Diversification and Balance: Still the Keys

By Roger Conrad • December 9, 2011 • Portfolio Update

Diversify your holdings among individual sectors as well as stocks. Periodically rebalance by selling a piece of your biggest winners when they move well past buy targets. Never average down in a falling stock or try to protect positions with self-defeating stop-losses. And always cut stocks loose when they fail the quality test.

Those aren’t boilerplate disclaimers. They’re words every investor in dividend-paying stocks must live by. And following them is why the Canadian Edge Conservative Holdings are up more than 9 percent year to date and the Aggressive Holdings are down just 4 percent, despite three full-scale blowups in 2011.

To recap, those were Yellow Media Inc (TSX: YLO, OTC: YLWPF), Perpetual Energy Inc (TSX: PMT, OTC: PMGYF) and, this month, Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF). In each case I stuck with management on the premise that the company would continue to meet longstanding guidance.

And all three times I was burned for the effort, as business conditions proved too difficult for the companies to handle.

Yellow has fallen another 80 percent since I recommended selling in August following the company’s abandonment of guidance and dividend cut. That’s not surprising, given management has since eliminated the dividend and is now selling assets in a desperate effort to avoid bankruptcy. Most disturbing, third-quarter revenue plunged 9 percent, indicating losses in the print businesses are now accelerating faster than digital advertising sales are rising.

I recommended exiting Perpetual Energy in a Flash Alert dated Oct. 20. Since then it’s shed an additional 27 percent, as its prognosis has become increasingly murky. Third-quarter numbers were worse on almost every metric, from a 5.9 percent drop in production to a rise in operating costs and a 59.4 percent nosedive in funds from operations, the primary measure of profitability.

At the root is a 37.7 percent drop in realized selling prices for the company’s output of natural gas, which is still 91 percent of production despite an all-out effort to boost all manner of liquids output. And with gas prices falling even further in the fourth quarter, there’s not a lot of hope for improvement, even as the company is forced to face the maturity of CAD75 million in convertible bonds (Jun. 30, 2012) and rolling over CAD98.1 million outstanding from its credit line that expires May 29, 2012.

Of course, getting out didn’t prevent taking a horrendous loss in both stocks this year, namely 54.4 percent for Perpetual and 82.6 percent for Yellow. But we did at least preserve some capital, and I’ve been able to turn my attention elsewhere, even as the strong performance of other stock holdings kept the overall Portfolio steady.

In other words, despite the paper loss made real, it was still worth it to sell these stocks when we did. That definitely applies to Capstone Infrastructure, which I now recommend selling, despite a loss of around 50 percent this year.

As I pointed out in a Dec. 6 Flash Alert, the company hasn’t yet cut its dividend from the current monthly rate of CAD0.055 per share. In fact, it may not until mid-2012. It has, however, virtually telegraphed a reduction sometime next year, the result of a steep cut in management’s cash flow guidance for 2012.

The Flash Alert has the basics of the guidance announcement. This month’s Dividend Watch List, meanwhile, fleshes out the details and my rationale for taking the loss now rather than waiting around in hopes of a recovery.

Basically, I’m deeply disturbed that the guidance released Dec. 6 reversed so many assumptions that were either implicit or explicit in the third-quarter conference call, which was held just three weeks earlier. Equally frightening, the projected 2012 payout ratio went from a range of 85 to 90 percent affirmed in the Nov. 15 call to a range of 120 to 130 percent.

That’s a staggering change that in my view undermines everything management has said before and is saying now.

The action of the stock since has been interesting to say the least, with a one-day drop of 33 percent followed by a surge that got about a third of it back. Bay Street analysts seem confused as anyone, with three houses upgrading their recommendations–one to “speculative buy”–and another cutting to “hold.” Capstone’s current yield is more than 17 percent, which indicates a lot of risk is priced in.

