Why Canada Pays

By David Dittman • May 20, 2011 • Canadian Edge Weekly

The basic outline of the long-term Canadian investment story–from an American perspective, although much of what follows is of a “good for the Yank, good for the Canuck” variety–is as follows.

Emerging markets, led by China and India, are consuming more and more resources as their respective middle-class populations expand.

Canada has a lot of the stuff that these countries, and others, need to accommodate new appetites for food, but also to build more urban housing, to provide better transportation infrastructure and to keep it all powered up.

A combination of established, reliable public and private institutions has shepherded Canada’s resource wealth in a manner that benefits the whole country while at the same time recognizing the entrepreneurial vigor required to properly exploit it.

Amid a tumultuous reordering of global economic leadership, relatively stable government and a recent history of prudent fiscal and monetary policy make Canada a safe harbor for American investors concerned about the direction of the US dollar.

There are many ways for income investors–investors of all stripes, for that matter, who are interested in building wealth–to get exposure to the Canadian story. We cover more than 120 in Canadian Edge, including high-yield, high-risk commodity plays as well as solid, reliable real estate investment trusts whose returns and prospects shame their American counterparts.

Canada is a veritable crossroads in this structural shift in the global economy. It will continue to benefit from what is and should remain, for the next decade, the biggest bilateral trade relationship in the world, its dealings with the US. And it will enjoy new demand from emerging markets that will reduce its reliance on its southern neighbor. It features emergent characteristics–such as high export potential for critical resources–along with developed institutions.

The Mexican Connection

Canada’s financial system is widely recognized as among the soundest in the world. Income investing is about dividend payment and growth that carries share prices higher. This requires stability and predictability as well as realistic pursuit of opportunities to grow the underlying business. A lot of Canadian dividend-payers deserve recognition for their ability to live up to such standards operationally and financially.

Chief among the institutions that comprise Canada’s now notorious financial system is one bank that’s taking lessons learned building a solid franchise at home into emerging markets in Asia and in Latin America.

Bank of Nova Scotia (TSX: BNS, NYSE: BNS), the third-largest of Canada’s Big Six banks reported solid numbers from its Mexico unit in April. Scotiabank is unique among its Big Six peers in that its international expansion strategy focues on emerging markets in Latin America and South Asia rather than the US, where Toronto-Dominion Bank (TSX: TD, NYSE: TD), which after the merger of its TD Banknorth and Commerce Bank units now has more branches south of the border than in Canada, Royal Bank of Canada (TSX: RY, NYSE: RY), via a large presence in the Southeast, and Bank of Montreal (TSX: BMO, NYSE: BMO), through its Chicago-area Harris Bank operation, have established large retail footprints.

Although from time to time we’ve had “buy” recommendations on the whole group, in Canadian Edge we’ve consistently favored Scotiabank among the Big Six because of its emerging-market exposure. If nothing else, Scotiabank isn’t exposed to still-unwinding US subprime mortgage fiasco that continues to impair performance for its America-centric Canadian peers.

Meanwhile, demand for mortgages and commercial loans are increasing in Mexico along with a recovering local economy. The Mexican government reported Thursday that gross domestic product grew at an annualized rate of 4.6 percent in the first quarter, up from 4.4 percent in the fourth quarter of 2010. Although analysts anticipated 5 percent growth, it was the seventh consecutive positive quarter, a solid stretch after the Mexican economy contracted by 6.1 percent during the global recession.

Fiscal and monetary stimulus in the US has led to increased demand for Mexican exports. Meanwhile, an improving employment situation has at the same time triggered domestic demand. The Mexican peso, along with many currencies, has surged more than 5 percent against the US dollar in 2011, and that, too, has stimulated consumers and companies.

Grupo Financiero Scotiabank Inverlat is seeing more mortgage and commercial loan applications; the unit forecast lending growth at least double the rate of Mexico’s gross domestic product growth in 2011.

Scotiabank’s 710 locations and outstanding loans of 110.4 billion pesos (USD9.4 billion)–5 percent of the market total–make it the seventh-largest in Mexico. The growth plan focuses on the country’s “under-banked” population. To attract more deposits and engagement of bill-paying services Grupo Financiero has negotiated arrangements to put mini-branches in 1,600 stores all over the country; the ultimate goal is to establish 10,000. Also under consideration is a plan to enable customers to transact via mobile phones. Mexican regulators are currently considering such technology and should approve soon.

Scotiabank reported in April that first-quarter profit from Grupo Financiero improved by 7.1 percent over the same period in 2010 to CAD75 million. Higher net interest income and lower provisions for bad loans were the primary factors in the better performance. The parent will report an CAD84 million quarterly profit when it submits fiscal second-quarter numbers and hosts a conference call to discuss same on May 31.

After boosting its dividend by 6.1 percent at the time it announced fiscal 2011 first-quarter results in March, Scotiabank now pays CAD0.52 per share per quarter. That’s a 3.6 percent yield as of Friday’s intraday trade. It’s a great way for risk-averse income investors to establish some exposure to emerging markets, while backing that risk with solid domestic retail banking operations. Deposit growth at local branches, after all, is the foundation of a healthy bank.

