In This Issue

THE YEAR AHEAD

By Gordon Pape, Editor and Publisher

Buckle up! It’s going to be a rocky year. Last week’s market gyrations, which ended with the TSX losing 379 points, was just a preview of what’s in store for 2015 so be prepared. This is shaping up as a year of uncertainty, a condition that sends investors running for cover.

The reality is that no one knows what is going to happen over the next few months. The plunge in the price of oil has thrown all projections out the window. Back on November when OPEC (really Saudi Arabia) decided not to cut production, $60 oil (U.S. currency) appeared to be the downside. Now $40 oil looks increasingly possible. While consumers may cheer, economists are deeply divided over what that will mean for the global economy.

Just a few weeks ago, the prospects for 2015 looked pretty good. The U.S. economy was in a strong recovery mode, and accelerating. The S&P 500, the Dow, and the TSX had all set record highs. And history is on our side. Over the past 15 years, the performance of the Dow on the first day of January trading was a predictor of how the year would turn out 80% of the time. On Jan. 2, the Dow registered a small gain of about 10 points. Not a lot, but at least it was up.

Then, there’s the fact this is the third year of a presidential term, which has historically been very good for stock markets. Barron’s recently published an analysis of third-year results that showed that since 1896 the stock market has risen 82% of the time with an average gain of 15% per year. Since 1940, the Dow has risen in every single third year of a term – never missed once! The average annual gain was 22.3%.

Those are pretty convincing numbers. But maybe this time it’s different.

It’s not just oil that has investors worried and analysts scratching their heads. Add interest rate uncertainty to the mix and then stir in a dose of European angst and we have a toxic brew that does not bode well for stocks, at least in the short term, and which may prolong the seemingly ageless bond bull market.

Against this backdrop, making predictions for the coming year is even more problematic than ever. Normally, the trend lines are reasonably clear and we can use them to extrapolate what is likely to unfold in the months ahead. But right now, all we have is a swirl of unknowns and possibilities. That said, here are my best guesses as to what may transpire as 2015 takes shape.

Oil will drop further, then recover. The markets always overshoot, whether to the upside or the downside. The current drama unfolding in the energy sector looks like yet another example of this. The way the oil price has been plunging, you might get the impression that suddenly no one wants the stuff any more. Buggy whips, anyone? Of course, that’s not the case. The world still runs on oil and will continue to do so for at least our lifetimes and probably much longer. What we have right now is a combination of supply/demand imbalance complicated by speculative mania. That will sort itself out in the coming weeks. In the meantime, the price could well sink to the $40 range but I don’t expect it to stay there for long. A rebound to the $60+ level is likely by spring followed by a lengthy period of consolidation which will give stock markets time to pause and stabilize.

New York will record modest gains. Forget about the average 22.3% gain in the Dow since 1940 in the third year of a presidential term. That’s not in the cards for 2015. In fact, if it happened, I’d be worried. As of the end of 2014, the Dow was showing a five-year advance of over 70% while the S&P 500 was up 85%. Most analysts agree that the U.S. markets are no longer cheap, with few bargains to be found. To expect gains of 20%+, or even in double digits, is simply unrealistic. I think the major U.S. indexes will finish the year in the black, but the gains will only be in the range of 5% to 8%. On that basis, my forecasts for year-end 2015 are:

S&P 500: 2,160 to 2,225.
Dow Jones Industrial Average: 18,715 to 19,250
Nasdaq Composite: 4,970 to 5,115

Toronto will struggle. It’s hard to be positive about the outlook for the TSX this year. Financials, the single largest sector with 35.7% of total assets, gained 8.6% in 2014 but recent statements from senior bank officials suggest that profit margins are tightening and we could see some retrenchment in 2015. The energy sector, which comprises 21.4% of the index, is in turmoil. Materials, which make up 11% of the S&P/TSX Composite, are in a prolonged slump. That’s more than two-thirds of the index that is shaping up as a drag on returns. Even if industrials surge on the strength of increased exports due to a weak loonie, those stocks only represent 8.6% of the total weighting. The TSX set an all-time record of 15,685.13 back in September. I don’t think we’ll see that again this year. A negative year is not out of the question.

Tough times overseas. Last year was one of relative calm in Europe. This year is starting off differently, with a looming election in Greece that could set in motion a series of events that would culminate in that country quitting the Eurozone. That, in turn, would lead to more uncertainty about the European economy and have a negative impact on markets. Sanctions against Russia, which hurt European exporters almost as much as they do the Russians, won’t help.

Emerging market nations that are oil consumers will be given a boost by the price drop but producing countries will be hurt, none more so than Russia. There’s nothing to indicate a quick turnaround in China’s slowing growth pace. Brazil looks weak, although there are signs Mexico’s prospects are improving. All in all, it looks like the rebound in emerging markets stocks has been put on hold for a while.

Interest rates will stay low. It’s widely expected that interest rates will start to rise this year. Until recently, I thought so too. Now I’m not so sure. The collapse of oil prices is going to slow the rate of inflation growth, perhaps considerably, and may push Europe into deflation. On top of that, we’re seeing another flight to safety as overseas investors pour money into U.S. Treasuries, knocking yields down and pushing prices higher. According to Yahoo! Finance, yields on U.S. Treasuries dropped from an average of 2.3% in December to 1.97% last week. Any increase in rates by the Federal Reserve Board would serve to attract more hot money into the U.S., driving up the value of the greenback and putting a crimp in American exports. So don’t be surprised if the Fed delays making any move until later in the year and perhaps not until 2016. As for the Bank of Canada, it’s not likely to move before the Federal Reserve, particularly with the country’s economic prospects now looking weaker.

