In This Issue

CHINA JOINS THE CURRENCY WARS

By Gavin Graham, Contributing Editor

On Tuesday, Aug. 11, the Peoples’ Bank of China (PBoC) shocked world markets by announcing a 1.9% devaluation of the Chinese yuan, otherwise known as the renminbi, from US$1=CNY6.21 to US$1=CNY6.32. That was followed up the next day with another surprise cut, with the yuan weakening another 2% to US$1=CNY6.44. The net effect was a devaluation of about 4% over two days.

While the PBoC lowered the official fixing rate by 1.6% on Wednesday, the currency has been allowed to trade in a band 2% either side of the official fix since 2012, and traders are speculating that the authorities wish to see the yuan weaken further. Bloomberg reported that the yuan was trading 2.7% lower at US$1=CNY6.57 at close of trade in Hong Kong on Wednesday, where it trades freely. It had previously been as much as 3.2% lower before intervention by the Chinese erased some of the losses.

Despite all of the claims being made by Donald Trump and other U.S. politicians that this amounts to unfair currency manipulation, this is actually the largest devaluation by China in 20 years. Until last week’s move, the yuan had appreciated by 25% against the U.S. dollar over the past decade and by 9% in the last five years.

Effectively, China has been operating a U.S. dollar peg for 10 years. As the greenback appreciated against other currencies over the last 18 months, so has the yuan. In fact, the yuan’s real effective exchange rate has climbed 13% over the last four quarters. That’s because the end of Quantitative Easing (QE) by the U.S. Federal Reserve and the increased likelihood of the first increase in U.S. short-term rates in seven years has driven the U.S. dollar higher against other currencies, pulling the yuan along with it.

This has contributed to the growing weakness in China’s economy. GDP growth for the first two quarters of 2015 was 7%, the lowest since 2009. Both imports and exports for July fell by over 8% from a year earlier, against forecasts of a 1.5% decline. Industrial output rose 6.2%, retail sales were up 10.2%, and fixed investment increased 11.5% but these numbers were below estimates.

China has lowered interest rates four times since November 2014 and reduced reserve requirements for its banks in a bid to stimulate domestic demand and ease the credit crunch it introduced last year.

As well, the government encouraged Chinese domestic investors to switch from bank deposits to investing in the stock market, which rose into bubble territory in the first half of 2015. The Shanghai Composite Index, comprised of A shares that can only be bought by domestic investors and qualified foreign institutions, rose by 50% in the second half of 2014 from the 2,000 level, which it had traded at for the previous two years. It closed the year at about 3,000. Then it really took off, fuelled by a wave of individual investors buying stocks because “they always go up”, as one Shanghai housewife told Bloomberg, hitting 5,166 in mid-June. This represented a 150% increase in a year and led to ridiculous valuations that rivaled the lunacies of the dot-com bubble. When the authorities moved to rein in the speculation in June, prices collapsed. Many of the listed stocks were suspended and the index fell almost 30% to 3,666 in six weeks, a full-fledged bear market.

The intention of the Chinese authorities is clear. They are attempting to move the Chinese economy away from its reliance on manufacturing for exports and capital investment. That has resulted in a misallocation of resources into ghost (unoccupied) cities and bridges to nowhere, carried out by loss-making state owned enterprises that then have to be bailed out by the government. Instead, Premier Li Keqiang and his colleagues are aiming to grow domestic consumer demand to offset the slowing pace of exports, although last week’s devaluation will help temper that export slowdown.

Of course, as the Asian currency crisis of 1997-98 showed, it is important for countries that are contemplating devaluing to reduce their hard currency borrowings before they begin the process, otherwise the cost of servicing and repaying those debts becomes much more expensive. It’s therefore not surprising that China’s foreign exchange reserves declined by $315 billion to $3.65 trillion in the first half of the year, according to statistics from the Hong Kong Monetary Authority, as Chinese companies and governments reduced their foreign currency exposure. Chinese companies have at least $8.5 billion in U.S. dollar and euro denominated loans coming due in the next six months.

The Chinese authorities evidently hope that the package of measures that includes lower interest rates, reduced reserve requirements, allowing local governments to use municipal bonds as collateral, and the currency devaluation will help counteract weak growth.

That’s asking a lot in the face of the latest numbers. Weaker than expected industrial production and retail sales demonstrate widespread weakness, with Bloomberg’s monthly GDP estimate falling to 6.6% growth in July from 6.9% in June. Steel output was down 4.6%, shoes produced were down 8%, and auto output was off 26.3%, although this latter figure is unsurprising with car sales hitting a 17-month low in July. Electricity output, regarded as one of the more reliable indicators, was down 2% year-over-year.

