Downgrade, Schmowngrade

By David Dittman • August 9, 2011 • Canadian Edge Weekly

“Buying opportunity” does not mean “back up the truck.” Never “double down” on a stock that sunk to what may seem to be a ridiculous value. Buying a stock because it’s “cheap” is no way to build wealth over the long term, and that’s the point of dividend investing. Other considerations–such as the relative weight of the particular stock in your overall portfolio, or the opportunity to use funds to further diversify into other sectors, regions or asset classes–are also important.

Selectivity, for that matter, isn’t a rainy-day practice, at least for the long-term investor. If you’re looking for total return–a combination of high current income capital appreciation–you can’t pay too much for any stock; the buy-below prices we proffer in Canadian Edge are based on value and the ability to sustain and grow dividends over time. We never want to chase a stock too high or too low.

But in absolutely all cases, remember that you’re buying a business and banking on the ability of management to execute a plan. If the plan wasn’t built to sustain conditions present as of 4 pm eastern time, Friday, Aug. 5, then it probably wasn’t capable of sustaining as of 9:30 am the following Monday. This brings us, of course, to Standard & Poor’s.

The methodology employed by S&P to evaluate sovereign debt includes additional factors that other agencies such as Moody’s and Fitch don’t utilize. Specifically, S&P takes account of political factors, which invites inherently subjective analysis, as opposed to statistical and data-driven conclusions.

And, as analysis by the New York Times blog FiveThirtyEight.com reveals, the value of S&P’s conclusions are undermined not only by purported USD2 trillion mathematical errors but also by suspect subjective reporting by third parties. That investors–fleeing equity markets as much on fear of an economic downturn as much as this unnecessary and destabilizing downgrade–drove the yield on the 10-year US Treasury note to a record low in its aftermath is all you need to know about what the market believes about S&P. In other words, the world is going to keep its own AAA rating on the US.

The US government, is as explicit terms as possible, said it would not default. Other credible agencies–Moody’s, which reiterated its AAA rating on the US, and Fitch–agree. In fact S&P itself has conceded that it doesn’t see a US default in the future. This is purely a symbolic act, more a statement on Washington gridlock than the health of the US economy and its ability to support public debt. And the latter is what the market is concerned with.

That’s not to say that the US fiscal position is sustainable. Spending must be cut, revenues must be raised, and we knew this well before Friday, Aug. 5. We also knew well before Aug. 5 that the political struggle over how to create revenue has gridlocked the federal government. All S&P did was manufacture a market event that could exacerbate a tenuous economic situation. But the economic situation isn’t on an irreversible course.

Futures pointed higher this morning, a sign, perhaps, that the market expects the US Federal Reserve to take some action during its meeting today. Follow-through ahead of the Fed’s 2:15 pm official policy statement was cautious, but major indexes were about 2 percent to the positive at midday.

Volatility, as measured by the Chicago Board Options Exchange Volatility Index, known as the VIX, spiked, pulling the broader HSBC Financial Clog Index to levels last seen around the time of the 2008 financial crisis. The Clog Index, an equally weighted measure of aggregate stress in the system, includes the VIX as a measure of equity volatility as well as interbank stress, measured by the TED Spread and the LIBOR-OIS Spread, financial institution default risk, measured by US financial credit-default swap spreads, and mortgage agency credit spreads, measured by credit spreads for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE).

S&P’s downgrade of long-term US government debt triggered similar action on the debt of Fannie and Freddie, which could drive spreads wider for their debt. But so far it appears we’re avoiding the type of freeze that followed Lehman Brothers’ bankruptcy in September 2008.

Of course, equity investors have been hit hard. And Canada, though its fiscal position and economic fundamentals remain strong, has suffered, as “risk-off” hysteria has overcome rationality. Although the two wild declines we’ve seen in recent days are of historic proportions, it pays long-term oriented investors little in the end to make wholesale adjustments to portfolios at this stage of the game. Nothing that’s happened since markets closed Friday afternoon in the US has changed the basic global economic equation.

The Fed, if you trust Chairman Ben Bernanke’s Jul. 13 semiannual Monetary Policy Report to Congress, will follow the following course:

Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate.

On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.

Today the Fed will likely reemphasize its commitment to keep its policy rate near zero and perhaps use language that clearly extends the timeline, such as “years.” It will also probably make a more explicit commitment to keep its balance sheet bloated. What it won’t do is announce a new round of purchases. The political damage is not yet done to politicians who’ve given up fiscal responsibility, though the environment is still too poisonous toward more central bank involvement in the economy. The Fed will try to thread a stimulating needle, however, and give the market a short-term boost. Stick with high-quality dividend-paying names and you’ll build wealth for the long term.

It pays to keep in mind that companies are not in need of access to cash right now. Credit markets are operating normally. The S&P 500 has an estimated USD2.5 trillion in cash on the books. Once the dust clears from the S&P selloff the US economy will still have its employment problems, its debt problems and its political problems. But so far it doesn’t look like funding costs are spiking, for the federal government, for businesses or for individuals. In other words, not much has changed.

If your time horizon is somewhere a decade or two out and you’re focused on dividend investing, this is likely to prove a good time to buy.

The Roundup

“If I were to sing a song about MEG’s second-quarter results,” said MEG Energy Corp (TSX: MEG, OTC: MEGEF) Chief Financial Officer Dale Hohm, “it would be ‘Taking Care of Business’ by the great Canadian band Bachman Turner Overdrive. MEG is like BTO: There’s nothing fancy, no smoke bombs, light shows or choreographed dancing, just good gold grinding rock and roll.

