Return to Canada

By David Dittman • March 8, 2014 • In Brief

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

The original case for Canada presented here, way back in July 2004, was that the Great White North offered income-focused investors some of the highest yields in the world, made possible by a unique business structure codified in Canadian law that allowed companies to “pass through” earnings to shareholders–or “unitholders,” as owners of Canadian income and royalty trusts came to be known–in the form of what were extremely generous distributions relative to traditional corporate dividends.

What seemed a too-good-to-be-true investor’s paradise began to evolve nearly seven and a half years ago, on the night of Oct. 31, 2006, when Canadian Finance Minister Jim Flaherty authored what came to be known as the “Halloween Massacre,” the announcement that, beginning Jan. 1, 2011, Canada levy a tax on so-called specified investment flow-through (SIFT) entities.

The SIFT tax was thought by many to be a “death knell” for market-beating Canadian yields in general, with some saying Canadian Edge would die too.

But businesses adapted, aided in no small part by a very long transition period and extremely favorable terms for “conversion” into corporations that would generate nominal transaction costs.

For those strong enough to survive–those with underlying businesses suited to sustaining and growing dividends for the long term–Mr. Flaherty’s announcement proved nothing more than a nuisance.

Others, never in position to follow through for the long term on commitments to investors but certainly enriched by the cash-out opportunity represented by an initial public offering (IPO) of new trust units in the early 21st century, have indeed withered away or been swallowed up by more worthy entities.

From the beginning, however, Canadian Edge was all about buying the business. We did make some aggressive choices, bending to super-high yields. But in the main our Portfolio was and has always been populated by solid businesses with relatively easy to understand operations and clearly identifiable cash flows.

Many of the companies that made their way into the CE Portfolio in 2004 and 2005, including Conservative Holdings Pembina Pipeline Corp (TSX: PPL, NYSE: PBA), RioCan REIT (TSX: REI-U, OTC: RIOCF), Keyera Corp (TSX: KEY, OTC: KEYUF) and AltaGas Ltd (TSX: ALA, OTC: ATGFF) and Aggressive Holdings ARC Resources Ltd (TSX: ARX, OTC: AETUF), Vermilion Energy Inc (TSX: VET, NYSE: VET) and Newalta Corp (TSX: NAL, OTC: NWLTF) continue to build wealth for us.

But it is a changed landscape, and now more than ever our focus is on not just a high yield but on the ability to consistently grow a dividend at a rate that will mitigate the impact of rising interest rates as well as the corrosive effects of inflation.

As we detail in this month’s Portfolio Update, the CE Portfolio is a good place to go for dividend growth.

More Loonie Tunes

When Canadian Edge debuted in July 2004 the Canadian dollar was trading around USD0.75. The middle stages of the China-driven commodity boom saw it soar to CAD1.09 in November 2007. The Great Financial Crisis/Great Recession took it down to CAD0.77 by March 2009.

What’s been a slow, sometimes torturous recovery–and that, as we’ve often noted, is par for the course for recoveries from credit crises, which are relatively rare but are defined by the long, slow effort by governments, businesses and households to deleverage–characterized by tepid employment and GDP growth has seen the loonie establish what appears to be a new, higher normal.

The Canadian currency has suffered a steep decline since late 2012, rolling over after Canadian equities gave up the lead to US counterparts in the post-GFC global stock market rally. But longer-term factors, including relatively healthy government balance sheets, resource wealth that far outstrips domestic needs and therefore establishes a solid base for exports, complemented by robust institutions that guarantee benefits of such natural gifts will be widely shared, support a stronger loonie.

Central banks, as revealed by the International Monetary Fund’s Composition of Foreign Exchange Reserves (COFER) report, have been accumulating Canadian dollar as they attempt to diversify holdings away from the traditional vehicles, including the US dollar, the Japanese yen, the British pound sterling, the euro and the Swiss franc.

Recent activity suggests too that the shorter-term tide is turning, as some of the forces that drove it below USD0.90 in early 2014 appear to be reversing. Foreign investors are once again buying Canada, as foreign direct investment (FDI) of USD64.2 million in 2013 was the best year on that metric since 2008. Outflows of CAD44 billion were a three-year low. Net FDI inflows were positive for the first time since 2007.

