The Geopolitical Correction

By David Dittman • August 9, 2014 • In Brief

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

It’s been a long time since the last real stock market correction, more than 500 days without a slide of more than 10 percent.

Plenty of pundits have predicted such a downside move was just over the horizon. I think Peter Lynch is instructive here: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

This run off the March 2009 Great Financial Crisis/Great Recession lows has taken on historic proportions, and it likely still has legs.

It’s endured the downgrade of US credit by Standard & Poor’s in August 2011, what many predicted would be a sure catalyst for disaster. The S&P 500 Index did slide about 19 percent from early July 2011 to October 2011. But US Treasuries rallied on the news of S&P’s rash move, yields stayed low and the rally resumed in the fall.

The next crushing blow should have been, according to doomsayers, the US budget sequestration fiasco of 2013. We did see significant pullbacks after a spending deal was struck in Washington, but the first was later, in the late spring of 2013, and another followed in the early fall.

But these too proved to be serious but buyable pullbacks in the context of a continuing bull run.

Last year the theory was rising interest rates, triggered by the Federal Reserve’s taper, would finally bring the party to a close. There was quite a “taper tantrum,” and some equity classes, particularly Canadian real estate investment trusts (REIT), have yet to fully recover. But markets continued to march higher. And rates have remained at historically low levels.

In fact late this week the yield on the 10-year US Treasury note dipped below 2.4 percent for the first time in 2014, as investors plowed into safe havens amid rising geopolitical tensions, the issue that will likely replace valuations, the latest standby rationale for impending doom.

Markets are overpriced. We’re in a bubble, or at least a tech bubble or an initial-public-offering bubble or a merger bubble.

At the same time Treasuries were rallying and yields were falling US stocks were well in the green, closing the week in positive territory after a red July.

Geopolitical risk is the key concern for investors right now.

US President Barack Obama authorized targeted air strikes and emergency-assistance missions in northern Iraq.

Also in the Middle East, Israel said Hamas had violated a 72-hour cease-fire and ordered the military to resume activity in the Gaza Strip.

And tensions are still running high over what actions Russia may take in its conflict with Ukraine and this week’s trade sanctions between Russia and the West.

But recent market response to significant events–the reaction of stocks and the behavior of benchmark interest rates–is the strongest proof available that this is a highly complex system, where no single variable will determine direction, where no individual, no matter how data-packed and colorful the presentation, knows what’s going to happen.

There’s no way of knowing when “the correction” will begin. What you can do is control your reaction.

In the prologue to the third and final volume in his engrossing history of the Allies’ victory over the Axis in North Africa and Europe Rick Atkinson notes that General Dwight D. Eisenhower “often quoted Napoleon’s definition of a military genius as ‘the man who can do the average thing when all those around him are going crazy.’”

I’m not a big proponent of war analogies. Only war is war, as Mr. Atkinson’s trilogy, focusing at least as much on the searing experiences of ordinary soldiers in the field as it does on the decisions of the supreme commander, surely illustrates.

But markets, like a battlefield, or a headquarters packed with ambitious and cunning rivals for leadership and glory, are by nature chaotic, with innumerable inputs and imperfect humans and now algorithm-powered computers acting within an extraordinarily complex system.

It’s a system where outputs are not necessarily determined in direct proportion to inputs, where the interaction of investors and machines based on different pieces of information cannot be determined.

In this context, a plan–in military conflict and in investing–is essential. But a plan is only as strong as is the commitment to following it.

The No. 1 principle of our investing philosophy is to focus on high-quality businesses with identifiable, easily understood revenue, earnings and cash flow that support sustainable and growing dividends. No. 2, don’t want to overpay for any company, no matter its quality.

Longer-term fundamentals–including revenue and earnings growth, with a reviving economy in support, remain in place. Should this slight downturn devolve into a full-blown correction, be prepared to establish positions in buy-rated Portfolio Holdings that suit your risk profile.

There will be bargains.

Being a successful long-term investor comes down to buying high-quality companies at low prices. High-quality companies are often relatively expensive. But the stock market sometimes gets a little crazy. If you have a plan and you’re patient, you’ll be able to build positions on favorable terms.

Keep it simple, keep your head and keep building wealth.

Indicators

News from the top part of North America was disappointing, while the middle segment produced an uplifting report in the two main economic indicators released on Friday, Aug. 8.

That’s in keeping with the long-term theme that’s defined the recovery from the Great Financial Crisis/Global Recession: jagged, lumpy and underwhelming.

Canada created only 200 net new jobs in July versus a consensus expectation of 25,000. The unemployment rate dipped to 7 percent from 7.1 percent, though that was attributed to a decline in the participation rate.

US productivity rebounded modestly in the second quarter after it fell sharply in the prior three months. Productivity during the three months ended June 30 increased by 2.5 percent, compared with a revised 4.5 percent drop in the first quarter.

One major sign that we’ll probably avoid a big down-move is that the American Association of Individual Investors weekly survey revealed that bearish sentiment rose to its highest levels since August 2013. When the masses start leaning one way, it’s a good sign it won’t happen.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

The most basic rule of successful investing is to buy low and sell high. The first part of this two-step process is a key to successful mergers-and-acquisitions strategies for companies, though in this context prices are negotiated to be fair to both sides of the transaction.

Nevertheless, businesses that add assets amid sluggish economies or difficult sector conditions that make weaker competitors consumable are setting foundations for long-term growth.

Consolidation boosts scale, and it can drives revenue and earnings growth that might otherwise be lacking due to macro conditions.