But again, when management flips like this, it’s rarely if ever a good sign for the future. And none of this guidance change has shed any light on the biggest issue facing Capstone: ongoing negotiations with the Ontario Power Authority for a new power sales contract for the Cardinal power plant.

As I wrote in the Flash Alert, that negotiation may provide the subtext for the dividend warning, as a less-than-satisfactory deal would almost surely force a dividend cut on its own. But I’m no long-distance mind-reader, and though Capstone may find a way out of its troubles, its shares could also fall a lot further if there’s another negative surprise. Sell Capstone Infrastructure Corp.

More Year-End Moves

There’s one other sell this month, as I now recommend exiting Aggressive Holding Daylight Energy Ltd (TSX: DAY, OTC: DAYYF). Shareholders have now approved the takeover offer of CAD10.08 per share in cash from China Petroleum & Chemical Corp, better known as Sinopec (NYSE: SNP). The deal still lacks approval from provincial and federal regulators as well as the granting of the Final Order by the Court of Queen’s Bench of Alberta.

At this point there’s no indication that won’t be forthcoming. But neither is there any reason to wait around for this deal to take place. Daylight no longer pays dividends. The Canadian dollar has ticked back up toward parity, eliminating leverage available to US investors. And the premium in Canadian dollars between Daylight’s current price and its current price is now barely a percentage point. Sell Daylight Energy.

My third change to the Portfolio this month is to add Noranda Income Fund (TSX: NIF-U, OTC: NNDIF) to the Aggressive Holdings. As I point out in the December High Yield of the Month feature, this is a high risk/reward play for aggressive investors, not a safe haven for income investors. That’s the role of co-High Yield of the Month and Conservative Holdings stalwart Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF).

We’re basically betting that a newly formed independent committee reviewing Noranda’s current distribution policy will find in favor of major shareholders’ assertion that the payout should be raised radically. The income trust’s fortunes have vastly improved over the past year, as the market for processed zinc and related byproducts like sulfuric acid has dramatically tightened and the company has slashed debt.

Taking the monthly distribution back where it was when Noranda launched its initial public offering in May 2002–essentially the position of several major unitholders–would effectively double the payout. And that level would still remain well covered by distributable cash flows, based on results in recent quarters, leaving plenty of cash for cutting debt further.

That would almost certainly also trigger a double in the stock. There’s absolutely no assurance that will happen. But this same group of major unitholders did face down Xstrata Plc (London: XTA, OTC: XSRAF) when it attempted to pressure Noranda into an all-cash takeover last year. Combined with the company’s improved results, momentum suggests at least some improvement in the distribution likely. Noranda is a buy for aggressive investors willing to take a calculated risk up to USD6.

I’m also moving Student Transportation Inc (TSX: STB, NSDQ: STB) to the Conservative Holdings. The immediate catalyst for the switch is the school bus operator’s acquisition of Dairyland Bus, Inc, adding 700 vehicles, USD36 million in additional revenue and five new locations to its Midwest US operations.

This is the kind of deal Student Transportation has routinely been able to make work in recent years. It’s expected to add an additional 6 percent in annualized revenue once it closes, pushing total growth to 18 percent for fiscal year 2012. It’s also expected to be immediately accretive to profits.

The company used proceeds from its newly inked credit deal to finance the acquisition, something it’s likely to repeat at least one more time this year. Student Transportation was also able last month to roll over USD35 million in senior notes maturing Dec. 15, 2011, for another five years, while cutting the rate from 5.94 percent to just 4.24 percent. That will save an estimated USD593,000 in annual interest charges.

The company has targeted a payout ratio of 80 to 85 percent going forward. That’s about where it stands now. Consistent and highly transparent revenue growth, however, should soon push that ratio well below that level, opening up the possibility of increases in the dividend yield that currently sits near 9 percent.

Best of all, the longer the US economy remains at constrained levels, the greater the company’s opportunity for expansion will be, as school districts look to cut costs by outsourcing bus service, or by outright selling of their operations.