China’s slowdown and devaluation is bad news for its Asian competitors and suppliers. If Canadian investors need any explanation of why commodity prices such as nickel, copper, and aluminum hit six-year lows last week, as did bulk commodities such as iron ore and metallurgical coal, then the fact that 36% of Australia’s exports in 2014 went to China is a simple explanation. In 2014, over 30% of Taiwan’s exports and 25% of South Korea’s also went to China, as did 20% of Japan’s and New Zealand’s. It’s no surprise that Asian currencies fell sharply last week, with those operating a managed float such as Vietnam specifically mentioning China’s devaluation as a reason for widening their trading bands.

In its defense, China can point to Japan’s adoption of Abenomics in 2012 as a reason for its move. Since late 2012, the Bank of Japan has let the yen slide from US$1=Y78 to US$1=Y124, a 35% depreciation. That was done in an attempt to stimulate exports and produce positive nominal inflation to defeat Japan’s long running deflation. As a result, Japanese exports have become notably more competitive against China’s. So have Korean, Taiwanese, and European exports as their central banks implemented QE programs. This has led to weaker Chinese growth, lower demand for commodities, and falling prices. So the Chinese can be relaxed about inflationary pressures caused by the devaluation, as commodities are so much cheaper in yuan terms than a year ago.

As for winners and losers from China’s move, commodity prices seem set to remain depressed for a while longer, as the devaluation makes them more expensive to China. Companies selling into China will see weaker demand. They include consumer goods companies such as my recommendations Unilever and Diageo, both off 5% last week, automakers and auto component stocks such as Honda and Linamar, and beneficiaries of Chinese tourism such as airlines, gaming, and cruise companies.

Interestingly, investments perceived as safe havens, such as developed countries’ government bonds, have seen prices rise. Bond guru Bill Gross, formerly of Pimco, now at Janus, sees U.S. Treasuries as the main beneficiary of the Chinese devaluation.

Gold and gold miners have risen 2% over the last week. The Chinese and Indians continue to regard gold as an attractive store of value, especially when their own currencies weaken. Although gold may be 4% more expensive in yuan terms than a week ago, it’s still 40% cheaper than it was four years ago.

Gavin Graham has had a long and successful career in money management and is a specialist in international securities. He held senior positions in financial organizations in London, Hong Kong, and Toronto. He currently is chief strategy officer at Integris Pension Management, a provider of personal pension plans for incorporated individuals. He divides his time between Toronto and the U.K.

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GAVIN GRAHAM’S UPDATES

Home Capital Group (TSX: HCG, OTC: HMCBF)

Originally recommended on Aug. 19/13 (#21330) at C$31.35, US$31.76. Closed Friday at C$29.02, US$23.52.

Background: Home Capital, through its mortgage lender Home Trust Co., makes loans that the banks normally refuse. These are usually to borrowers with credit histories that do not match the banks’ criteria. They include recent immigrants, the self-employed, and those who work in sectors such as entertainment and media, which do not have as much perceived job security as other professions.

Recent developments: Home Capital saw its share price plummet from $42.40 at the end of June to $28.40 at the end of July, before rebounding slightly to about $29 at time of writing. The sell-off came after the company revealed in early July that its mortgage originations for the second quarter (to June 30) would be well below those in the same quarter of 2014.

Specifically, traditional single-family mortgage originations were $1.29 billion against $1.53 billion in 2014 (down 15.4%) and just under $1 billion in the first quarter of 2015. Insured single family mortgage originations were $280 million against $619.6 million in the same quarter of 2014 (down 54.9%).

Home Capital revealed the reason for the dramatic decline in the insured mortgage category when it released its second-quarter earnings on July 29. In late 2014, an external source (i.e. a whistleblower) alerted the board of directors to possible discrepancies in income verification information submitted by certain mortgage brokers. As a result, the company statement said: “during the period September 2014 to March 2015, (it) had suspended its relationship with 18 independent mortgage brokers and two brokerages, for a total of approximately 45 individual mortgage brokers.”

Home Capital immediately retained independent professional advisers to investigate the allegations, overseen by its independent directors. They determined that there had been falsification of income information but not property valuations or credit scores. The company concluded that it is unlikely that there will be credit losses. It also conducted a wider test to ensure that income falsification is not an issue in its portfolio, as well as splitting its sales and underwriting functions and putting additional controls in place.

CEO Gerald Soloway said there was no evidence that any of the fraudulent applications were from people trying to defraud the company. None of them have defaulted, said Soloway, adding: “These are not people who set out to get something, who didn’t want to make the payments and comply…The value of the home…and the credit score was accurate and that’s why they’re performing so well.”

As far as the effect on its financials is concerned, Home Capital noted that mortgages originated by the suspended group of brokers accounted for $6 million (2%) of its $313 million of net income in 2014. The group originated $960.4 million worth of single-family mortgages in 2014, or 5.3% of its $20.5 billion of assets.

