Great White Shoots

By David Dittman • September 6, 2013 • In Brief

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

A little more than two-thirds of the way through the third quarter of 2013, Canadian equities appear to have regained some of the mojo that carried them to a strong record of outperformance versus US stocks throughout most of the first decade of the 21st century.

From June 28, 2013, through midday on Sept. 6, 2013, the S&P/TSX Composite Index (SPTSX) had generated a total return in US dollar terms of 7.5 percent, while the S&P 500 Index (SPX) was up just 3.8 percent. The SPTSX still trails the SPX for 2013, 0.7 percent versus 18.1 percent. But it does appear that the underlying fundamental strengths of a Canadian economy that’s muddled through quite well after outperforming wildly into and out of the Great Recession and the wealth-building potential of its many high-quality publicly traded businesses are once again attracting investors.

There’s probably a good bit of bargain hunting going on here after the SPTSX underperformed the SPX for the last two and a half years. And there’s probably a bit of renewed confidence being shown as well, as “Canada” has certainly represented the “-on” side of the recent “risk-on, risk-off” rhythm that’s seemed to prevail in the aftermath of the Great Recession.

The closer we get to the resumption of global economic growth trends that prevailed pre-2008, in other words, the better will Canadian equities perform.

That’s also reflected in a more modest 1.1 percent increase in the value of the Canadian dollar versus the US dollar since June 28.

Indeed, after four lumpy, unsatisfying years the US recovery finally appears to be on a smoother road. Many economists now predict 2014 will be the best year for growth since 2005, while joblessness is expected to click below 7 percent next year for the first time since 2008.

Houses are selling again, the energy sector is booming and jobs, while not plentiful, are being created at a steady pace.

The US remains Canada’s No. 1 energy customer, so rising domestic production south of the border presents a bit of a headwind. Canada, for its part, is working on infrastructure that will open Asian and European markets to its oil and gas, which would likely more than offset any export decline caused by greater American energy independence.

All the other stuff is unabashedly positive for Canada.

The SPTSX is now up 8.3 percent from its 2013 low of 11,836.86, established June 24. And the Canadian dollar is off its low of USD0.9450 set July 5.

Despite all the noise caused by speculation about the US Federal Reserve and its “taper” and all the storm and stress over Syria noise, markets ended the week in the green.

In its latest Beige Book the Fed noted “modest to moderate” growth across the US, which, despite what it may mean for a rollback of Federal Open Market Committee bond purchases is a net positive.

And, while recognizing the potential human toll involved, from a clinical, dispassionate perspective it must be noted that tensions in the Middle East inevitably drive oil price higher. And that, to the extent that demand isn’t destroyed by too rapid a rise, helps Canadian energy producers.

US auto sales were 16.02 million units on an annualized basis, beating the consensus forecast by 200,000 and hitting the highest level since November 2007. That’s another positive for Canada, which has a significant auto parts manufacturing and export industry.

US unemployment is at 7.3 percent, the lowest since December 2008, while average hourly earnings ticked up by 2.2 percent year over year, the best showing since July 2011. Jobless claims fell by 9,000 to 323,000 versus expectations of 330,000.

July construction spending was up 0.6 percent year over year, beating expectations of a 0.4 percent increase and bolstering the outlook for Canadian timber and other materials industries.

That other global growth engine, China, is also showing signs of a rebound.

Chinese factory activity expanded for the first time in four months in August as domestic demand rebounded, a further sign that policymakers may have averted a sharp slowdown in the world’s second-largest economy.

The final HSBC/Markit Purchasing Managers Index climbed to 50.1 in August, up sharply from 47.7 in July. China’s official manufacturing PMI showed factory activity expanded at the fastest pace in more than a year in August on a jump in new orders.

The official PMI, which came in at 51.0 versus expectations for 50.6, is more weighted towards bigger and state-owned firms, which have easier access to credit and the scale to cope better with downturns.

Our goal here is not cheerlead or even accentuate the bullishness. We have to take account of contrary signs as well.

US PMI declined to 53.1 versus expectations of 54, though it’s still consistent with moderate improvement in manufacturing conditions.

And the US employment picture is not totally rosy, as the labor force participation rate declined to 63.2 percent, the lowest level since 1978. The US economy added jobs in August, but the Dept of Labor revised downward July’s additions from 162,000 to 104,000.

Meanwhile, the Fed’s Beige Book revealed that lending activity has weakened.