Student Transportation is a buy up to USD7 for those who don’t already own it.

Finally, the end of the year is an ideal time to rebalance your holdings to improve diversification and reduce risk by paring back the biggest winners. What you should do depends on your individual situation.

But the larger any holding becomes in relation to the rest of your positions, the greater the impact an unexpected setback will have on your overall wealth.

If you have 20 stocks, for example, it’s probably not worth it to pare back a stock that rises to become 7 or 8 percent of the portfolio. Should that same holding hit 15 percent, however, it would definitely be worth taking some money off the table and deploying it elsewhere.

In addition, a number of Portfolio companies have surged above my buy targets. These include Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) from the Aggressive Holdings and AltaGas Ltd (TSX: ALA, OTC: ATGFF), Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Cineplex Inc (TSX: CGX, OTC: CPXGF), EnerCare Inc (TSX: ECI, OTC: CSUWF), Keyera Corp (TSX: KEY, OTC: KEYUF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF), Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF), Provident Energy Ltd (TSX: PVE, NYSE: PVX) and RioCan REIT (TSX: REI-U, OTC: RIOCF) in the Conservative Holdings.

These 10 companies have all performed very well for us this year, and for good reason. They’re growing earnings and strengthening balance sheets in an environment that’s crippled other companies. All have either returned to dividend growth or else they’ve positioned themselves to do so in the near future. And all appear ready to weather whatever comes down the pike for the markets and the economy, by virtue of conservative financial and operating policies and secure business niches.

No stock, however, is a buy at any price. And all too many investors seem willing to pay through the nose for stocks that are perceived to be safe, just as they’re quick on the trigger to unload anything that smacks of risk no matter how far it may drop.

If you’re eying a stock for purchase that’s run past its buy target, I have three words for you: Wait on it. All 10 of the stocks above have at one time or another this year traded below my buy targets. Some traded well below target for uncomfortably long periods of time, before investors decided they weren’t so risky after all.

To be sure, buying them above target likely won’t be the worst investment move you’ll ever make. But with European credit worries still commanding the headlines and so many investors scared stiff about being caught in another Yellow Media, it won’t take much to push these stocks back into bargain range again. Exercising a little patience now is likely to dramatically increase your return, no matter how long you plan on holding a stock.

And don’t be afraid to invest funds in stocks that continue to demonstrate strong business numbers but that for some reason are perceived by investors to be at greater risk of a dividend cut. As I pointed out in In Brief, for every battered stock that’s completely imploded this year, there are at least three that have recovered spectacularly, as they continued to perform as businesses and eventually investor perception of dividend risk lessened.

Parkland Fuel Corp’s (TSX: PKI, OTC: PKIUF) 60 percent-plus surge off its October low is a particularly striking example of how a battered stock can rally hard when investor perception changes. In fact, there’s nothing like a rising stock price to convince people risk has vanished and ignite even more buying–just as a falling stock often creates its own wave of panic and triggers more selling.

The keys are balance and diversification. Even the strongest looking stock can stumble. Only by holding a mix of high-quality companies drawn from a range of industries can you guard against emotion, bad judgment and just plain bad luck. And if you are diversified and balanced, you can make bets on future Parklands with the security of knowing that even on the off chance it turns out to be another Capstone or Yellow, your overall portfolio will still be in good shape, as other winners inevitably pick up the slack.

What the Numbers Said

All the third-quarter results are now in for the Canadian Edge How They Rate universe. I’ve highlighted comments and payout ratios for each of the 165 companies tracked in How They Rate, accessible with live price and dividend quotes at www.CanadianEdge.com.

All How They Rate companies are also given a CE Safety Rating of between “0” (riskiest) and “6” (safest) depending on how many criteria they meet. The six are:

  • payout ratio;
  • earnings visibility and what it means for future payout ratios;
  • debt-to-capital ratio;
  • debt due through 2012 as a percentage of market capitalization;
  • exposure of earnings to changes in commodity prices; and
  • the number of dividend cuts the last five years.

