amid a favorable set of prevailing macro circumstances. Our top six picks are all doing good work where it counts: at the drill bit.

Dividend Watch List

Argent Energy Trust (TSX: AET-U, OTC: ANGYF) slashed its monthly distribution rate from CAD0.0875 (CAD1.05 on an annualized basis) to CAD0.02 (CAD0.24 per year) on April 10, 2014, citing “recent market activity resulting in a significantly lower unit price” and a corresponding “significant” change in the company’s “balanced financial structure.”

Shares of fellow “new” oil-and-gas-focused Canadian income trusts Eagle Energy Trust (TSX: EGL-U, OTC: ENYTF) and Parallel Energy Trust (TSX: PLT-U, OTC: PEYTF), which cut its monthly distribution rate from its original level of CAD0.08 to CAD0.05 in November 2012, have been volatile in the aftermath of Argent’s cut, as investors question long-term viability of high payout E&P model.

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 is set to produce stronger growth in the months ahead, but that also means enduring the occasional disappointment along the way, notes CE Associate Editor Ari Charney in this month’s Canadian Currents.

Bay Street Beat–First-quarter reporting season is well underway for the Canadian Edge Portfolio.

Bay Street Beat has analysts’ reactions to the first wave of financial and operating numbers and how they see Portfolio Holdings midway through the second quarter of 2014.

How They Rate Update

Coverage Changes

We have no additions to or subtractions from the How They Rate coverage universe this month.

Our evaluation of the coverage universe is ongoing, as we streamline our focus to companies with realistic opportunities 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.

Advice Changes

Argent Energy Trust (TSX: AET-U, OTC: ANGYF)–From Hold to SELL. Management announced a 77.1 percent distribution cut, reduced its 2014 CAPEX budget to USD55 million from USD77 million and lowered its production guidance to 6,000 barrels of oil equivalent per day (boe/d).

The CEO announced his resignation, as the board of directors seeks to carve out a new strategic direction. The company will also cut costs and sell assets to reduce debt.

IBI Group Inc (TSX: IBG, OTC: IBIBF)–From SELL to Hold. Adjusted EBITDA margin was just 3.5 percent for the fourth quarter of 2013, though there was sequential improvement. And free cash flow was positive. Management has guided to modest revenue improvement in 2014.

Key catalysts will be successful implementation of a recapitalization plan, which in addition to continued operational improvements and a focus on increasing cash flow addresses the divestiture of non-strategic assets the refinancing of CAD46 million of 7 percent subordinated notes maturing December 2014.

Methanex Corp (TSX: MX, NSDQ: MEOH)–From Hold to Buy < 65. A selloff since a March 6, 2014, all-time high on the Toronto Stock Exchange and the Nasdaq has brought the share price back into value range.

Dividend growth has been solid (management announced a 25 percent increase in the quarterly rate along with first-quarter earnings), the payout ratio is low, and the company occupies a dominant position in a vital industry.

Rating Changes

There are no Safety Rating changes this month.

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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