“Our engineering and operations personnel are just taking care of business.” That’s certainly a rollicking way for the CFO of a publicly traded company to introduce his segment of a quarterly presentation. But it also reflects reality: MEG continues to perform at a highly efficient clip, setting itself apart from other operators in the Canadian oil sands. Management continues to demonstrate the ability to keep costs under control in an industry that’s traditionally known for the enormous gobs of cash it takes to keep turning bitumen into synthetic crude.

“Standardizing” is a word that comes up a lot during MEG conference calls and presentations; it’s the key to MEG’s success. It means the company expands its drilling program according to what it learns at existing operational sites into areas that show similar characteristics. This deliberate pace allows it to keep steady and stable staffs of engineers and geophysicists, who build concentrically, if you will, around previously gleaned knowledge and help hold costs down. It’s not a dividend payer. But MEG is a growth play we like because it does a great job of controlling the things that it can control.

The all-important steam-to-oil ratio (SOR) was 2.5 during the three months ended Jun. 30, in line with the first quarter. Management expects SOR to range between 2.2 and 2.6 over the next few years. Management is currently building and incorporating into future forecasts–when it’s in a “more mature phase of [its] development”–the use of infill wells and non-condensable gas to further reduce its SOR.

Operating costs came down again, to CAD14 per barrel. Non-energy per-barrels costs of CAD8.74 were in line with first-quarter results. Netting out power revenue, total net operating costs were CAD11.36, in the words of CEO Bill McCaffrey “top-decile performance for a project that is still relatively new.” Operating costs will rise in the third quarter because production will be reduced by the mandatory downtime as well as the costs of doing the work, estimated at between CAD5 million and CAD10 million. Full-year guidance for non-energy costs per barrel remains CAD9 to CAD11, which includes the impact of the turnaround.

Management touched on an array of impressive expansion accomplishments during its second-quarter call, including the approval by its board of directors of a plan to boost 2011 CAPEX to complete construction of the Stonefell Terminal, a 900,000 barrel storage facility located near Edmonton.

MEG plans to tie the Stonefell facility and the Access Pipeline, a 215-mile dual system that connects MEG’s core Christina Lake project to a regional upgrading, refining, diluent supply and transportation hub, into the regional pipeline structure.

MEG will be able to distribute blended bitumen to multiple markets and gather condensate supplies from multiple sources, including rail offloading facilities and third-party pipelines. It’ll be an important hub for the company that should further its focus on extracting the highest value possible out of each barrel it produces.

The six 150,000 barrel storage tanks are to be completed by 2013. MEG Energy bought Stonefell Terminal from BA Energy last September for CAD42.5 million in a court-ordered sale and will spend an additional CAD150 million to complete  tie-ins and install pumps.

MEG averaged 27,800 barrels per day (bpd) of production during the second quarter, in line with results for the first three months of the year. Production has averaged 27,700 bpd for the first six months, but management’s 2011 overall forecast of 25,000 to 27,000 bpd takes into account a planned three-week turnaround period in September.

Operating earnings were CAD36 million (CAD0.18 per share), while cash flow from operations were CAD88 million (CAD0.44 per share). Management spent CAD210 million in the second quarter, CAD186 million of which went to horizontal drilling, facilities, procurement and construction at Christina Lake.

As of Jun. 30 MEG had CAD1.9 billion in cash and short-term investments. It also has access to an undrawn USDD500 million revolving credit facility. There will be no difficulties the 35,000 bpd Cristina Lake Phase 2b expansion or the completion of the Stonefell facility. MEG Energy is a buy up to USD55.

Here are estimated and confirmed second-quarter reporting dates for the CE Portfolio, including links to summaries for those Holdings that have already released numbers.

We’ll update the list as official dates are announced and provide analysis shortly following the release of numbers via Flash Alerts. Look for a complete summary and a look at how numbers for individual companies fit within the current investing climate in the September Canadian Edge.

Conservative Holdings

  • AltaGas Ltd (TSX: ALA, OTC: ATGFF)–Jul. 29 Flash Alert
  • Artis REIT (TSX: AX-U, OTC: ARESF)–Aug. 10 (confirmed)
  • Atlantic Power Corp (TSX: ATP, NYSE: AT)–Aug. 12 (confirmed)
  • Bird Construction Inc (TSX: BDT, OTC: BIRDF)–Aug. 9 (confirmed)
  • Brookfield Renewable Power Fund (TSX: BRC-U, OTC: BRPUF)–August CE Portfolio Update
  • Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)–Aug. 9 (confirmed)
  • Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–Aug. 12 (confirmed)
  • Cineplex Inc (TSX: CGX, OTC: CPXGF)–Aug. 11 (confirmed)
  • Colabor Group Inc (TSX: GCL, OTC: COLFF)–Jul. 29 Flash Alert
  • Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)–Aug. 9 (confirmed)
  • Extendicare REIT (TSX: EXE-U, OTC: EXETF)–Aug. 9 (confirmed)
  • IBI Group Inc (TSX: IBG, OTC: IBIBF)–Aug. 12 (confirmed)
  • Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)–Aug. 10 (confirmed)
  • Just Energy Group Inc (TSX: JE, OTC: JUSTF)–Aug. 11 (tentative)
  • Keyera Corp (TSX: KEY, OTC: KEYUF)–August CE Portfolio Update
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)–Aug. 9 (confirmed)
  • Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)–August CE Portfolio Update
  • Provident Energy Ltd (TSX: PVE, NYSE: PVX)–Aug. 10 (confirmed)
  • RioCan REIT (TSX: REI-U, OTC: RIOCF)–August CE Portfolio Update
  • TransForce Inc (TSX: TFI, OTC: TFIFF)–August CE Portfolio Update

Aggressive Holdings

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