The table below goes one step further for my current roster of Portfolio companies, showing how each company rates on each of these criteria. Note that the table still includes the two stocks I’m selling this month, Capstone Infrastructure and Daylight Energy.

It also doesn’t include new Aggressive Holding Noranda Income Fund, which rates a 3 under the Rating System. The company gets points for a very low current payout ratio, no near-term debt maturities and low overall debt. It misses for dividend cuts in the past five years, commodity-price exposure and payout visibility, as profits rise and fall with commodity prices.

In general, there wasn’t much change in ratings for Portfolio companies this month based on their third-quarter results. Northern Property is now a perfect 6, the result of solid third-quarter numbers that seem to make moot the issue of what happens to its staple share structure next year.

I’m also now rating Artis REIT (TSX: AX-U, OTC: ARESF) a perfect 6, as the past two years of aggressive acquisitions are now definitely feeding cash flow. The company’s diversification is also now sufficient to protect it from a future pullback in Alberta, the primary reason it’s missed a point in the past.

EnerCare has earned an upgrade from 3 to 4 on the strength of its solid earnings and improved visibility of future numbers, based on rapidly improving metrics for its submetering and water heater rental businesses.

Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF) gets a lift to 4 from the dramatic drop in its payout ratio and demonstrated ability to raise low-cost capital, which has reduced near-term debt obligations. And Provident Energy also now earns a 4, thanks to the drop in its payout ratio and improved earnings visibility thanks to asset additions.

On the minus side, now-sold Capstone’s downgrade to 2 reflects not only a high payout ratio but a lack of visibility for future earnings, as management’s credibility is shot in my view.

In contrast, my reasoning for cutting Just Energy Group Inc (TSX: JE, OTC: JSTEF) to 4 from 5 may seem trivial to some. And it’s certainly no reflection on the company’s very strong operating numbers, including an expectation-beating 25 percent jump in cash flow per share in its fiscal 2012 second quarter.

Rather, it’s recognition that the company’s core business does face some headwinds now. These include still slow economic growth in much of North America and low natural gas prices, which influence the price of energy. None of these challenges have prevented the company from growing its profits and customer base to date. And they’re not likely to going forward in my view. But they do present some risk and it’s the job of a safety ratings system to present that.

Aside from these companies, third-quarter results merely confirmed the underlying strength of our holdings, and why we want to keep on holding them through the New Year.

Here’s where to find my analysis and the numbers for Canadian Edge companies, all of which have now reported third-quarter results.

Conservative Holdings

Aggressive Holdings

Balance and Conquer

Finally, a word about diversification: Each of the current CE Portfolio companies stacks up well on its own merits, offering a solid combination of potential reward–high yield and growth–balanced with risks, based on what we know now.

Eight of the companies currently rate a perfect 6, meeting all of the Safety Rating System criteria. That doesn’t mean they can’t weaken in the future. But at this point they’re the furthest away from real weakness of any company in Canada. Another 11 meet five criteria, making them nearly as safe. Of the rest, nine more rate 4 and six rate a 3, including Noranda. Both holdings rated 2 have now been sold, Capstone and Daylight, and are no longer part of the Portfolio.

The six that rate 3 miss primarily for three reasons. First, their core businesses are heavily impacted by commodity price swings. That’s true of Acadian Timber Corp (TSX: ADN, OTC: ACAZF), Newalta Corp (TSX: NAL, OTC: NWLTF), Noranda, Parkland Fuel and PHX Energy Services Corp (TSX: PHX, OTC: PHXHF). Second, they’ve cut dividends at least once in the past five years.

That’s true of Acadian, Extendicare REIT (TSX: EXE-U, OTC: EXETF), Newalta, Noranda, Parkland and PHX. Third, commodity-price exposure or some other risk beyond their control limits future earnings visibility. That’s true of all six companies.