And net foreign purchases of Canadian equities have risen for four consecutive months, for a total of CAD22.6 billion, the best run in a decade.

Perhaps the strongest support derives from the Bank of Canada, which in recent weeks has issued upbeat commentary on the condition of the Canadian economy, suggesting there will be no rate cut to provide stimulus.

The Canadian economy established some momentum during the second half of 2013 that should persist. The recovering US economy will eventually translate into healthier demand from down south for Canadian goods, particularly with the loonie at its most competitive level in years.

Strong and sustained commodity demand and growing foreign purchases should also support Canadian stocks. The S&P/Toronto Stock Exchange Composite index is up nearly 5 percent in local terms in 2014, while the S&P 500 Index is up 1.6 percent. That’s a reversal of the last two years, when the main US benchmark handily outperformed its Canadian counterpart.

Canada and the loonie represent good value for US-based investors at these levels.

David Dittman
Chief Investment Strategist, Canadian Edge

Portfolio Update

Four more CE Portfolio Holdings announced dividend increases over the past month, bringing to six the total number that have boosted their payouts during fourth-quarter and full-year 2013 reporting season.

Of the 35 companies currently held in the Portfolio 21 have announced at least one dividend or distribution increase over the past 12 months. These 21 have combined for a total of 27 dividend-increase announcements.

Six of the 16 Aggressive Holdings have announced dividend increases since February 2013. Recent Portfolio addition Magna International Inc (TSX: MG, NYSE: MGA), including the 18.8 percent increase management announced along with fourth-quarter and full-year 2013 financial and operating results on Feb. 13, 2014, has boosted its payout twice within the past 12 months.

Fifteen of the 19 Conservative Holdings have raised their payouts.

Consistent dividend growth indicates reliable revenue and earnings. It also serves the important purpose of telegraphic management’s feelings about the future: It indicates optimism, that the underlying business will not only be able to support existing commitments but is strong enough to support the extension of same.

Consistent dividend growth also provides the best inflation hedge of them all.

And over the long term dividend growth is highly correlated with strong share performance.

It’s a lead-pipe certainty that interest rates, at some point in the not-distant future, will rise. And one of the surest bets for a rising-rate environment is dividend growth.

Portfolio Update has fourth-quarter and full-year 2013 financial and operating highlights from most of the rest of the CE Portfolio, with numbers generally supportive of current dividend rates as well as future growth, in addition to details on whose actually boosting payouts right now.

Best Buys

Few Canada-based exploration and production (E&P) companies can match gas-focused Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) long-term growth profile, whether you’re looking back or looking forward.

The key is that Peyto is essentially self-contained: It owns land, production and processing assets that have supported and will continue to underpin steady, consistent output, financial and dividend growth.

The CE Portfolio Aggressive Holding’s conventional asset base and great well-head performance allow it to generate some of the most efficient production in the Canadian E&P space.

Equally unique in its own industry is Conservative Holding Brookfield Renewable Energy Partners LP (TSX: BEP-U, NYSE: BEP), the biggest publicly traded pure-play renewable power companies in North America and among the biggest in the world.

Brookfield Renewable continues to add to its power-generation portfolio in a low-price environment, with projects that combine stable, contracted revenues and strong prospects for long-term cash flow growth.

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

In Focus

Canadian stock market performance–based on the S&P/Toronto Stock Exchange Composite Index (SPTSX)–has been more closely correlated with the MSCI Emerging Markets Index (MXEF) than the S&P 500 Index over the past half-decade, a curiosity given Canada’s longstanding and significant trading relationship with the US.

The explanation lies in the fact that Canada’s main equity benchmark is heavily weighted toward resources. Prices of things such as oil, coal, iron ore and potash are driven nowadays by demand from high-growth markets such as the 21 represented in the MXEF, including Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

It’s no great mystery that Canada’s abundant natural resources form the backbone of its trading relationship with fast-growing emerging economies and will continue to do so for years to come.

Although Canadian businesses are diversifying their export markets, the US still accounts for approximately 70 percent of outbound goods and services, based on 2012 data. But this is down from more than 80 percent in 2000.