For the second quarter of 2015, Home Capital reported net income of $72.3 million ($1.03 per share), down 1.9% compared to $73.7 million ($1.05 per share) in the comparable quarter in 2014. For the first half of this year, net income was up 0.8% to $144.6 million ($2.05 per share) against $143.7 million ($2.04 per share) in 2014.

Non-performing loans as percentage of total loans was 0.33% at the end of the quarter against 0.32% in 2014, return on capital was 19.1%, and the dividend was maintained at $0.22 a quarter, compared to $0.16 in the same quarter in 2014. Based on the current price the yield is 3%.

The news was embarrassing for management and some investors felt more detail could have been given when the initial statement on lower originations was made in July. President Martin Reid acknowledged that point. However, long-term investors such as Mawer Investment Management’s Jeff Mo described the company’s actions “as exactly the type we would want the management to take when dealing with an issue like this.”

The fall in the share price means Home Capital is selling at only 1.33 times its book value of $21.87. That’s the lowest since the financial crisis, from which Home Capital emerged unscathed, a tribute to its conservative underwriting and strong capital base.

On Aug. 10, Home Capital announced it had bought CFF Bank of Oakville Ontario for approximately $15 million, adding $1.5 billion in loans and $235 million in assets. CEO Gerald Soloway said “the deal represents a major step towards realizing our long-term plan to achieve greater funding diversification”. Analysts feel the purchase furthers Home Capital’s goal of becoming a Schedule 1 lender, having applied for a license last year. Mr. Reid said the deal won’t “impede our efforts to manage the recently disclosed situation” (with fraudulent mortgage originations).

Conclusion: With a price/earnings ratio of 7.8 times 2015 forecast earnings and a yield of 3%, Home Capital is very cheap. However, it becomes a Hold until it is apparent that confidence in its ability to grow earnings is restored.

Action now: Hold. – G.G.

 

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MARKING TIME: RRSP PORTFOLIO UPDATE

By Gordon Pape, Editor and Publisher

I know that most people aren’t thinking about RRSPs in the middle of August but we try to update our model portfolios every six months. Since the last review of the IWB RRSP Portfolio was in early February, it’s that time again.

Our RRSP Portfolio has two main goals. The first is capital preservation – as with any pension plan, you don’t want to lose money. The second is to earn a higher rate of return than you could get from a GIC.

I’ve therefore constructed the portfolio to include bonds and defensive securities in order to reduce risk. But I also added some growth-oriented securities including mutual funds that offer exposure to the Canadian, U.S., and international equity markets. The securities were chosen from the Recommended Lists of our three newsletters: the IWB, The Income Investor, and Mutual Funds/ETFs Update. The portfolio contains a mix of ETFs, mutual funds, common stocks, and limited partnerships. This means that readers who wish to replicate it must have a self-directed RRSP with a brokerage firm.

The portfolio was launched in February 2012 with an initial value of $25,031.92.

These are the securities currently in the portfolio with some comments on how they have performed since the last review.

iShares DEX Short Term Corporate Universe + Maple Bond Index Fund (TSX: XSH). This exchange-traded fund invests primarily in bonds that mature in five years or less, so it is basically a short-term bond fund. The bonds may be issued by Canadian companies or by foreign corporations in Canadian currency (the Maple Bonds). Short-term bond funds are essentially defensive positions so returns are low. Over the latest six-month period this fund lost $0.21 per unit in market value but we received about $0.32 in distributions for a small net gain.

iShares Canadian Bond Index ETF (TSX: XBB). We added this ETF to the portfolio in February and so far we have incurred a small loss. The unit price is down from $32.70, where we bought it, to $32.11. We received distributions of about $0.45 per share but that wasn’t quite enough to offset the loss in market value. However, this type of portfolio requires a fixed income allocation so we will continue to hold this position and add to it at opportune times.

Fidelity Canadian Large Cap Fund B units (FID231). It was a rough six months for Canadian stocks and this fund didn’t escape, posting a small loss of $0.45 per share or just over 1%. There were no offsetting distributions as the fund only makes one payment annually, in December. Despite the setback, we are ahead more than 36% on this one.

Beutel Goodman American Equity Fund D units (BTG774). Fortunately, this well-run U.S. equity fund helped to compensate for the weakness in the Canadian market that we experienced. The net asset value (NAV) gained $0.89 per unit during the period for a return of 6.6%. There were no distributions.

Black Creek International Equity Fund A units (CIG11118). We added this international fund to the portfolio in September 2013. It got off to a strong start with a total return of 16.4% in the first six months, then slackened off for a while. It made a nice recovery in the latest six-month period, with an increase of $1.29 (6.3%) in the NAV. Here again, there were no distributions.