Why own companies rated just 3? Because in many cases they offer superior upside to higher-rated fare. Acadian Timber, for example, has returned more than 40 percent year to date, though it’s currently well off its 52-week high. Parkland Fuel has moved out to new 52-week high this month. And having commodity-price exposure can also be a huge plus under the right market conditions.

A portfolio that holds stocks like these only will almost surely be more volatile than one holding only stocks rated 5 or 6. But if you hold these stocks in a balanced, diversified portfolio that includes higher-rated companies from a range of sectors you can get the benefit of their upside potential without exposing your overall wealth to excessive risks.

Every sector holds its own unique combination of risk and reward. By holding stocks in several, you’ll be able to benefit under a range of economic and market possibilities while limiting the risk of one area turning against you.

On Halloween Night 2006 Finance Minister Jim Flaherty announced the tax on income trusts. Until that time virtually all Canadian Edge companies shared a common risk, i.e. that they’d wind up being taxed. Once that risk became reality, the trusts shared the common risk-reward of how they’d deal with pending taxation in 2011 and what they’d do with their dividends when they started paying taxes.

The conversion wave that occurred this year–and to a lesser extent in 2008, 2009 and 2010–proved far more benign than anyone expected. Dozens of companies managed to start paying taxes without cutting their dividends a penny. Others cut, but far less than expected. But however that shook out, the common risk-reward of trust taxation is no more.

Canadian companies are still affected by the ups and downs of the Canadian economy, very much a positive in recent years. And for US investors all Canadian stocks are heavily impacted by the ups and downs of the Canadian dollar, which affects the US dollar value of dividends and share prices. That’s something to keep in mind if you’re paying your bills in US dollars. And it’s why no US resident should ever put all of their funds into Canadian stocks.

Otherwise, however, dividend-paying Canadian stocks are behaving very much like their counterparts in the US. Mainly, investor perception of the relative risk to dividends in particular sectors is starting to play a major role in stock performance.

Getting lucky and loading up on an in-favor sector can bring great reward under the right conditions. But missing your timing and putting all your eggs in a sector going out of favor can leave you under water for an uncomfortably long period of time. And if the particular stocks you’ve chosen in that sector wind up facing severe business stress, you may not recover.

That’s why the best route to follow is to own some stocks in a range of sectors, which is what I do in the Canadian Edge Portfolio. The primary demarcation between “Conservative” and “Aggressive” for purpose of the Portfolio is still exposure to swings in commodity prices. That’s why Capstone has been in the Conservative Holdings, while even consistently higher rated Vermilion Energy Inc (TSX: VET, OTC: VEMTF) has been in the Aggressive Holdings.

Taking Conservative and Aggressive together, however, there’s a representative from nearly every sector covered in How They Rate. Here’s the breakdown:

Business Construction Services

  • Bird Construction Inc (TSX: BDT, OTC: BIRDF)
  • IBI Group Inc (TSX: IBG, OTC: IBIBF)

Consumer Services

  • Cineplex Inc (TSX: CGX, OTC: CPXGF)
  • EnerCare Inc (TSX: ECI, OTC: CSUWF)
  • Just Energy Group Inc (TSX: JE, OTC: JSTEF)
  • Parkland Fuels Corp (TSX: PKI, OTC: PKIUF)

Electric Power

  • Atlantic Power Corp (TSX: ATP, NYSE: AT)
  • Brookfield Renewable Energy Partners LP (TSX: BEP-U, OTC: BRPFF)
  • Innergex Renewable Energy Inc (TSX: INE, OTC: INGXF)

Energy Infrastructure

  • AltaGas Ltd (TSX: ALA, OTC: ATGFF)
  • Keyera Corp (TSX: KEY, OTC: KEYUF)
  • Pembina Pipeline Corp (TSX: PPL, OTC: PBNPF)
  • Provident Energy Ltd (TSX: PVE, NYSE: PVX)