Bonds will be positive. Uncertainty tends to be good news for bonds, especially government issues, which are seen as safe havens. Don’t expect another 2014, which saw the FTSE TMX Universe Bond Index rise 8.8%. But a combination of continued low interest rates and weak economic growth in Canada should translate into positive returns for investors in the 3% to 4% range.

The loonie will fall, rebound. We may be number one in junior hockey but when it comes to our currency things are looking grim. The loonie slipped below US$0.85 last week and we could see US$0.80 if oil doesn’t right itself soon. Since I believe oil will recover to the US$60 range by spring, it follows that the loonie should rebound somewhat at that time, since traders see it as a petro-currency. Look for it to be back around US$0.85 by year-end.

Gold will falter. Only dedicated gold bugs, which have been predicting the collapse of the world financial system for years, can find a good reason for investing in bullion. Unless you are a true believer, stay away. The fall in the oil price has had a ripple effect on all commodities and exacerbated deflationary concerns in Europe and Japan. Gold can’t thrive in that kind of environment.

As readers know, I am normally not pessimistic. But this year is shaping up to be something of a dog’s breakfast. I believe the overall outlook for the economy remains modestly positive but there is a lot of ambiguity in the short-term situation. That may mean some changes in your investment strategies for the coming year. See the following article for my suggestions.

 

Gordon Pape’s book, RRSPs: The Ultimate Wealth Builder, is available in both paperback and Kindle editions. Go to: http://astore.amazon.ca/buildicaquizm-20

INVESTMENT STRATEGIES FOR 2015

TOP

Based on my outlook for the year ahead, these are the investment strategies I recommend.

Overweight U.S. stocks. Although I don’t expect big gains from the U.S. market this year, the prospects on Wall Street look better than in most other parts of the world, including Canada. Plus U.S. stocks will give you a currency bonus if the loonie continues to drop.

Underweight Canadian stocks. Most of us have far too much money invested in Canada. That hasn’t been a good idea for the past few years and it won’t be again in 2015. The only way the TSX is going to outperform the S&P 500 is if the price of oil suddenly turns around and soars back over US$100. That’s not going to happen, at least not this year.

Underweight global stocks. Apart from India and Mexico, I don’t see a lot to like on world markets.

Maintain a healthy fixed-income weighting. Even if the prospects for bonds were negative, I would counsel keeping a portion of your portfolio in fixed-income securities, with ETFs or mutual funds the best choice for most people. They provide stability in difficult times and in most recent years they have also generated respectable returns. GICs are still not a good substitute because of their low interest rates and lack of any upside potential.

Minimize gold holdings. If you want to hold some bullion as an insurance policy against hyperinflation, go ahead. But don’t expect it to produce much in the way of profits.

Raise cash. In times of market turbulence, it’s always a good idea to have some cash reserves. Cash provides a cushion when stocks fall and gives you the flexibility to take advantage of opportunities. This is a good time to review your portfolio and see if you have some securities that should be sold. These may be stocks where you want to lock in profits or loss positions with little hope of recovery any time soon.

Be cautious. We could be in for some treacherous markets for a while. I do not expect a major crash of the 2008 type but look for a lot of volatility. If you are uncomfortable with that, reduce your equity weightings and build the cash and fixed income sectors of your portfolio. – G.P.

 

SHAWN ALLEN NAMED CONTRIBUTING EDITOR

TOP

This month we welcome Shawn Allen as a contributing editor to the IWB. Shawn, who has been an occasional guest contributor since July 2013, has a long record of successful stock picking. He is based in Edmonton.

Shawn has been providing stock picks on his website at www.investorsfriend.com since the beginning of 2000. The average stock that he has rated Buy or higher in the past 15 years has risen 13.8% per annum. The cumulative gain over the 15 years has been 598%, excluding dividends. His stock picks have beaten the market index in 13 out of the 15 years with positive returns in 13 years and negative returns twice. As for his personal portfolio, his return in these same 15 years has averaged 14.6% per annum.

Of course, as they say in the financial industry, past results are no guarantee of future performance but I suggest Shawn’s track record speaks for itself.

Shawn has an extensive amount of formal education in finance, business, and accounting. He holds an MBA degree and is a Certified Management Account. He also has a Chartered Financial Analyst (CFA) designation and, to top things off, he has an engineering degree.

Clearly, he is very well qualified to step into the role of IWB contributing editor. I am sure readers will find his columns both interesting and profitable for many years to come. – G.P.

 

MY APPROACH TO STOCK PICKING

TOP

By Shawn Allen, Contributing Editor

People often ask me how I go about selecting stocks for InvestorsFriend, and now for the IWB. It’s a reasonable question – readers have every right to know the thought process that goes in to selecting one security over another.

Given my academic background it was natural for me to gravitate to an approach using fundamentals as opposed to technical analysis (chart reading). And that has very much been the case. My approach has been to select a limited number of companies and then run them through a standardized analysis that always includes the following:

• A summary description of the business, which, if applicable, indicates the percentage of revenues and earnings from each of its major segments and geographic territories.

• Calculating and graphing earnings per share growth over the past ten years. This includes both GAAP earnings and my view of earnings as adjusted to remove unusual and one-time items.

• Calculating and graphing revenue per share growth over the past ten years

• Calculating various financial ratios including the price to book ratio, the price to earnings ratio, the return on equity, and the five-year growth in earnings and revenues per share. I also note how steady the earnings growth has been. I then reach a conclusion on what rating these value ratios (in isolation from other factors to be considered below) would indicate.

• Reviewing and summarizing the recent insider trading.

• Reviewing management compensation.

• Reviewing the strength of the balance sheet including the level of debt as compared to equity.

