Full episode: Market Call Tonight for Wednesday, May 16, 2018
Brian Madden, senior vice-president and portfolio manager at Goodreid Investment Counsel
Focus: Canadian equities
Canadian stocks are recovering nicely from their earlier weakness, with the S&P TSX Composite index up nearly 9 per cent off its’ Feb. 9 lows and now back to within 2 per cent of its all-time high. A number of factors are involved in this resurgence, but the most impactful surely has to be the rapid growth in Canadian corporate profits. Earnings are up 23 per cent above their levels a year ago for the constituents of the S&P TSX Composite index. The index itself is up just 3.5 per cent since that time (although it’s paid a further 2.9 per cent in dividends) such that the net effect has been to compress the price-to-earnings ratio for Canadian stocks down to 17.9 times actual reported earnings from 21.3 times a year ago. With earnings forecast to grow a further 18 per cent over the coming twelve months, Canadian stocks, as represented by the S&P TSX Composite, trade at a fairly modest 15.1 times forecast earnings. First-quarter financial reporting shows that roughly half of Canadian companies have been exceeding consensus earnings forecasts and half have been falling short of estimates, but the aggregate earnings surprises have been about 2.3 per cent for S&P TSX Composite members as bigger companies have been more apt to have large upside to analysts’ expectations. The 2.3 per cent aggregate earnings surprise is somewhat below the recent average of 4 per cent earnings surprises, although the heavyweight banking complex will be front and centre with their earnings parade next week and the following week and their results could add some further thrust to these figures, as the banks are well positioned to benefit from rising interest rates, a topic we recently addressed in a piece on our website.
A close second to rapid growth in corporate earnings in terms of factors explaining the renewed strength in Canadian stocks is the price of oil. Not only are the prices of major international oil blends like Brent light sweet crude and West Texas Intermediate crude up sharply year to date (up 17 per cent and 18 per cent, respectively), with Venezuelan oil production falling into the abyss and with Iranian sanctions imminent, but the steep discounts Canadian producers had been receiving for their production have narrowed considerably with the return to full service on TransCanada’s Keystone pipeline, which had been under volume constraints for several months following a spill last fall. The discount for Western Canadian Select crude has narrowed to around $15 per barrel from as much as $28 earlier this year. The impact of this, coupled with higher benchmark Brent and WTI prices is difficult to overstate. For instance, Scotia Economics in mid-February estimated that the then-prevailing WCS-WTI discount was costing the Canadian energy sector $15.6 billion annually in revenue. Since the lows in the stock market (which coincided almost perfectly, within a single day, with the deepest WCS-WTI discounts), the energy sector has shone brightly after being all but left for dead since 2014. Energy stocks have risen 14.3 per cent since the market lows of Feb. 9. This is exactly neck-and-neck with the other leader of the pack, the technology sector. Apart from the return to full service on the Keystone pipeline, a few other glimmers of hope are emerging in regards to some of the government and regulation-inflicted problems this sector has been plagued with.
First, Canada’s finance minister this morning reaffirmed the federal government’s commitment to advancing the Trans Mountain Express pipeline expansion project that would move crude from Alberta to tidewater in British Columbia, and ultimately onto global markets. Secondly, Enbridge advanced a step closer towards approval of its massive $8-billion Line 3 replacement that would double oil export capacity on that line into markets in the U.S. Midwest. And finally, the global energy giants backing the $40-billion LNG Canada project on the British Columbian coast are sounding increasingly confident they will sanction a go-ahead decision and begin construction on this crucial project by the end of this year.
A third consideration in the rebound in Canadian stocks has been the more conciliatory tone negotiators at the NAFTA table have been taking in recent months. U.S. legislative deadlines and procedures and the imperative of getting ahead of the midterm elections in November seem to have eroded the brash and bullying leverage the Trump negotiators initially brought to bear on this file, and it’s entirely possible we may see an agreement on this crucial trade policy within a matter of weeks.
As a partial offset to these three very important supports for higher stock prices, Canada is experiencing a weakening in both its housing markets and its labour markets. In housing, resale activity, resale prices and new construction activity are all down, with weakness especially concentrated in certain cities. In jobs activity, after a torrid pace of job creation last year, Canada has suffered net job losses in two of the last four months, and net job losses year-to-date overall after the dreadful January jobs report saw 88,000 jobs disappear - a drop that the last three months have thus far been unable to recover. In some measure, the housing weakness is a function of government policies undertaken by the federal, provincial, municipal and regulatory bodies to cool down an overheated and overvalued market in several cities. These measures are now being compounded by rising interest rates, which further erodes housing affordability. Housing has a high “multiplier effect” on economic activity overall, so the slowdown in housing and the generally high levels of consumer debt may now be spilling over into other areas of consumer spending and negatively impacting employment growth. This will certainly bear watching in the coming quarters.
