Standing Pat

By Roger Conrad • December 7, 2012 • Portfolio Update

November was generally a rough month for Canadian stocks.

But despite some big hits to a few recommended stocks, CE Portfolio Conservative Holdings are still up 10.2 percent on average with less than a month left in 2012.

Our three Mutual Fund Alternatives have returned 10.1 percent, while the Aggressive Holdings are still up 0.6 percent.

Underneath these headline numbers performance has been considerably more jagged.

Starting with the bad news, three recommended companies are down more than 40 percent: IBI Group Inc (TSX: IBG, OTC: IBIBF), Pengrowth Energy Corp (TSX: PGF, NYSE: PGH) and Poseidon Concepts Corp (TSX: PSN, OTC: POOSF).

Meanwhile, three stocks largely offset those losses by gaining more than 40 percent year to date: Acadian Timber Corp (TSX: ADN, OTC: ACAZF), Parkland Fuel Corp (TSX: PKI, OTC: PKIUF) and TransForce Inc (TSX: TFI, OTC: TFIFF).

The far right-hand column of the table “Performance” features the year-to-date total return in US dollar terms for all CE Portfolio Holdings. As long-time readers know, I believe in using value as your primary investing guide, not market momentum.

That means I’m generally willing to ride out downside in recommended companies, as long as I’m also convinced the underlying business still has what it takes to build wealth over time.

This does not mean adding to positions in fallen stocks, the so-called practice of averaging down.

Yes, we’ve seen time and again over the past few years how beaten down stocks have staged big recoveries, as doom-fearing sellers have calmed their nerves and become buyers again. The stellar performances of Parkland Fuel and TransForce this year are excellent cases in point.

But doubling down all too often has the effect of bringing emotion into decision-making. And if real business weakness does appear, you’ll lose that much more when you do have to cash out.

When a stock really gets kicked in the teeth, as several did this month, I’m willing to stick in there with the initial position, at least until there are signs of something besides changing opinion behind the selling momentum.

But I can only afford to do that if I’m not pouring more money in–and thereby overweighting.

Conversely, I never recommend reaching above buy targets–again, based on value–for recommended stocks, no matter how much Bay Street seems to love them.

I will raise buy targets when companies increase shareholder value, as this month’s Best Buys Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) and Vermilion Energy Inc (TSX: VET, OTC: VEMTF) did last month.

Barring that, however, my standing advice for bid-up favorites is to take a partial profit to bring the total amount invested back into line with the rest of your portfolio. Even if you can’t buy back in at a better price later on, you’ll still be minimizing the overall risk of your portfolio to a single over-weighted stock.

Below I look at the CE Portfolio’s top and bottom performers this year and what to do with them now.

Unlike in past years I’m not recommending making many year-end moves. That’s mainly due to the unusual action in the markets in the past few weeks.

It’s become almost a routine practice for companies to report mildly disappointing news and then see their stocks plunge as though doom was nigh. The only way to understand this kind of action is to realize that large institutions dominate trading and therefore the near-term action in most stocks.

Big money is highly motivated right now to meet performance benchmarks by the close of trading on Monday, Dec. 31. And that means most managers simply can’t afford to ignore momentum as the year comes to a close.

Of the three biggest losers in the CE Portfolio for 2012, only Pengrowth Energy has actually cut its dividend. All three stocks, however, crashed and burned as though they were going out of business.

And in a normal market that wouldn’t have happened given actual developments.

Just the Facts

When a stock you own goes into panic-selling mode, you basically have two choices.

You can do what most apparently do and sell into the momentum, taking whatever price the market will bear.

Or you can stay with the stock until the selling plays out and see if the underlying company is still capable of building wealth and thereby recouping its losses.

Neither is a particularly comfortable decision to make. Selling, for example, will limit your losses to whatever your exit price is.

But unless there’s a real company setback to match the panic, you’ll just be locking in losses that will be later erased.

Sticking around, meanwhile, runs the risk of even greater losses if there really is a problem.

And even if a stock has hit bottom, it can be weeks, months or even years before you’re made whole.

Whatever your choice, however, your decision must be based on how the company is actually performing as a business.

And the best place to look for that is the most recent round of earnings results.

Here are links to my analysis of all Portfolio Holdings’ numbers for the third quarter. See How They Rate for numbers from non-Portfolio companies in the CE coverage universe.

Conservative Holdings

Aggressive Holdings

The table “Performance” sums up these results as they pertain to the Canadian Edge Safety Rating System. An in-depth explanation of the System is available here.

In brief, the six criteria are:

  • Payout ratio
  • Predictability of future cash flows and payout ratio
  • Reliability of revenue
  • Competitive debt-to-capitalization
  • Lack of debt maturing before the end of 2014
  • Lack of dividend cuts during the last five years

Safety Ratings are determined by adding up the total number of criteria met. The maximum rating–or safest–is “6” and the lowest is “0,” indicating a company that meets none of the ratings criteria.