• Noting the apparent quality of management based on the track record.

• Summarizing the company’s competitive advantages (if any) as I see them.

• A summary of how the company fares on certain criteria favored by Warren Buffett.

• A summary of how the company appears to fare under the four forces of competition as defined by Michael Porter of Harvard University.

• Calculating the intrinsic value per share based on a range of relatively conservative assumptions regarding the future growth in earnings per share and the dividend and based on a range of assumptions regarding the p/e ratio that is likely to apply at the end of five years.

• A consideration of the near- and long-term growth outlook for the company as I see it.

• A consideration of the major risks facing the company.

• A comment on the composition and apparent quality of the board of directors.

• Finally, all of the above is used as input for an overall rating of the stock on a scale that ranges from Strong Sell to Strong Buy. None of the individual criterion is necessarily determinative and the final rating is always a judgment call.

I developed and added to this system over a period of years. My methods owe a debt a gratitude to Warren Buffett and a number of other fundamental investors that I have learned from. The track record has been good.

All of my past and future stock picks for IWB have been and will continue to be based on this approach.

It is my belief that there are never any guarantees in the stock market, especially when it comes to any individual company. Investing entails risks and investors must be willing to accept responsibility for their own decisions. No stock picker has a crystal ball. Nevertheless, I have certainly found investing to be rewarding in the past and I expect it to be rewarding in the future, though not without the possibility of negative returns in some years.

 

SHAWN ALLEN’S UPDATES

TOP

Toll Brothers (NYSE: TOL)

Originally recommended on Nov. 11/13 (#21340) at $31.94. Closed Friday at US$35.37. (All prices in U.S. dollars.)

Toll Brothers, a U.S. luxury homebuilder, reported its fiscal 2014 earnings on Dec. 12. Earnings continue to rebound in line with the recovery of the U.S. economy and American home prices.

TOL’s adjusted earnings doubled in fiscal 2014 and revenues per share were up 40%. Based on a recent price of $35.18, the p/e ratio is 18.7, the price to book ratio is 1.69, and return on equity (ROE) is 9.75%. The stock does not pay a dividend.

The profit outlook is for modest growth in the next year as contracts signed in 2014 for houses to be completed mostly in 2015 were flat in units compared to those signed in the previous year. However, they were up somewhat in price. There is a lag of over one year before signed contracts become home sales.

Management appears to believe that the flat performance for signed contracts in 2014 was just a pause in a long-term growth trend and notes that growth in signed contracts did resume in the final quarter of the year and into early fiscal 2015. Management expects an increase in signed deals in 2015, which would lead to an increase in profits in 2016 as those homes are completed and delivered.

Action Now: Buy for medium term growth.

Costco Wholesale (NDQ: COST)

Originally recommended on July 15/13 (#21326) at $116.46. Closed Friday at US$143.32. (All prices in U.S. dollars.)

Costco continues to show growth. In fiscal 2014, which ended in August, adjusted earnings per share were up 3.6% and revenues per share were ahead 6.6%.

First quarter fiscal 2015 earnings (to Nov. 24), which were released on Dec. 10, were even better with profits up 17%. Net income came in at $496 million ($1.12 per share) as compared to $425 million ($0.96 per share) the year before. Sales were $23.6 billion, up 7% per share.

Based on a recent price of $145.56, the p/e ratio is 30.2, the price to book ratio is 5.2, and the ROE is 18.1%. The dividend yield is 1%.

Costco is a very well managed company and has the lowest cost structure of any major retailer. This gives it major advantages. It is a virtual certainty that Costco will continue to grow and prosper over the years.

Unfortunately, these advantages tend to be reflected in its stock price and this seems to be particularly the case at this time. Occasionally during stock market corrections or if the company reports a bad quarter it may be available at a more reasonable p/e ratio.

Action now: Hold or continue to monitor this stock and consider initiating a position if it falls back to the $130 level.

Melcor Developments Ltd. (TSX: MRD, OTC: MODVF)

Originally recommended on Sept. 30/13 (#21335) at $19.33. Closed Friday at C$18.34, US$16.37 (Dec. 18).

Melcor is an Edmonton headquartered company that is mostly in the business of developing land for sale as residential building lots in western Canada. It also develops and then rents out retail and office building space in Alberta. It has been a publicly traded company since 1968.

Melcor’s adjusted earnings per share in the past four quarters, starting with the most recent, were up 161%, up 42%, down 56%, and up 39%. Melcor’s earnings are both seasonal and cyclical and have been quite volatile over the years. However, its annual earnings have never been negative in the 15 years that I have followed the company.

Like the earnings, Melcor’s share price has a history of volatility and of apparently over-reacting to the ups and downs in earnings. In part, this may be due to the fact that it is quite thinly traded.

After advancing quite rapidly in the past few years, the share price has declined about 30% from its highs. This is likely due to fears that lower oil prices could sharply curtail new home building in Alberta and/or lower the market price of building lots and land holdings.

Based on a recent price of $18.25, the P/E ratio is just 6.7. The price to book ratio is very low at 0.70 and the ROE is 11.3%. The dividend yield is 3.3%.

While Melcor’s stock price could continue to decline, especially if a home building recession does develop in Alberta, I believe that it represents good value at this price and that its share price will almost certainly be higher in the long term. It may not be for the faint of heart but buying Melcor on pullbacks has proved to be rewarding in the past.

Action now: Buy for long-term capital appreciation.

American Express (NYSE: AXP)

Originally recommended on Feb. 17/14 (#21407) at $89. Closed Friday at $90.42. (All prices in U.S. dollars.)

In its recently reported third-quarter results, American Express reported an earnings per share growth of 12% and revenue per share growth of 4%.