Energy and Industrial Services

  • Newalta Corp (TSX: NAL, OTC: NWLTF)
  • PHX Energy Services Corp (TSX: PHX, OTC: PHXHF)

Financials

  • Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF)

Food Services

  • Colabor Group Inc (TSX: GCL, OTC: COLFF)

Medical Services

  • Extendicare REIT (TSX: EXE-U, OTC: EXETF)

Natural Resources

  • Acadian Timber Corp (TSX: ADN, OTC: ACAZF)
  • Ag Growth International Inc (TSX: AFN, OTC: AGGZF)
  • Chemtrade Logistics Income Fund (TSX: CHE-U, OTC: CGIFF)
  • Noranda Income Fund (TSX: NIF-U, OTC: NNDIF)

Oil and Gas Producers

  • ARC Resources Ltd (TSX: ARX, OTC: AETUF)
  • Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF)
  • Enerplus Corp (TSX: ERF, NYSE: ERF)
  • Penn West Petroleum Ltd (TSX: PWE, NYSE: PWT)
  • Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF)
  • Vermilion Energy Inc (TSX: VET, OTC: VEMTF)

Real Estate

  • Artis REIT (TSX: AX-U, OTC: ARESF)
  • Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF)
  • Northern Property REIT (TSX: NPR-U, OTC: NPRUF)
  • RioCan REIT (TSX: REI-U, OTC: RIOCF)

Transportation

  • Student Transportation Inc (TSX: STB, NSDQ: STB)
  • TransForce Inc (TSX: TFI, OTC: TFIFF)

The key takeaways from this breakdown are these. First, there’s at least one representative from each of Canada’s highest potential sectors. The only exception is Communications, where I’ve yet to replace melted down Yellow Media and Bell Aliant Inc (TSX: BA, OTC: BLIAF), which I sold from the Portfolio when it converted to a corporation, as it had made itself inaccessible to US investors with less than USD1 million in liquid assets.

Second, while all of these sectors are growing strongly, they perform well in different economic/market environments. My strongest performers by far this year, for example, have been the four Energy Infrastructure picks. All currently trade above my buy targets, thanks to a perception that they’re safe even in the event of a market crack.

I’m thankful to have owned these stocks this year, as they’ve pretty much balanced out the losers. Market history, however, shows clearly that sectors often swap places, and that 2012’s biggest winners could well be a group that mostly lagged this year like Oil and Gas Producers. Either way, the CE Portfolio is covered with representatives from both.

Interestingly, there’s a wide divergence of performance between stocks in some of the sectors. Electric Power returns, for example, ranged from Brookfield Renewable Energy Partners LP’s (TSX: BEP-U, OTC: BRPFF) 27 percent positive return to Capstone’s crackup.

Consumer Services had an even wider range, from EnerCare’s 40 percent gain to Just Energy’s 30 percent loss. Others, like Business Construction Services, featured almost identical breakeven performances by Bird Construction Inc (TSX: BDT, OTC: BIRDF) and IBI Group Inc (TSX: IBG, OTC: IBIBF).

The primary reason for divergences in this market is perception of risk to dividends. EnerCare’s rapid growth in submetering and dividend increase obviously did a better job convincing investors its dividend is safe than Just Energy’s assertions that it was beating cash flow guidance. So long as Just Energy continues to perform, however, it’s likely to be a much bigger winner next year than EnerCare, which currently yields 5 percentage points less.

Again, however, I don’t much care if EnerCare continues to lead the way the Just Energy lags again in 2012. I own both. So long as they’re both performing well as businesses, they’ll keep paying a superior stream of dividends. And I can always get rid of one or both of them if they seem to falter.

You don’t have to own each and every one of these sectors to have a balanced portfolio. But the more you do, the steadier your overall performance will be–and that will make it that much easier to control your emotions and make the best rational decisions you can the next time the stock market lays an egg.

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