Crude oil is headed for its highest close since May 2011. Though Congressional approval for Syrian strike remains uncertain, international cooperation is mixed. Nevertheless, the impact on pocket books could slow consumer spending.

The yield on the 10-year US Treasury note continues to trend higher, spiking above 3 percent for the first time since July 2011. It’s not the absolute number that is worrisome, but the rate at which rates have accelerated.
Looking abroad, both India’s manufacturing and services indexes for August, for example, indicate contraction and confirm the dramatic slowing in this key Asian economy.

German exports unexpectedly fell by 1.1 percent on a month-over-month basis in July versus and estimate of a 0.7 percent gain. July industrial production was also lower, while June’s figure was revised downward. Europe remains a sore spot.

Recoveries from the type of balance-sheet recession that afflicted the world during 2008-09, as demonstrated by history, are never as smooth as those that follow typical business-cycle downturns.

This one has proven no different. The key for dividend-focused investors is to focus on high-quality companies that can endure fluctuations in operating conditions while remaining poised for long-term growth.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

Earnings season for the Canadian Edge Portfolio is largely complete. We still await fiscal 2013 fourth-quarter and full-year numbers from Student Transportation Inc (TSX: STB, NSDQ: STB), which will be released on Sept. 11, 2013. Barring anything in the numbers that indicates immediate action is required, we’ll have a full rundown in the October issue’s Portfolio Update.

This month we lead off with a look at results for the five Canadian real estate investment trusts (REIT) we hold in the Portfolio. The market has not been kind to this group amid widespread panic about what the US Federal Reserve will do with its “quantitative easing” program, when it will do it and what impact all of it will have on interest rates.

Market rates have already surged since the spring, and the short-term impact, at least in terms of Canadian REITs’ unit prices, has been uniformly negative. But the picture for the long term is more nuanced.

And second-quarter financial and operating results for Artis REIT (TSX: AX-U, OTC: ARESF), Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Dundee REIT (TSX: D-U, OTC: DRETF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF) suggest once again that they have what it takes to build wealth for investors for the long term.

In fact Northern Property was one of four Portfolio Holdings that announced dividend increases along with results, joining August addition Bank of Nova Scotia (TSX: BNS, NYSE: BNS), EnerCare Inc (TSX: ECI, OTC CSUWF) and Pembina Pipeline Corp (TSX: PPL, NYSE: PBA).

In this month’s Portfolio Update we have second-quarter earnings reviews for the following Conservative Holdings:

Artis REIT (TSX: AX-U, OTC: ARESF)
Bank of Nova Scotia (TSX: BNS, NYSE: BNS)
Bird Construction Inc (TSX: BDT, OTC: BIRDF)
Brookfield Renewable Energy Partners LP (TSX: BEP-U, NYSE: BEP)
Canadian Apartment Properties REIT (TSX: CAR, OTC: CDPYF)
Cineplex Inc (TSX: CGX, OTC: CPXGF)
Dundee REIT (TSX: D-U, OTC: DRETF)
Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)
Northern Property REIT (TSX: NPR, OTC: NPRUF)
Pembina Pipeline Corp (TSX: PPL, NYSE: PBA)

Note that EnerCare Inc (TSX: ECI, OTC: CSUWF) is discussed in this month’s Best Buys feature.

We also have second-quarter earnings reviews for the following Aggressive Holdings:

Ag Growth International Inc (TSX: AFN, OTC: AGGZF)
Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF)
Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF)
Enerplus Corp (TSX: ERF, NYSE: ERF)
Extendicare Inc (TSX: EXE, OTC: EXETF)
Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF)
Wajax Corp (TSX: WJX, OTC: WJXFF)–Aug. 9

Portfolio Update has the latest on Portfolio Holdings that reported second-quarter earnings since the August issue of CE.

Best Buys

CE Portfolio Conservative Holding EnerCare Inc (TSX: ECI, OTC: CSUWF) has evolved into a veritable fee-for-service business generating very stable returns. The core waterheater business is now complemented by a submetering business that’s overcome early challenges and is now adding customers at a healthy clip.

The more it grows, the more EnerCare’s cash flows grow, and the more likely we’ll see further dividend growth down the road that will push the share price higher.

Delivering on this promise for the fourth time in the last two years, management, along with second-quarter results, announced a 1.8 percent increase in its monthly dividend rate, to CAD0.058 per share (CAD0.696 annualized) from CAD0.057 (CAD0.684 annualized), effective with the September payment due in October.