For our part, we continue to see a market of stocks, rather than a stock market. In this environment, active management is rewarded and we have added some exposure to both defensive sectors like grocery, property and casualty insurance, and gold royalties in recent months, as well as exposure to more pro-cyclical sectors, like oil, for instance. We remain mindful of the late stage of the economic cycle we’re in, but we are also unconvinced that the economy is at imminent risk of tipping into recession, given the massive U.S. fiscal stimulus boosting growth in that country, strong corporate profit growth domestically, improving terms of trade with key commodity prices back on the upswing, and at long last, signs of the political and regulatory clouds parting over the critical energy infrastructure sector, potentially opening a floodgate of new capital spending. As such, we see good prospects for Canadian stocks to surge to fresh highs this year, and are investing accordingly.
TD BANK (TD.TO)
Last purchase on May 2018 at $73.40.
TD is Canada’s second-largest bank and the second-largest company in any industry. It’s also increasingly a force to be reckoned with in U.S. banking and brokerage services. TD earns a 16 per cent return on shareholders’ equity and has grown earnings per share at a 9 per cent rate over the last decade, with a commensurate increase in its dividend as the firm has remained very well capitalized through the cycle. With nearly 40 per cent of its revenues originating in the U.S., TD should benefit from recent and expected upcoming interest rate hikes in that country, as well as from the recently enacted corporate tax cuts. Trading at 11.7 per cent expected earnings, TD looks well poised to continue its consistent pattern of outperforming the TSX, a feat that it and other members of the Canadian banking oligopoly have accomplished in 20 of the last 25 years.
PAREX RESOURCES (PXT.TO)
Latest purchase on April 2018 at $22.23.
Parex is a mid-sized, rapidly growing oil producer operating in Colombia. Parex enjoys some of the highest netbacks (operating profits) of any mid to large-sized Canadian energy producer. The company has nearly tripled production since 2013 and expects to end 2019 producing 50,000 barrels of oil per day as they contine drilling out their Colombian land blocks. Crucially (and refreshingly for a resource company), the management team is very focused on profitability, such that commensurate with its prolific growth in production, earnings have quadrupled and the return on shareholders’ equity in the latest quarter surged to 26 per cent. With zero debt and $300 million in cash on their books, and with mostly unhedged exposure to rising international oil prices, Parex is well positioned both to fund their capital program enabling further organic production and cash flow growth and to repurchase their own shares, which they recently began doing. Parex is expected to grow earnings per share by 64 per cent this year yet trades at a very modest 10-times earnings.
FINNING INTERNATIONAL (FTT.TO)
Latest purchase on May 2018 at $32.51.
Finning is the world’s largest Caterpillar heavy equipment dealer, selling, renting and servicing equipment and engines to customers in mining, public works, energy, forestry, construction and other industries. With an expansive network and footprint in Western Canada, South America and the U.K and Ireland, Finning is geographically well diversified, with balanced exposure to different business cycles and industries in each geography. Management is intensely focused on driving higher returns on invested capital and has pushed support and maintenance revenues from 30 per cent of sales to 56 per cent over the last decade, which serves both to reduce cyclicality and to lower the capital intensity of the business. The mining industry, which is their second largest customer segment, have been starving their mines for capital investment since 2012, but the last several quarters of results for both Finning and Caterpillar have shown that an inflection point is at hand. Prior cyclical upturns for Finning have lasted on average 4.25 years, with the current upcycle just over two years old. Finning earns a 15 per cent and rising return on equity, offers a dividend which has grown at a 6 per cent annual rate over the past decade and currently yields 2.4 per cent, while trading at 17-times expected earnings.
PAST PICKS: JULY 12, 2017
- Then: $51.14
- Now: $41.80
- Return: -18%
- Total return: -14%
ALIMENTATION COUCHE-TARD (ATDb.TO)
- Then: $62.40
- Now: $54.21
- Return: -13%
- Total return: -13%
TD BANK (TD.TO)
- Then: $65.16
- Now: $75.53
- Return: 16%
- Total return: 19%
Total return average: -3%
Goodreid North American Balanced
Goodreid’s balanced approach allows investors to participate in the potential growth of equity holdings while mitigating risk through ownership of quality fixed income instruments.
Performance as of: March 31, 2018
- 1 year: 6.6% fund, 1.1% index
- 3 Year: 5.5% fund, 2.8% index
- 5 Year: 9.4% fund, 5.7% index
*Figures include reinvested income and are net of fees
*Index is Globe Canadian Equity Balanced Peer Index Average
TOP HOLDINGS AND WEIGHTINGS
- U.S. equities: 40%
- Canadian equities: 33%
- Canadian fixed income: 17%
- Cash: 10%