That’s another way of saying that Canada’s exports to markets beyond the US have increased from a share of about 19 percent in 2000 to about 30 percent in 2012.

In Focus takes a look at the evolving make-up Canada’s export markets and identifies several high-potential opportunities for investors to profit.

Dividend Watch List

After a couple uneventful months on the dividend-cut front the harsh realities of fourth-quarter and full-year 2013 reporting season exposed vulnerabilities for two members of the CE How They Rate Electric Power group. It should be noted that both operate unregulated businesses subject to ups and downs of merchant power and energy prices.

Merchant power producer TransAlta Corp (TSX: TA, NYSE: TAC) announced, to the apparent surprise of many Bay Street observers, a 37.9 percent dividend cut, as management seeks to shepherd cash to fund growth projects.

Crius Energy Trust (TSX: KWH-U, OTC: CRIUF), an independent energy retailer with more than 600,000 customers in the US, cut its monthly dividend rate by 30 percent from CAD0.0833 to CAD0.0583, management attributing the decision to soaring costs of energy during a particularly cold first quarter in the markets it serves as well as slowing customer growth.

And Equal Energy Ltd (TSX: EQU, NYSE: EQU), pursuant to the agreement by which Petroflow Energy Corp will acquire it, won’t pay a first-quarter dividend.

Dividend Watch List has the details on members of the How They Rate coverage universe whose current dividend rates are in jeopardy.

Canadian Currents

Canada’s first-quarter growth is forecast to slacken after last quarter’s stronger-than-expected showing, but it should reaccelerate later this year, notes CE Associate Editor Ari Charney in this month’s Canadian Currents.

Bay Street Beat–Reporting season for fourth-quarter and full-year operating and financial results is well under way for Canadian companies.

Here’s how Bay Street has reacted to report and how it sees the CE Portfolio as we approach the end of the first quarter of 2014.

How They Rate Update

Coverage Changes

As we detail in this month’s In Focus feature, we’re adding Methanex Corp (TSX: MX, NSDQ: MEOH) to the How They Rate coverage universe within the Natural Resources group.

Please note that we have dropped Royal Host Inc (TSX: RYL, OTC: None) from How They Rate.

After this issue we will discontinue coverage of Armtec Infrastructure Inc (TSX: ARF, OTC: AIIFF), and Imvescor Restaurant Group Inc (TSX: IRG, OTC: IRGIF).

Our evaluation of the coverage universe will be 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

Bonavista Energy Corp (TSX: BNP, OTC: BNPUF)–From Hold to Buy < 16. The gas-focused energy producer posted solid growth in funds from operations and production as well as much-improved development costs.

Enbridge Inc (TSX: ENB, NYSE: ENB)–From Hold to Buy < 44. Management reported another solid set of operating and financial numbers for the fourth quarter and for 2013. The company continues to invest heavily in North American energy infrastructure, which will support continued dividend growth. Bay Street is bullish, with 15 “buy” recommendations versus two “hold” and two “sell” ratings and an average 12-month target price of USD48.12.

Superior Plus Corp (TSX: SPB, OTC: SUUIF)–From Hold to Buy < 12. The diversified company with propane distribution, chemicals and construction interests posted decent 2013 revenue growth, and management issued positive guidance for 2014. The share price has also come down from recent highs.

BlackBerry (TSX: BB, NSDQ: BBRY)–From SELL to Hold. The introduction of new mobile devices and the potential of its QNX operating system have revived hopes for a long-term turnaround, as new CEO John Chen continues to make a significant impact.

Rating Changes

TransAlta Corp (TSX: TA, NYSE: TAC)–From 3 to 2. The struggling merchant power producer cut its quarterly dividend rate by 37.9 percent to CAD0.18 per share, costing it a point otherwise due for companies with no dividend cuts over the trailing five years.

Chorus Aviation Inc (TSX: CHR/B, OTC: CHRVF)–From 0 to 1. Management followed through on its pledge to restore some of what was lost when it slashed the dividend in preparation for a potential negative outcome to its arbitration with Air Canada (TSX: AC/B, OTC: AIDIF), and 2013 revenue was basically stable. There are challenges, including the still-significant exposure to Air Canada. But the current dividend rate looks sustainable.

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.