Based on a recent price of $91.58, the stock’s p/e ratio is 17.8, the price to book ratio is 4.7, and the ROE is 27%. The shares pay an annual dividend of $1.04 to yield 1.1%.

American Express continues to benefit from the movement towards electronic payments and the public’s appetite for reward cards.

Action now: Hold for long-term capital appreciation.

Stantec Inc. (TSX, NYSE: STN)

Originally recommended by Tom Slee on Aug. 28/06 (#2632) at C$10.24 US$9.23 (split-adjusted). Closed Friday at C$30.76, US$25.95.

Stantec Inc. is a professional services consulting firm in engineering, architecture, and related disciplines. It operates largely on a fee for service basis and is not a contractor in building projects. It has about 14,000 employees operating out of about 230 offices in North America and four international offices. Head office, in Edmonton, integrates the far-flung offices through centralized computer and finance systems. The company generates 42% of revenues from the U.S., 54% from Canada, and 4% from international clients. For many years, Stantec has very successfully pursued a business model of growth by acquisition (plus organic growth).

Stantec’s earnings per share growth in the past four quarters, starting with the most recent (third quarter, 2014) was 5%, 18%, 12%, and 10%.

Based on a recent price of C$30.94, the p/e ratio is 17.1, the price to book ratio is 2.8, and the ROE is 18%. The dividend yield is 1.2%.

The long-term outlook seems good as the company continues to target increasing revenues by 15% annually by continuing its growth-by-acquisition (and organic) approach. However, the company will suffer somewhat due to the oil and gas industry slowdown, although this could be offset by increased growth in other areas. The recent earnings trend is very strong although with slower growth in the latest quarter. Profitability as a percentage of sales has increased in recent years and there is some danger that that this could trend back to more normal levels.

Stantec’s stock price has recently declined from a high of $38.14. This is likely due to fears regarding the impact on its business of lower oil prices. I think this fear may be over-blown given that about 42% of revenues come from the U.S. and that it has offices across Canada, not just in Alberta. Also its practice areas include many segments not related to energy.

The stock split two for one in November.

Action now: Buy for medium and long-term capital appreciation.

– end Shawn Allen

 

GORDON PAPE’S UPDATES

TOP

Enbridge Inc. (TSX, NYSE: ENB)

Originally recommended by Tom Slee on Aug. 23/99 at C$8 (split-adjusted). Closed Friday at C$55.49, US$46.75.

Any company associated with the energy sector saw its share price hit as oil prices plunged. Enbridge was no exception. In early December, the stock traded as high as $65.13 in Toronto and US$57.19 in New York. It is now down about 15% from those levels (TSX price). That qualifies it as a bargain in my view.

This pipeline and natural gas distribution giant has been a mainstay of our Recommended List since 1999, having originally been recommended by former contributing editor Tom Slee. It is a stable company with a long reputation for dividend increases and share price appreciation.

The company recently announced a whopping 33% dividend increase. At the new rate the shares yield a generous 3.3% plus there’s a good chance the stock will regain its 2014 highs before the year is out.

Action now: Buy. The current price weakness should be seen as temporary – this stock will come back.

Vermilion Energy (TSX, NYSE: VET)

Originally recommended on June 16/14 at C$75.79, US$69.68. Closed Friday at C$51.31, US$43.24.

The secret to wealth is to buy great companies when everyone else is selling. There are lots of opportunities to do that in the energy sector right now. The uncertainty over how low the price of oil will go and how long this environment will last has produced a massive sell-off with some names down more than 50% from their 2014 highs.

This Canadian-based company hasn’t dropped that much but as of the close of trading on Friday it had retreated 34% from its June 20 high of $78.24 on the TSX. I think it is oversold at this level and therefore offers an excellent opportunity for investors who are prepared to deal with the volatility that will pervade the energy sector in the coming months.

Although it is headquartered in Calgary, the company has extensive overseas operations in Europe and Australia. The business model aims at annual organic production growth of 5% or more along with providing reliable and increasing dividends to investors. Vermilion is targeting growth in production primarily through the exploitation of light oil and liquids-rich natural gas conventional resource plays in Western Canada, the exploration and development of high impact natural gas opportunities in the Netherlands and Germany, and through drilling and workover programs in France and Australia. Vermilion also holds an 18.5% working interest in the Corrib gas field in Ireland. The stock pays a monthly dividend of C$0.215 per share, which provides a current yield of 5%. 

The company recently announced 2015 guidance, which forecast a 22% reduction in capital expenditure from 2014, due to the low oil price. However, management said it expects to increase production by 15% and indicated the company would make further cuts in its capital budget rather than reduce the dividend or compromise the strong balance sheet.

There’s short-term downside here if the price of oil drops further but the mid to long-term prospects are excellent and the current price looks cheap.

But you will have to be patient. The recovery will take time. However, you’ll have the benefit of a healthy dividend while you’re waiting for the turnaround.

Action now: The stock is a Buy for aggressive investors. – G.P.

 

HOUSEKEEPING

TOP

The following have been deleted from our on-line Recommended List. Sell advisories were published in the IWB previously. This notice is for record-keeping purposes only.

Youku.com (YOKU). Originally recommended by Glenn Rogers on Feb 20/11 at US$34.50. Sold Jan 22/12 at US$20.97.

Fortress Paper (FTP). Originally recommended by Irwin Michael on Oct 1/07 at C$7.82. Sold May 21/12 at C$20.14.

The Santander Group (SAN). Originally recommended by Glenn Rogers on May 17/10 at US$10.44. Sold Jun 18/12 at US$6.19.

 

That’s it for this week. We’ll see you again on Jan. 19.