M&A can also be driven by strategic considerations, as businesses look to expand on existing capabilities or establish new, complementary services.

This month we have three big deals to report for CE Portfolio Conservative Holdings.

We also break down second-quarter earnings reports from Conservative Holding Dream Office REIT (TSX: D-U, OTC: DRETF) and Aggressive Holding Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF).

Portfolio Update takes a look at big deals involving three Conservative Holdings and focuses on Portfolio weak spots in the aftermath of a huge weak of second-quarter earnings reports.

Best Buys

Vermilion Energy Inc (TSX: VET, NYSE: VET) has suffered a double-digit decline since it hit an all-time closing high of CAD77.92 on the Toronto Stock Exchange (TSX) on June 20, 2014, while RioCan REIT (TSX: REI-U, OTC: RIOCF) has only partially recovered from the “taper tantrum” that knocked it from CAD29.19 on May 3, 2013, to CAD23.55 by Aug. 30, 2013.

Declining crude oil prices and a shift away from risker assets–both events driven by geopolitical tensions, including events in the Middle East and along the Black Sea–have hurt Vermilion.

The sense that bond investors would rotate back into US Treasuries and that REITs’ expenses would soar when official rates spiked continue to hinder RioCan.

But Vermilion has one of the best production-plus-dividend-growth stories in the North American energy patch. And RioCan’s portfolio, concentrated in Canada’s biggest cities and with growing and beneficial US exposure, is among the best among continental retail property owners.

The former is the quintessential growth-with-income story, the latter a poster child for income supported by consistent growth. Vermilion, exposed to commodity price fluctuations, as recent history demonstrates, is the more aggressive choice. RioCan, with strong occupancy and built-in rent increases, is more conservative.

Both are suitable for investors of all risk tolerances in the context of a balanced portfolio.

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

In Focus

The Canadian Edge Portfolio represents our top choices for investors seeking exposure to high-quality dividend-paying companies based in the Great White North.

And each month we offer two selections from the Portfolio–typically one Conservative Holding and one Aggressive Holding–that represent our “Best Buys” for new money right now.

If you have money to invest, the Best Buys feature is the place to start.

At the same time, How They Rate includes buy-rated businesses that may also help income- or growth-oriented investors achieve their objectives.

This month we review of 10 companies from various segments of the coverage universe. Some offer extremely attractive yields, though there are considerable risks attached that clearly identify them as aggressive recommendations.

For the most part, however, we’re attracted to consistent growth–in revenue, earnings and dividends–as opposed to the biggest yield. But we do have a “treat,” if you will, in the form of a 9 percent-plus yielder. Please, if you can’t tolerate big price swings stay away. We very much advocate the “tortoise” approach to investing versus the “hare” method: Slow and steady wins what is a marathon, not a sprint.

We lead off with a Canadian real estate investment trust (REIT) that indeed is a candidate for the Portfolio.

Among the 10 members of the How They Rate coverage universe profiled in this month’s In Focus feature are a promising REIT, a super-high-yielder, Canada’s biggest telecom, three utilities, three resource plays and a garbage collector.

Dividend Watch List

Once again there were no dividend cuts in the How They Rate coverage universe, for the second month running. We do have one addition to the List–and one subtraction.

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 Canada’s economy is rebounding, rising GDP and surging export activity have yet to translate into job creation, notes CE Associate Editor Ari Charney in this month’s Canadian Currents.

Bay Street Beat–Second-quarter reporting season is just about over for the Canadian Edge Portfolio.

We take a look at how analysts reacted to financial and operating numbers and how it sees the Portfolio Holdings now well into the third quarter in this month’s Bay Street Beat.

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

Dream Office REIT (TSX: D-U, OTC: DRETF)–From Buy < 39 to Hold. The CE Portfolio Conservative Holding continues to put up solid if unspectacular financial and operating results. The unit price remains range-bound, even as Canadian REIT peers post solid recoveries in the aftermath of the “taper tantrum” selloff.

It’s not necessarily a question of business quality here, and the distribution remains well covered by funds from operations. We are, however, reviewing our position from the perspective of opportunity cost: Can we do better from a capital-appreciation perspective with another REIT that’s equally capable of generating solid income?

Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF)–From Buy < 8 to Hold. Just three months ago we named it a Best Buy, for which we were rewarded with a pretty sharp six-week rally. But things fell apart for this debt-burdened turnaround play once oil prices weakened in late June due to geopolitical tensions and a retreat from risky assets.

Management has also cut its 2014 production forecast due to underwhelming results from key assets.

Northland Power Inc (TSX: NPI, OTC: NPIFF)–From Hold to Buy < 16. Second-quarter revenue grew by 36.6 percent to CAD169.9 million, while adjusted earnings before interest, taxation, depreciation and amortization (EBITDA) were up 62.6 percent to CAD81.5 million.

Free cash flow was up 42.7 percent to CAD31.4 million. Dividends as a percentage of free cash flow declined to 93.3 percent from 108.1 percent in the second quarter of 2013, as management’s forecast that free cash flow would cover dividends by mid-2014 was realized.

Rating Changes

Medical Facilities Corp (TSX: DR, OTC: MFCSF)–From 3 to 5. The operator of private surgical centers in South Dakota, Oklahoma and Arkansas hasn’t cut its dividend in the past five years. Its revenues, relatively immune to economic ups and downs, are supported by an expanding base due to extension of health care benefits via Obamacare.

There is no debt coming due before Dec. 31, 2016, nor is overall leverage burdensome. The payout ratio is high but within management’s policy range, and visibility is good.

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.