Aggressive Holding ARC Resources Ltd (TSX: ARX, OTC: AETUF) sold off from a five-year closing high of CAD28.70 on the TSX on May 31, 2013, to a six-month closing low of CAD25 on Aug. 27 due to the renewed deterioration of natural gas prices.

But the company is poised to build wealth for investors over the long term, as evidenced by the fact that ARC boosted volume and funds from operations during a period when its capital program is focused on 2014.

ARC continues to build value for investors, evidenced by its long-term production improvements. With a 4.5 percent dividend yield heading into a strong production ramp-up for 2014, investors can collect while ARC management builds value. A management-forecast decline in third-quarter production could provide another buying opportunity, though the shares are currently trading below our recommended buy-under target, even after spiking off late August, early September near-term lows.

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

In Focus

It was a sigh of relief so powerful it lifted the share prices of Canada’s Big Three mobile network operators–as well as those of smaller regional players–to one-day gains of 4, 5 and even 7 percent.

The domestic incumbents–including No. 1 Roger Communications Inc (TSX: RCI/B, NYSE: RCI), No. 2a BCE Inc (TSX: BCE, NYSE: BCE) and No. 2b TELUS Corp (TSX: T, NYSE: TU)–surged from oversold levels after the Sept. 2, 2013, announcement by Verizon Communications Inc (NYSE: VZ) that it was buying joint venture partner Vodafone Group Plc’s (London: VOD, NSDQ: VOD) 45 percent stake in Verizon Wireless for USD130 billion.

Verizon is no longer a threat. But the auction will be conducted under existing rules, despite very public lobbying efforts by Canada’s Big Three.

A more critical factor for Canadian wireless companies–as it is for US-based carriers–is the potential data-driven growth on the horizon.

Evidence continues to mount in support of the proposition that the mobile phone is humankind’s primary tool. With the rise of smart phones, e-mail is displacing text messaging, but social networking, audio streaming, music and games are also seeing strong growth.

And these are data-intensive activities.

Cisco Systems Inc (NSDQ: CSCO) forecast data growth of 13 times 2012 levels through 2017. Sweden-based vendor Telefonaktiebolaget SM Ericsson, known in the US simply as Ericsson (NSDQ: ERIC), expects 12 times 2012 levels through 2018. Qualcomm Inc’s (NSDQ: QCOM) prediction of 1,000-fold growth by 2020 dwarfs those figures.

In Focus profiles five Canadian wireless telecom service providers, including the Big Three, in the context of an ongoing global explosion for mobile data demand.

Dividend Watch List

There were no dividend cuts by members of the How They Rate coverage universe last month, a generally positive sign for underlying business conditions and management confidence in the future.

CE Portfolio Aggressive Holding Lightstream Resources Ltd (TSX: LTS, OTC: LSTMF) has, however, made its debut on the List this month.

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 Bank of Canada continues to maintain its dovish stance toward monetary policy, while the latest US jobs report could force the US Federal Reserve to defer what had been a widely expected September taper, explains CE Associate Editor Ari Charney in this month’s Canadian Currents.

Canadian Currents explains how central bankers still hold the key to the economy.

Bay Street Beat–Reporting season is over, and Bay Street analysts have made their calls on our Portfolio Holdings. Here’s how Bay Street responded to Canadian Edge Portfolio Holdings’ second-quarter earnings reports.

How They Rate Update

Coverage Changes

We have no additions or subtractions from How They Rate this month.

We are however, 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, we will begin paring the ranks next month.

Early candidates for removal from How They Rate coverage include:

Armtec Infrastructure Inc (TSX: ARF, OTC: AIIFF) pays no dividend and has a market capitalization of just CAD56.3 million.
Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF), which discontinued its dividend in March 2011 and has a market capitalization of just CAD62.6 million.
Lanesborough REIT (TSX: LRT-U, OTC: LRTEF) hasn’t paid a dividend since March 2009, and its market cap is just CAD12.3 million.
Tree Island Steel Ltd (TSX: TSL, OTC: TWIRF) pays no dividend and has a market cap of CAD13.6 million.
Tuckamore Capital Management Inc (TSX: TX, OTC: NWPIF) pays not dividend and has a market cap of CAD14.3 million.

CML Healthcare Inc (TSX: CLC, OTC: CMHIF) shareholders have approved the CAD10.75 per share buyout of the company by LifeLabs Ontario. Closing of the deal now depends on the grant of a final order by the Ontario Superior Court of Justice approving the plan of arrangement.