Best regards,

Gordon Pape

In This Issue

THE YEAR AHEAD

By Gordon Pape, Editor and Publisher

Buckle up! It’s going to be a rocky year. Last week’s market gyrations, which ended with the TSX losing 379 points, was just a preview of what’s in store for 2015 so be prepared. This is shaping up as a year of uncertainty, a condition that sends investors running for cover.

The reality is that no one knows what is going to happen over the next few months. The plunge in the price of oil has thrown all projections out the window. Back on November when OPEC (really Saudi Arabia) decided not to cut production, $60 oil (U.S. currency) appeared to be the downside. Now $40 oil looks increasingly possible. While consumers may cheer, economists are deeply divided over what that will mean for the global economy.

Just a few weeks ago, the prospects for 2015 looked pretty good. The U.S. economy was in a strong recovery mode, and accelerating. The S&P 500, the Dow, and the TSX had all set record highs. And history is on our side. Over the past 15 years, the performance of the Dow on the first day of January trading was a predictor of how the year would turn out 80% of the time. On Jan. 2, the Dow registered a small gain of about 10 points. Not a lot, but at least it was up.

Then, there’s the fact this is the third year of a presidential term, which has historically been very good for stock markets. Barron’s recently published an analysis of third-year results that showed that since 1896 the stock market has risen 82% of the time with an average gain of 15% per year. Since 1940, the Dow has risen in every single third year of a term – never missed once! The average annual gain was 22.3%.

Those are pretty convincing numbers. But maybe this time it’s different.

It’s not just oil that has investors worried and analysts scratching their heads. Add interest rate uncertainty to the mix and then stir in a dose of European angst and we have a toxic brew that does not bode well for stocks, at least in the short term, and which may prolong the seemingly ageless bond bull market.

Against this backdrop, making predictions for the coming year is even more problematic than ever. Normally, the trend lines are reasonably clear and we can use them to extrapolate what is likely to unfold in the months ahead. But right now, all we have is a swirl of unknowns and possibilities. That said, here are my best guesses as to what may transpire as 2015 takes shape.

Oil will drop further, then recover. The markets always overshoot, whether to the upside or the downside. The current drama unfolding in the energy sector looks like yet another example of this. The way the oil price has been plunging, you might get the impression that suddenly no one wants the stuff any more. Buggy whips, anyone? Of course, that’s not the case. The world still runs on oil and will continue to do so for at least our lifetimes and probably much longer. What we have right now is a combination of supply/demand imbalance complicated by speculative mania. That will sort itself out in the coming weeks. In the meantime, the price could well sink to the $40 range but I don’t expect it to stay there for long. A rebound to the $60+ level is likely by spring followed by a lengthy period of consolidation which will give stock markets time to pause and stabilize.

New York will record modest gains. Forget about the average 22.3% gain in the Dow since 1940 in the third year of a presidential term. That’s not in the cards for 2015. In fact, if it happened, I’d be worried. As of the end of 2014, the Dow was showing a five-year advance of over 70% while the S&P 500 was up 85%. Most analysts agree that the U.S. markets are no longer cheap, with few bargains to be found. To expect gains of 20%+, or even in double digits, is simply unrealistic. I think the major U.S. indexes will finish the year in the black, but the gains will only be in the range of 5% to 8%. On that basis, my forecasts for year-end 2015 are:

S&P 500: 2,160 to 2,225.
Dow Jones Industrial Average: 18,715 to 19,250
Nasdaq Composite: 4,970 to 5,115

Toronto will struggle. It’s hard to be positive about the outlook for the TSX this year. Financials, the single largest sector with 35.7% of total assets, gained 8.6% in 2014 but recent statements from senior bank officials suggest that profit margins are tightening and we could see some retrenchment in 2015. The energy sector, which comprises 21.4% of the index, is in turmoil. Materials, which make up 11% of the S&P/TSX Composite, are in a prolonged slump. That’s more than two-thirds of the index that is shaping up as a drag on returns. Even if industrials surge on the strength of increased exports due to a weak loonie, those stocks only represent 8.6% of the total weighting. The TSX set an all-time record of 15,685.13 back in September. I don’t think we’ll see that again this year. A negative year is not out of the question.

Tough times overseas. Last year was one of relative calm in Europe. This year is starting off differently, with a looming election in Greece that could set in motion a series of events that would culminate in that country quitting the Eurozone. That, in turn, would lead to more uncertainty about the European economy and have a negative impact on markets. Sanctions against Russia, which hurt European exporters almost as much as they do the Russians, won’t help.

Emerging market nations that are oil consumers will be given a boost by the price drop but producing countries will be hurt, none more so than Russia. There’s nothing to indicate a quick turnaround in China’s slowing growth pace. Brazil looks weak, although there are signs Mexico’s prospects are improving. All in all, it looks like the rebound in emerging markets stocks has been put on hold for a while.

Interest rates will stay low. It’s widely expected that interest rates will start to rise this year. Until recently, I thought so too. Now I’m not so sure. The collapse of oil prices is going to slow the rate of inflation growth, perhaps considerably, and may push Europe into deflation. On top of that, we’re seeing another flight to safety as overseas investors pour money into U.S. Treasuries, knocking yields down and pushing prices higher. According to Yahoo! Finance, yields on U.S. Treasuries dropped from an average of 2.3% in December to 1.97% last week. Any increase in rates by the Federal Reserve Board would serve to attract more hot money into the U.S., driving up the value of the greenback and putting a crimp in American exports. So don’t be surprised if the Fed delays making any move until later in the year and perhaps not until 2016. As for the Bank of Canada, it’s not likely to move before the Federal Reserve, particularly with the country’s economic prospects now looking weaker.