The first takeaway from the current table that leaps to mind is the majority of CE Portfolio Holdings draw reasonably high Safety Ratings based on the latest data. Even the Aggressive Holdings–which are more exposed to commodity-price and economic swings–on average meet more than half the criteria. Conservative Holdings, meanwhile, score on average between “5” and “6,” at the very high end of the spectrum.

That matches the objectives of these Portfolios. Mainly, Conservative Holdings are best suited for investors in search of yield and growth with less risk and volatility.

All Canadian stocks are priced in and pay dividends in Canadian dollars. This has the effect of increasing the price volatility of even the least economically sensitive fare. But Conservative Holdings’ underlying businesses are generally steady in the face of swings in commodity prices and economic ups and downs. That makes dividends more proof against disaster, a fact they proved during the 2008-09 crash despite what proved to be temporary share-price slides.

Companies do occasionally stumble for a variety of reasons. And because industries and economies aren’t static, risk sometimes rises and falls at the business level, making the company in question a better fit in the Aggressive Holdings. When that happens we’ll make a switch.

That’s because we own Aggressive Holdings precisely for their link with Canada’s economy, particularly the resource patch. This exposure by definition means they have lower CE Safety Ratings than Conservative Holdings, sometimes much lower. But for those prepared to take on the greater risk they often generate the fattest returns.

The hallmark of both Conservative and Aggressive stocks is they are backed by strong underlying companies. Revenue and earnings are more volatile at some than at others. But all have what it takes to grow the business and weather external and internal setbacks. And if they should weaken on that basis we’ll exit.

Buy, Hold or Sell

So where do the operating numbers direct us now with stock-price momentum spinning out of control, both up and down?

First, nothing has happened that’s dramatic enough at any CE Holdings’ businesses to justify this much stock-price volatility.

That’s been the case all year. What’s made the volatility more extreme in the past couple months has been a rising level of fear in the market as US budget negotiations have dragged on, Chinese demand for natural resources has seemed to stall, Europe’s economies have sunk deeper into recession and several companies have reported earnings below what many analysts were expecting.

Second, company numbers may not have been as strong as hoped. But neither did anyone report anything bad enough to trigger even a dividend cut. In fact management of every company in the Portfolio went out of its way to affirm the safety of its respective dividend, barring additional unforeseen setbacks in 2013.

Selling institutions’ motivations are profoundly short-term oriented.

That means they’ll likely be buyers again sometime after the first of the year, as long as there’s not a complete meltdown of the underlying business.

We’ll almost surely see a mighty recovery in most of the stocks getting battered now.

Conversely, buying institutions have also been motivated by near-term concerns, mainly the need to ride buying momentum to get a better result on Dec. 31.

That doesn’t necessarily mean their favored stocks will sell off on Jan. 1. And I continue to like all of them as businesses. But selling is precisely what we did see for several CE Portfolio Holdings in early 2012 that were red hot at the end of 2011.

Consequently, here’s what I recommend.

First, hold onto most of your battered fare now. Even if the underlying companies do weaken as businesses in 2013, any reasonable worst-case scenario is priced in and much more by the out-of-control selling momentum we’ve seen the past few weeks.

It’s just not a good time to take tax losses as it would be in a normal year, with very rare exceptions.

In fact this month’s only sale is Pengrowth Energy, and it’s only as a way to shelter gains from taxes.

The stock has been one of our biggest losers since I recommended swapping into it for Enerplus Corp (TSX: ERF, NYSE: ERF) last spring. It’s also quite liquid as an NYSE-listed stock, and there is a fundamental case why it could go lower in the near term: Pengrowth will suffer should energy prices, particularly oil, slump in early 2013.

Pengrowth is easily the most exposed to a drop in energy prices of any Portfolio producer holding. These otherwise include ARC Resources Ltd (TSX: ARX, OTC: AETUF), Crescent Point Energy Corp (TSX: CPG, OTC: CSCTF), PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF), Peyto Exploration & Development Corp (TSX: PEY, OTC: PEYUF) and Vermilion Energy.

I’m still convinced Pengrowth stock is due to make a strong recovery next year, as the company continues to execute on plans to develop rich reserves of light oil as well as an oil sands project. The purchase of the Lochend Cardium Assets and solid third-quarter earnings announced last month support the dividend and point to the company’s ability to access low-cost funds needed for development.

In the final analysis, the weakening of oil prices in spring is what tripped up Pengrowth returns this year, as worries about threats to global growth grew. That cast its ambitions to grow oil production in a far less favorable light so far as investors were concerned. So did the dividend cut announced last spring.

As an investment Pengrowth has given us about the same negative return as hanging onto Enerplus would have this year. And with more untapped credit to finance its efforts Pengrowth still appears to be the better positioned of the two. But recovery isn’t likely until sometime next year, and that makes the stock a decent candidate for taking a tax loss to apply against gains taken on winners.

In the latter category are all three of this year’s top performers. I intend to hold all three–Acadian Timber, Parkland Fuel and TransForce–in the Portfolio.