Management expects all necessary approvals by Oct. 1, 2013, with shareholders receiving CAD10.75 per share in cash upon closing. CML shares will be de-listed from the Toronto Stock Exchange within two days following the close of the deal.

CML will be removed from How They Rate effective with the November 2013 issue.

Advice Changes

Boardwalk REIT (TSX: BEI-U, OTC: BOWFF)–From Hold to Buy < 54. The REIT selloff has gotten out of hand. This is a solid business with a high-quality portfolio, and management just reported good financial and operating results for the second quarter.

We prefer the higher-yielding REIT selections in the CE Portfolio Conservative Holdings, but Boardwalk is now well off its 2013 high near CAD68.50 on the Toronto Stock Exchange.

Colabor Group Inc (TSX: GCL, OTC: COLFF)–From SELL to Hold. The share price has rallied from an all-time low of CAD3.13 on July 11, 2013, a week ahead of the 66.7 percent dividend cut announcement, to CAD4.41 as of this writing.

Colabor has potential to capitalize on its solid brands and niche markets in an improving economy, particularly with the added flexibility the dividend cut provides. There are operational issues to work through, but the company is well positioned to get back on a sustainable growth track in 2014.

GMP Capital Inc(TSX: GMP, GMPXF)–From Hold to SELL. The independent investment dealer posted a 3.8 percent decline in second-quarter revenue to CAD60.3 million, though net income of CAD4.8 million improved on a year-ago loss of CAD400,000.

That was accomplished largely through the sale of contracts to provide advisory services to managed funds that generated CAD10.8 million. Excluding items the company posted a net loss of CAD300,000, as underlying business conditions remain difficult. Management maintained the dividend rate, but the payout ratio for the second quarter was negative.

IBI Group Inc (TSX: IBG, OTC: IBIBF)–From SELL to Hold. The damage has been done, and the cash saved from the recent dividend suspension should help the company accomplish its turnaround plan. Management also raised its full-year revenue guidance.

Manitoba Telecom Services Inc (TSX: MBT, OTC: MOBAF)–From Hold to Buy < 33. The company posted solid second-quarter numbers, strengthening the case that the CAD520 million sale of Allstream, announced on May 24, 2013, has made the company a stronger, more focused enterprise.

Wireless revenue was up 4.5 percent, while wireless subscriber data revenue surged by 21.9 percent. “Strategic” services revenue, including wireless, Internet (3.6 percent) and IPTV (4.1 percent) all grew. MTS increased the number of customers with bundled services by 5.1 percent to 99,418.

Quebecor Inc (TSX: QBR/B, OTC: QBCRF)–From Hold to Buy < 24. It’s the early favorite among analysts in the “who benefits most from Verizon not coming north” contest. Quebecor is in a very strong position to buy a block of spectrum that will not be very expensive.

Wireless is already generating solid growth for Quebecor, which probably would have fared well in an auction that included Verizon.

Quebecor reported a 15 percent increase in second-quarter adjusted income from operations to CAD52.9 million, or CAD0.82 per share. Revenue was up to CAD1.09 billion. Videotron mobile unit posts solid sales and customer growth, while ARPU increased by 5.9 percent.

Royal Host Inc (TSX: RYL, OTC: ROYHF)–From Hold to SELL. Second-quarter numbers show nothing but continued deterioration in the underlying business, as management continues to sell assets to pay down debt. Royal Host has been cash-flow negative “for several consecutive years,” and now management is striving to create a corporate and operational structure that is “sustainably cash-flow positive.”

Rating Changes

IBI Group Inc (TSX: IBG, OTC: IBIBF)–From 3 to 1. The company has suspended its dividend, with no clear guidance on when it will be resumed. Debt coming due before Dec. 31, 2015, is high relative to market capitalization, and overall borrowings are relatively high as well. IBI retains a point for the nature of its business, which is generally stable and defensive relative to other industries. IBI is particularly burdened by a debt load incurred in pursuit of growth.

ShawCor Ltd (TSX: SCL, OTC: SAWLF)–From 3 to 5. The company earns both payout ratio points–a low number for the second quarter and solid visibility on maintaining a low number for the next 18 to 24 months. And it earns two debt-related points, as its overall debt-to-assets ratio is very low and there are no obligations coming due before Dec. 31, 2015.

Also, ShawCor has no dividend cuts during the past five years. I’m withholding one point due to the nature of its business. Global demand for pipeline infrastructure remains solid, but it is, albeit to a lesser degree than oil and gas producers, subject to the direction of commodity prices.

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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