Bonds will be positive. Uncertainty tends to be good news for bonds, especially government issues, which are seen as safe havens. Don’t expect another 2014, which saw the FTSE TMX Universe Bond Index rise 8.8%. But a combination of continued low interest rates and weak economic growth in Canada should translate into positive returns for investors in the 3% to 4% range.

The loonie will fall, rebound. We may be number one in junior hockey but when it comes to our currency things are looking grim. The loonie slipped below US$0.85 last week and we could see US$0.80 if oil doesn’t right itself soon. Since I believe oil will recover to the US$60 range by spring, it follows that the loonie should rebound somewhat at that time, since traders see it as a petro-currency. Look for it to be back around US$0.85 by year-end.

Gold will falter. Only dedicated gold bugs, which have been predicting the collapse of the world financial system for years, can find a good reason for investing in bullion. Unless you are a true believer, stay away. The fall in the oil price has had a ripple effect on all commodities and exacerbated deflationary concerns in Europe and Japan. Gold can’t thrive in that kind of environment.

As readers know, I am normally not pessimistic. But this year is shaping up to be something of a dog’s breakfast. I believe the overall outlook for the economy remains modestly positive but there is a lot of ambiguity in the short-term situation. That may mean some changes in your investment strategies for the coming year. See the following article for my suggestions.

 

Gordon Pape’s book, RRSPs: The Ultimate Wealth Builder, is available in both paperback and Kindle editions. Go to: http://astore.amazon.ca/buildicaquizm-20

INVESTMENT STRATEGIES FOR 2015

Based on my outlook for the year ahead, these are the investment strategies I recommend.

Overweight U.S. stocks. Although I don’t expect big gains from the U.S. market this year, the prospects on Wall Street look better than in most other parts of the world, including Canada. Plus U.S. stocks will give you a currency bonus if the loonie continues to drop.

Underweight Canadian stocks. Most of us have far too much money invested in Canada. That hasn’t been a good idea for the past few years and it won’t be again in 2015. The only way the TSX is going to outperform the S&P 500 is if the price of oil suddenly turns around and soars back over US$100. That’s not going to happen, at least not this year.

Underweight global stocks. Apart from India and Mexico, I don’t see a lot to like on world markets.

Maintain a healthy fixed-income weighting. Even if the prospects for bonds were negative, I would counsel keeping a portion of your portfolio in fixed-income securities, with ETFs or mutual funds the best choice for most people. They provide stability in difficult times and in most recent years they have also generated respectable returns. GICs are still not a good substitute because of their low interest rates and lack of any upside potential.

Minimize gold holdings. If you want to hold some bullion as an insurance policy against hyperinflation, go ahead. But don’t expect it to produce much in the way of profits.

Raise cash. In times of market turbulence, it’s always a good idea to have some cash reserves. Cash provides a cushion when stocks fall and gives you the flexibility to take advantage of opportunities. This is a good time to review your portfolio and see if you have some securities that should be sold. These may be stocks where you want to lock in profits or loss positions with little hope of recovery any time soon.

Be cautious. We could be in for some treacherous markets for a while. I do not expect a major crash of the 2008 type but look for a lot of volatility. If you are uncomfortable with that, reduce your equity weightings and build the cash and fixed income sectors of your portfolio. – G.P.

 

SHAWN ALLEN NAMED CONTRIBUTING EDITOR

This month we welcome Shawn Allen as a contributing editor to the IWB. Shawn, who has been an occasional guest contributor since July 2013, has a long record of successful stock picking. He is based in Edmonton.

Shawn has been providing stock picks on his website at www.investorsfriend.com since the beginning of 2000. The average stock that he has rated Buy or higher in the past 15 years has risen 13.8% per annum. The cumulative gain over the 15 years has been 598%, excluding dividends. His stock picks have beaten the market index in 13 out of the 15 years with positive returns in 13 years and negative returns twice. As for his personal portfolio, his return in these same 15 years has averaged 14.6% per annum.

Of course, as they say in the financial industry, past results are no guarantee of future performance but I suggest Shawn’s track record speaks for itself.

Shawn has an extensive amount of formal education in finance, business, and accounting. He holds an MBA degree and is a Certified Management Account. He also has a Chartered Financial Analyst (CFA) designation and, to top things off, he has an engineering degree.

Clearly, he is very well qualified to step into the role of IWB contributing editor. I am sure readers will find his columns both interesting and profitable for many years to come. – G.P.

 

MY APPROACH TO STOCK PICKING

By Shawn Allen, Contributing Editor

People often ask me how I go about selecting stocks for InvestorsFriend, and now for the IWB. It’s a reasonable question – readers have every right to know the thought process that goes in to selecting one security over another.

Given my academic background it was natural for me to gravitate to an approach using fundamentals as opposed to technical analysis (chart reading). And that has very much been the case. My approach has been to select a limited number of companies and then run them through a standardized analysis that always includes the following:

• A summary description of the business, which, if applicable, indicates the percentage of revenues and earnings from each of its major segments and geographic territories.

• Calculating and graphing earnings per share growth over the past ten years. This includes both GAAP earnings and my view of earnings as adjusted to remove unusual and one-time items.

• Calculating and graphing revenue per share growth over the past ten years

• Calculating various financial ratios including the price to book ratio, the price to earnings ratio, the return on equity, and the five-year growth in earnings and revenues per share. I also note how steady the earnings growth has been. I then reach a conclusion on what rating these value ratios (in isolation from other factors to be considered below) would indicate.

• Reviewing and summarizing the recent insider trading.

• Reviewing management compensation.

• Reviewing the strength of the balance sheet including the level of debt as compared to equity.