But they’re still good candidates for paring back a bit. So is any other company in which investors have a big capital gain and that have grown to become a disproportionate piece of an overall portfolio.

I don’t have a crystal ball. And no matter how closely I analyze a company, adverse events do happen. What I do to minimize risk is gauge companies’ health by how they perform as businesses and project cash flow and distribution growth based on that.

Most of the time Canadian Edge does get it right. That’s clear from the fact that our winners vastly outnumber our losing positions and the fact that our winning years have far offset the losers.

But I don’t always get it right. Every once is a while there’s a stumble. And if the market is fearful enough it can turn into a big loss in a hurry.

The only way to protect yourself when this happens is by diversifying and balancing as evenly as possible between your holdings.

This, in a nutshell, is why we’ve produced positive returns despite taking some big losses in individual stocks.

Focusing on quality eliminates the pure junk from consideration. And if one of our stocks does falter anyway diversification and balance ensure the damage it does won’t destroy the entire portfolio’s value.

In fact I can afford to be patient and sit with a loser until momentum shifts, at least so long as the underlying company of the battered stock appears to be healthy.

That in effect is what I’m advising this month for my two other big losers thus far in 2012: IBI Group and Poseidon Concepts.

As I reported in a Nov. 15 Flash Alert, IBI’s distributable cash flow did once again cover the dividend. Management, meanwhile, issued a generally optimistic outlook for overall operations, with job backlog holding steady (65 percent of future contracted work is government work) and cost efficiency plans making progress.

Chairman Phil Beinhaker also stated during the company’s third-quarter conference call that the company intended to maintain its dividend.

As point out in Dividend Watch List, IBI does face a challenge in delivering on its cost-cutting guidance. Progress was hard to find in the third-quarter numbers, and without it it’s hard to see how IBI will be able to continue paying its current dividend and deal with maturing debt in coming years.

There’s still some time to accomplish that, as the first big chunk of maturing debt is a 7 percent convertible that comes due Dec. 31, 2014, and is currently well out of the money. But until we do see progress IBI’s dividend should be considered at some risk. And because of that I’m moving the stock to the Aggressive Holdings.

On the other hand, a yield of nearly 17 percent is pricing in a lot of bad news that hasn’t occurred and may never. Insiders have remained buyers on the way down, and IBI related entities control more than 75 percent of shares. That’s a powerful constituency to keep the payout flowing so long as earnings cover it, as they did once again in the third quarter.

The bottom line is I want to see more numbers here for IBI before giving up on this position, particularly given that the stock trades where it does after a selling momentum wash out. I’m keeping IBI Group a hold.

As for Poseidon Concepts, selling pressure began with the stock at nearly USD15 a share shortly before earnings were announced on Nov. 15. It’s scarcely abated since, though some of the brokerages downgrading the stock in recent weeks have shifted to a neutral-to-bullish stance.

Here too selling momentum continued to build in the days following the announcement despite a clear lack of hard news on the company, as a reaction to losses already realized.

The result is after a 72 percent boost in third-quarter revenue, an apparently successful launch of new products and posting enough cash flow to cover the dividend by a 1.1-to-1 margin in the third quarter, the stock trades at a yield of better than 30 percent.

That’s a level of yield reserved for companies ready to file for bankruptcy protection. The fact that it’s been reached for Poseidon means one of two things.

First, there’s some bigger problem here that neither the company’s insiders nor the analysts covering the stock have yet seen. Insiders, for example, have remained prolific buyers as the stock’s price has fallen. And the lowest 12-month price target by any of the 11 analysts covering the stock is roughly USD5, nearly 50 percent above the stock’s current price.

The other possibility is that the selling momentum driving down this stock has reached a ridiculous level as institutions have tried to exit the stock all at once. This momentum, incidentally, seems to have reversed, with large players boosting their holdings by 21.65 percent this week. Insiders for their part have lifted their stake by 2.4 percent. Perhaps tellingly, US ownership has dropped in the stock while Canadians’ holdings have risen over that time.

Whether this shift means the selling wave will become an equally powerful buying surge and wipe out the losses we’ve seen since mid-November will depend on one thing: Poseidon posting some better results. The bar for realizing gains forecast by most analysts is very likely going to be very low–probably just some evidence that the business isn’t deteriorating as fast as it was previously growing.

Unfortunately, we’re not going to see hard numbers for Poseidon again until March. That in a normal year would be a good enough reason to just sell the stock, take the tax loss and come back if the news improves. But, again, this isn’t a normal year. And barring an absolute worst-case for this company, we’re either at or very close to a bottom.

Given that a worst-case would likely evaporate this position, I’m not going to keep this stock as a buy. But neither am I going to sell it after such devastating selling momentum has done its worst. Hold Poseidon.

Note that I’ve also changed my advice on Extendicare Inc (TSX: EXE, OTC: EXETF) this month, due to uncertainty regarding the Medicare system. Extendicare is now a hold.

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