A good foundation in Canada and an innovative approach to international expansion set Bank of Nova Scotia apart from the rest of the Big Six.

The Roundup

No less a benchmark than Bank of Nova Scotia (TSX: BNS, NYSE: BNS), which is trading just above its USD60 buy target, for broad global conditions and the Canadian economy in particular, Canadian National Railway (TSX: CNR, NYSE: CNI) continues to distinguish itself from its primary competitor, Canadian Pacific Rail (TSX: CP, NYSE: CP).

CN is making several small but significant upgrades along key segments of its rail infrastructure to support increased freight traffic and the economy in northern Alberta and Western Canada.

The company is looking to increase capacity and velocity along its main transcontinental line between Edmonton and Winnipeg ease congestion in one of its heaviest corridors to facilitate access the capital of the oil sands region, Fort McMurray, Alberta.

Reflecting demand from Asia as well as from oil sands developers, CN is experiencing solid traffic growth in Western Canada for grains, coal, sulphur, potash, forest products and chemical goods. The company is making investments in Alberta to increase network capacity and improve train velocity along its transcontinental main line between Edmonton and Winnipeg and to position for rising freight volumes over its line to Fort McMurray.

CN is investing CAD12 million to build 11,400 feet of track to facilitate switching and expedite arrivals and departures at a yard outside Edmonton, part of a larger effort, according to the company, “to expand the rail corridor to Fort McMurray to handle petroleum coke and sulphur going south out of that area.” CN is also investing CAD3 million to reconfigure tracks at Walker Yard in Edmonton, which will also increase velocity, which will help as more and more construction material, equipment and machinery arrives for oil sands projects.

The company is investing another CAD10 million on its secondary Lac La Biche Subdivision in northern Alberta to support additional traffic to and from Fort McMurray. CN bought the Athabasca Northern Railway Ltd in December 2007 for CAD25 million specifically for exposure to oil sands development projects in the Athabasca, Peace River and Cold Lake regions.

The deal involved a CAD135 million rehabilitation plan over three years to improve transit times and service between Boyle, Alberta, and Fort McMurray. CN’s rehabilitation plan is supported by long-term traffic volume guarantees the company negotiated with shippers, including Suncor Energy Inc (TSX: SU, NYSE: SU) and Nexen Inc (TSX: NXY, NYSE: NXY). These oil sands producers ship sulphur and petroleum coke to Asia and receive construction materials, machinery and diluent, a petroleum product used to thin out bitumen so it can move through pipelines. The upgrade of the 300-kilometre length line increased train speed from an average of 16 kilometres an hour to 40 kilometres per hour and allowed for heavier loads.

CN separated itself from CP during the winter months because its innovative approach to moving trains through snow allowed it to maintain velocity, even as CP experienced delays, moved less freight and paid more for fuel. Doing something like putting locomotives in the middle of trains to make them faster doesn’t seem like such a remarkable idea, but CN did it and CP didn’t.

That’s one reason we like it more. Canadian National Railway is a buy up to USD70.

Here is a summary of the state of first-quarter earnings for Portfolio recommendations, including links to where to find analysis of numbers for those that have reported and announced (or estimated) dates for those that have not.

Aggressive Holdings 

Conservative Holdings
  • AltaGas Ltd (TSX: ALA, OTC: ATGFF)–May Portfolio Update
  • Artis REIT (TSX: AX-U, OTC: ARESF)–May 20 Flash Alert
  • Atlantic Power Corp (TSX: ATP, NYSE: AT)–May 13 Flash Alert
  • Bird Construction Inc (TSX: BDT, OTC: BIRDF)–May 25 (estimate)
  • Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRBMF)–May 20 Flash Alert
  • Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)–May 13 Flash Alert
  • Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–Jun. 9 (confirmed)
  • Cineplex Inc (TSX: CGX, OTC: CPXGF)–May 13 Flash Alert
  • Colabor Group (TSX: GCL, OTC: COLFF)–May Portfolio Update
  • Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)–May 13 Flash Alert
  • Extendicare REIT (TSX: EXE-U, OTC: EXETF)–Jun. 7 (confirmed)
  • IBI Group Inc (TSX: IBG, OTC: IBIBF)–Jun. 1 (confirmed)
  • Innergex Renewable Energy (TSX: INE, OTC: INGXF)– Jun. 7 (confirmed)
  • Just Energy Group Inc (TSX: JE, OTC: JSTEF)–May 20 Flash Alert
  • Keyera Corp (TSX: KEY, OTC: KEYUF)–May 13 Flash Alert
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–Jun. 14 (confirmed)
  • Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–May 25 (confirmed)
  • RioCan REIT (TSX: REI-U, OTC: RIOCF)–May 20 Flash Alert
  • TransForce Inc (TSX: TFI, OTC: TFIFF)–May 20 Flash Alert

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