• Noting the apparent quality of management based on the track record.

• Summarizing the company’s competitive advantages (if any) as I see them.

• A summary of how the company fares on certain criteria favored by Warren Buffett.

• A summary of how the company appears to fare under the four forces of competition as defined by Michael Porter of Harvard University.

• Calculating the intrinsic value per share based on a range of relatively conservative assumptions regarding the future growth in earnings per share and the dividend and based on a range of assumptions regarding the p/e ratio that is likely to apply at the end of five years.

• A consideration of the near- and long-term growth outlook for the company as I see it.

• A consideration of the major risks facing the company.

• A comment on the composition and apparent quality of the board of directors.

• Finally, all of the above is used as input for an overall rating of the stock on a scale that ranges from Strong Sell to Strong Buy. None of the individual criterion is necessarily determinative and the final rating is always a judgment call.

I developed and added to this system over a period of years. My methods owe a debt a gratitude to Warren Buffett and a number of other fundamental investors that I have learned from. The track record has been good.

All of my past and future stock picks for IWB have been and will continue to be based on this approach.

It is my belief that there are never any guarantees in the stock market, especially when it comes to any individual company. Investing entails risks and investors must be willing to accept responsibility for their own decisions. No stock picker has a crystal ball. Nevertheless, I have certainly found investing to be rewarding in the past and I expect it to be rewarding in the future, though not without the possibility of negative returns in some years.

 

SHAWN ALLEN’S UPDATES

Toll Brothers (NYSE: TOL)

Originally recommended on Nov. 11/13 (#21340) at $31.94. Closed Friday at US$35.37. (All prices in U.S. dollars.)

Toll Brothers, a U.S. luxury homebuilder, reported its fiscal 2014 earnings on Dec. 12. Earnings continue to rebound in line with the recovery of the U.S. economy and American home prices.

TOL’s adjusted earnings doubled in fiscal 2014 and revenues per share were up 40%. Based on a recent price of $35.18, the p/e ratio is 18.7, the price to book ratio is 1.69, and return on equity (ROE) is 9.75%. The stock does not pay a dividend.

The profit outlook is for modest growth in the next year as contracts signed in 2014 for houses to be completed mostly in 2015 were flat in units compared to those signed in the previous year. However, they were up somewhat in price. There is a lag of over one year before signed contracts become home sales.

Management appears to believe that the flat performance for signed contracts in 2014 was just a pause in a long-term growth trend and notes that growth in signed contracts did resume in the final quarter of the year and into early fiscal 2015. Management expects an increase in signed deals in 2015, which would lead to an increase in profits in 2016 as those homes are completed and delivered.

Action Now: Buy for medium term growth.

Costco Wholesale (NDQ: COST)

Originally recommended on July 15/13 (#21326) at $116.46. Closed Friday at US$143.32. (All prices in U.S. dollars.)

Costco continues to show growth. In fiscal 2014, which ended in August, adjusted earnings per share were up 3.6% and revenues per share were ahead 6.6%.

First quarter fiscal 2015 earnings (to Nov. 24), which were released on Dec. 10, were even better with profits up 17%. Net income came in at $496 million ($1.12 per share) as compared to $425 million ($0.96 per share) the year before. Sales were $23.6 billion, up 7% per share.

Based on a recent price of $145.56, the p/e ratio is 30.2, the price to book ratio is 5.2, and the ROE is 18.1%. The dividend yield is 1%.

Costco is a very well managed company and has the lowest cost structure of any major retailer. This gives it major advantages. It is a virtual certainty that Costco will continue to grow and prosper over the years.

Unfortunately, these advantages tend to be reflected in its stock price and this seems to be particularly the case at this time. Occasionally during stock market corrections or if the company reports a bad quarter it may be available at a more reasonable p/e ratio.

Action now: Hold or continue to monitor this stock and consider initiating a position if it falls back to the $130 level.

Melcor Developments Ltd. (TSX: MRD, OTC: MODVF)

Originally recommended on Sept. 30/13 (#21335) at $19.33. Closed Friday at C$18.34, US$16.37 (Dec. 18).

Melcor is an Edmonton headquartered company that is mostly in the business of developing land for sale as residential building lots in western Canada. It also develops and then rents out retail and office building space in Alberta. It has been a publicly traded company since 1968.

Melcor’s adjusted earnings per share in the past four quarters, starting with the most recent, were up 161%, up 42%, down 56%, and up 39%. Melcor’s earnings are both seasonal and cyclical and have been quite volatile over the years. However, its annual earnings have never been negative in the 15 years that I have followed the company.

Like the earnings, Melcor’s share price has a history of volatility and of apparently over-reacting to the ups and downs in earnings. In part, this may be due to the fact that it is quite thinly traded.

After advancing quite rapidly in the past few years, the share price has declined about 30% from its highs. This is likely due to fears that lower oil prices could sharply curtail new home building in Alberta and/or lower the market price of building lots and land holdings.

Based on a recent price of $18.25, the P/E ratio is just 6.7. The price to book ratio is very low at 0.70 and the ROE is 11.3%. The dividend yield is 3.3%.

While Melcor’s stock price could continue to decline, especially if a home building recession does develop in Alberta, I believe that it represents good value at this price and that its share price will almost certainly be higher in the long term. It may not be for the faint of heart but buying Melcor on pullbacks has proved to be rewarding in the past.

Action now: Buy for long-term capital appreciation.

American Express (NYSE: AXP)

Originally recommended on Feb. 17/14 (#21407) at $89. Closed Friday at $90.42. (All prices in U.S. dollars.)

In its recently reported third-quarter results, American Express reported an earnings per share growth of 12% and revenue per share growth of 4%.

