Jun 28, 2018

Brian Madden's Top Picks: June 28, 2018

BNN Bloomberg

Brian Madden , BNN Bloomberg

Brian Madden, senior vice-president and portfolio manager at Goodreid Investment Counsel
Focus: Canadian equities

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MARKET OUTLOOK

After a tumultuous first quarter, equity markets in Canada and the U.S. have regained their footing and turned in strong gains this quarter, as did Canadian corporate bonds and preferred shares. Bonds and prefs took a roundtrip ride in terms of price movement this quarter, with interest rates rising and their prices falling amidst economic optimism and rising risk appetites generally during the first half of the quarter, only to reverse those moves during the second half. The end result has been negligible overall price appreciation, with all of the return stemming from dividends and interest, which in our view is a reasonable expectation for these two asset classes going forwards.

The relative rank of each of these four asset classes has been exactly opposite the ranking we saw in the first quarter, but notably, all four of them are now in the black with modest gains for the year-to-date period, which illustrates why we advocate strongly for balanced portfolios. We don’t know which asset class is going to be the hero or the scapegoat in any given quarter, but we do know they all have a role to play in managing risk, in capturing gains and in earning income, and each in turn will have its time in the sun.

Probably the most impactful variable in explaining the reversal of fortunes this quarter for Canadian stocks has been the strength in oil prices, with West Texas Intermediate (WTI) oil prices up 11 per cent during the quarter, as OPEC production increases announced during the cartel’s June meeting were modest and should keep inventories manageable and the global supply/demand balance fairly tight. Moreover, the Permian basin production miracle in west Texas ran into a logistical roadblock this quarter with insufficient pipeline capacity to carry supplies to market. This too helped to firm up pricing. This is a problem Canadians are no strangers to, as our own oil producers have faced similar and more severe pipeline constraints over the last few years as NIMBY obstructionists and a cumbersome regulatory process have made it increasingly difficult to get new pipelines permitted and built.

This dysfunctional business and competitive environment for energy producers was showcased as front-page news in a way that was globally embarrassing for Canada with the nasty spat between Alberta and British Columbia over the proposed (and previously approved) Trans Mountain Express pipeline expansion, which the federal government felt compelled to nationalize in order to ensure the project’s completion when its foreign owners threatened to walk away amidst the preposterous interprovincial brouhaha.

Nevertheless, for better or worse, taxpayers now own the asset and the oil patch has been assured by the prime minister, the finance minister and the ministerr for natural resources that the pipeline will be built. With the energy sector finally seeing light at the end of the tunnel (or shall we say, pipeline?), and with it holding the second-largest sector weighting on the TSX, it’s resurgence this quarter has gone a long way towards propelling the Canadian market higher. We believe the oil price rally to be sustainable and entirely consistent with strong global growth and rising energy demand.

While energy stocks have been most impactful in propelling the S&P TSX Composite higher, the rally this quarter has been broad-based, with 70 per cent of index constituents moving higher, and with 10 of 11 economic subsectors making gains.

Stock prices continue to climb the proverbial wall-of-worry, shaking off erratic communication from the White House, legislative impasse on numerous key files, most notably the degradation of hostile trade rhetoric into outright hostile trade action with the executive branch invoking “national security concerns” to justify the imposition of duties on Canadian, European and Chinese imports. Many pundits and casual observers of the markets are scratching their heads wondering how stocks can continue to climb amidst these emerging risks.

We’ve said it before, and we’ll say it again: economics and corporate profits drive share prices far more so than politics ever will, and the well-oiled gears of the Canadian and U.S. economies are not easily fouled up by even the most inept of political leadership. It’s axiomatic to say so, but shareholders own the profits in the economy. This is the very premise upon which we invest in stocks. Rapidly rising corporate profits support rising share prices.

We acknowledge the economy is in the late stages of expansion, but shows no signs of rolling over into recession. Significant capital gains on bonds and preferred shares are unlikely in the current interest rate regime, but safe and stable income streams underpin both of these asset classes, which furthermore provide important balance and diversification to an otherwise equity-oriented portfolio, as we saw early this year. Valuations are fair to full across broad swaths of the stock market, but we continue to find compelling opportunities and undervalued stocks in quieter and less followed corners of the market. As such, our portfolios are always in a process of slow evolution, like a plant turning towards the sun: imperceptibly slow to the naked eye, but undeniably effective in result.

Calm, rational decision-making, backed up by significant research and deep qualitative and quantitative analysis is a lasting hallmark of our practice, and we're more convinced than ever that it will serve us very well in this oftentimes manic and hyperbolic market regime where a tweet, a press conference or a rumour sets off a tempest in teapot, triggering knee-jerk responses from less disciplined, hyperactive traders, only to be negated or contradicted within a matter of days.

TOP PICKS

SUNCOR (SU.TO)
Latest purchase on June, 2018 at $51.13.

Suncor is Canada’s largest integrated oil company, and the longest running operator of oil sands assets in the country. Their oil sands assets have a 36 year reserve life index, and with breakeven oil prices below $35, the company is enjoying prolific free cash flow with the recent spike in oil prices. Downstream integration via their ownership of four world class refineries and approximately 1750 gas stations has been very effective in insulating Suncor from the steep discounts other Western Canadian oil producers have suffered when selling heavy crude oil into captive American refining markets while relying on often overcrowded pipelines. With their final two major expansion projects, Fort Hills and Hebron now in production, Suncor’s capital expenditures are set to fall 25% this year and remain at these lower levels, sustaining their established pattern of dividend increases, which have grown at a 12% compound rate the last five years, and providing optionality to step up the pace of their share buyback program.

RIOCAN REIT (REI_u.TO)
Latest purchase on June, 2018 at $24.37.

RioCan is the largest commercial property REIT in Canada. It owns 284 properties, primarily in the country's six largest metropolitan areas. The company has a stable base of recurring rental income from primarily national, investment-grade creditworthy tenants. It's also in an advantaged position, with a deep development pipeline, much of which is already permitted and zoned for mixed-use residential.

The company is executing a portfolio high-grading strategy by disposing of $2 billion of non-core assets in secondary and tertiary communities in order to focus on the six faster-growing and higher-income metro markets. There, RioCan is increasingly seeing density intensification opportunities to repurpose assets by selling air rights or by building, for instance, high-rise condos above existing commercial properties. This slow metamorphosis of the company away from shopping malls and towards residential property has important re-rating implications. Over time, it should allow the units to re-rate towards the 3 per cent yield that residential REITs trade at versus its current 6 per cent yield.

ROYAL BANK (RY.TO)
Latest purchase on June, 2018 at $101.

Royal Bank is Canada’s largest company and one of the largest banks in the world. With a domestically dominant personal and commercial banking franchise, a top-10 global capital markets business and the leading Canadian wealth management franchise rounded out with smaller insurance and investor services/treasury businesses, Royal has a very solid and well diversified earnings stream. Royal is also well diversified by geography, with large-scale businesses in Canada, the U.S., Europe and various other global financial centres.

The bank is a leader in digital banking as well as in artificial intelligence and is using its scale to invest heavily behind these drivers of long-term competitive advantage. The goal of these investments is attracting, both by itself and with its affinity program partners, an additional 2.5 million new Canadian banking clients by 2023. Meanwhile, with a dividend yield of 3.8 per cent and with dividends growing at a 7 per cent compound annual rate over the last decade, we see a logical and highly visible path towards double-digit returns in this stock over the course of a cycle.