Based on a recent price of $91.58, the stock’s p/e ratio is 17.8, the price to book ratio is 4.7, and the ROE is 27%. The shares pay an annual dividend of $1.04 to yield 1.1%.

American Express continues to benefit from the movement towards electronic payments and the public’s appetite for reward cards.

Action now: Hold for long-term capital appreciation.

Stantec Inc. (TSX, NYSE: STN)

Originally recommended by Tom Slee on Aug. 28/06 (#2632) at C$10.24 US$9.23 (split-adjusted). Closed Friday at C$30.76, US$25.95.

Stantec Inc. is a professional services consulting firm in engineering, architecture, and related disciplines. It operates largely on a fee for service basis and is not a contractor in building projects. It has about 14,000 employees operating out of about 230 offices in North America and four international offices. Head office, in Edmonton, integrates the far-flung offices through centralized computer and finance systems. The company generates 42% of revenues from the U.S., 54% from Canada, and 4% from international clients. For many years, Stantec has very successfully pursued a business model of growth by acquisition (plus organic growth).

Stantec’s earnings per share growth in the past four quarters, starting with the most recent (third quarter, 2014) was 5%, 18%, 12%, and 10%.

Based on a recent price of C$30.94, the p/e ratio is 17.1, the price to book ratio is 2.8, and the ROE is 18%. The dividend yield is 1.2%.

The long-term outlook seems good as the company continues to target increasing revenues by 15% annually by continuing its growth-by-acquisition (and organic) approach. However, the company will suffer somewhat due to the oil and gas industry slowdown, although this could be offset by increased growth in other areas. The recent earnings trend is very strong although with slower growth in the latest quarter. Profitability as a percentage of sales has increased in recent years and there is some danger that that this could trend back to more normal levels.

Stantec’s stock price has recently declined from a high of $38.14. This is likely due to fears regarding the impact on its business of lower oil prices. I think this fear may be over-blown given that about 42% of revenues come from the U.S. and that it has offices across Canada, not just in Alberta. Also its practice areas include many segments not related to energy.

The stock split two for one in November.

Action now: Buy for medium and long-term capital appreciation.

– end Shawn Allen

 

GORDON PAPE’S UPDATES

Enbridge Inc. (TSX, NYSE: ENB)

Originally recommended by Tom Slee on Aug. 23/99 at C$8 (split-adjusted). Closed Friday at C$55.49, US$46.75.

Any company associated with the energy sector saw its share price hit as oil prices plunged. Enbridge was no exception. In early December, the stock traded as high as $65.13 in Toronto and US$57.19 in New York. It is now down about 15% from those levels (TSX price). That qualifies it as a bargain in my view.

This pipeline and natural gas distribution giant has been a mainstay of our Recommended List since 1999, having originally been recommended by former contributing editor Tom Slee. It is a stable company with a long reputation for dividend increases and share price appreciation.

The company recently announced a whopping 33% dividend increase. At the new rate the shares yield a generous 3.3% plus there’s a good chance the stock will regain its 2014 highs before the year is out.

Action now: Buy. The current price weakness should be seen as temporary – this stock will come back.

Vermilion Energy (TSX, NYSE: VET)

Originally recommended on June 16/14 at C$75.79, US$69.68. Closed Friday at C$51.31, US$43.24.

The secret to wealth is to buy great companies when everyone else is selling. There are lots of opportunities to do that in the energy sector right now. The uncertainty over how low the price of oil will go and how long this environment will last has produced a massive sell-off with some names down more than 50% from their 2014 highs.

This Canadian-based company hasn’t dropped that much but as of the close of trading on Friday it had retreated 34% from its June 20 high of $78.24 on the TSX. I think it is oversold at this level and therefore offers an excellent opportunity for investors who are prepared to deal with the volatility that will pervade the energy sector in the coming months.

Although it is headquartered in Calgary, the company has extensive overseas operations in Europe and Australia. The business model aims at annual organic production growth of 5% or more along with providing reliable and increasing dividends to investors. Vermilion is targeting growth in production primarily through the exploitation of light oil and liquids-rich natural gas conventional resource plays in Western Canada, the exploration and development of high impact natural gas opportunities in the Netherlands and Germany, and through drilling and workover programs in France and Australia. Vermilion also holds an 18.5% working interest in the Corrib gas field in Ireland. The stock pays a monthly dividend of C$0.215 per share, which provides a current yield of 5%. 

The company recently announced 2015 guidance, which forecast a 22% reduction in capital expenditure from 2014, due to the low oil price. However, management said it expects to increase production by 15% and indicated the company would make further cuts in its capital budget rather than reduce the dividend or compromise the strong balance sheet.

There’s short-term downside here if the price of oil drops further but the mid to long-term prospects are excellent and the current price looks cheap.

But you will have to be patient. The recovery will take time. However, you’ll have the benefit of a healthy dividend while you’re waiting for the turnaround.

Action now: The stock is a Buy for aggressive investors. – G.P.

 

HOUSEKEEPING

The following have been deleted from our on-line Recommended List. Sell advisories were published in the IWB previously. This notice is for record-keeping purposes only.

Youku.com (YOKU). Originally recommended by Glenn Rogers on Feb 20/11 at US$34.50. Sold Jan 22/12 at US$20.97.

Fortress Paper (FTP). Originally recommended by Irwin Michael on Oct 1/07 at C$7.82. Sold May 21/12 at C$20.14.

The Santander Group (SAN). Originally recommended by Glenn Rogers on May 17/10 at US$10.44. Sold Jun 18/12 at US$6.19.

 

That’s it for this week. We’ll see you again on Jan. 19.

Best regards,

Gordon Pape