Brookfield Renewable Energy Partners LP (TSX: BEP.UN, NYSE: BEP). This Bermuda-based limited partnership owns a range of renewable power installations (mainly hydroelectric) in North America and Brazil. After a strong run last year, it has been pretty much marking time, with the share price down $0.55 since the last update. However, we received two quarterly distributions of US$0.415 (US$0.83 total) for a small net gain for the period.

Brookfield Infrastructure Partners LP (TSX: BIP.UN, NYSE: BIP). This limited partnership has also been marking time. It invests in infrastructure projects around the world so it faces some global economic headwinds. The share price is down $0.51 from our last review but we received two distributions totaling about US$1.06 to offset that. This is the top performer in the portfolio with a total return of just over 93%.

Capital Power Corporation (TSX: CPX). We added 60 shares of this company in February 2014 as a replacement for Firm Capital. The stock started strongly, gaining 24.5% in the first six months after being added. But it has regressed badly since, with the shares losing $5.78 in the latest six-month period. Not good.

Interest. We invested cash holdings and the accumulated distributions of $1,091.29 in a Tangerine high interest savings account paying 1.05%. That provided $5.73 in interest during the latest period.

Here is how the RRSP Portfolio stood as of the afternoon of Aug. 13 (mutual fund prices are as of the close of trading on Aug. 12). Commissions have not been factored in and Canadian and U.S. currencies are treated at par for ease of tracking.

IWB RRSP Portfolio (as of Aug. 13/15)

Security

Weight
%

Shares

AveragePrice

Book
Value

Current
Price

Market
Value

Cash
Retained

Gain/Loss
%
XSH

16.7

310

$19.65

$6,091.50

$19.94

$6,181.40

$198.87

+ 4.7
XBB

3.9

45

$32.70

$1,471.50

$32.11

$1,444.95

$20.38

– 0.4
FID231

20.9

185

$31.08

$5,750.47

$41.76

$7,725.60

$119.18

+36.4
BTG774

20.9

540

$8.42

$4,549.03

$14.31

$7,727.40

0

+69.9
CIG11118

9.5

160

$18.28

$2,924.30

$21.92

$3,507.20

$87.04

+22.9
BEP.UN

10.4

100

$27.86

$2,786.02

$38.25

$3,825.00

$160.50

+43.1
BIP.UN

13.4

90

$30.26

$2,723.40

$54.99

$4,949.10

$316.08

+93.3
CPX

3.3

60

$22.92

$1,375.20

$20.33

$1,219.80

$119.40

– 2.6
Cash

1.0

$407.92

$413.65

Totals

100.0

$28,079.34

$36,994.10

$1,021,45

+35.4
Inception

$25,031.92

+51.9

Comments: We eked out a gain of 1.1% during the latest six months, thanks mainly to good performances from the Beutel Goodman American Equity Fund and the Black Creek International Equity Fund. This shows the importance of geographic diversification; if all our equity assets had been in Canada the portfolio would have been in the red for the period.

Since inception, we have a total return of 51.9%. That works out to an average annual compound rate of return of 12.7%. That’s down from 14.5% in February but well ahead of our target of between 6% and 8%.

Changes: Capital Power has run into some serious problems, despite a 7.4% dividend increase. The company reported a loss attributable to shareholders of $34 million ($0.39 per share) in the second quarter, primarily due to an unplanned 28-day outage at one of its power plants. CEO Brian Vaasjo said the plant is now back on line but investors were also rattled by changes in carbon emission regulations by the new Alberta government and the possible impact on the company’s future profitability. Given the uncertainty surrounding the stock, we will sell our position for a total of $1,339.20, including accumulated dividends.

We will use some of that money to add to our position in XBB, buying 40 shares at a cost of $1,284.40. That will bring our total holding to 85 shares and leave $54.80 to add to our cash reserve. That cash plus accumulated dividends totals $1,370.50. The interest rate on our Tangerine account is now 0.8%. The rest of the portfolio will remain intact for now.

Here is a look at the revised portfolio. I’ll review it again in February.

IWB RRSP Portfolio (revised Aug. 13/15)

Security

Weight
%

Shares

Average
Price

Book
Value

Current
Price

Market
Value

Cash
Retained
XSH

16.7

310

$19.65

$6,091.50

$19.94

$6,181.40

$198.87
XBB

7.4

85

$32.42

$2,755.90

$32.11

$2,729.35

$20.38
FID231

20.8

185

$31.08

$5,750.47

$41.76

$7,725.60

$119.18
BTG774

20.8

540

$8.42

$4,549.03

$14.31

$7,727.40

0
CIG11118

9.4

160

$18.28

$2,924.30

$21.92

$3,507.20

$87.04
BEP.UN

10.3

100

$27.86

$2,786.02

$38.25

$3,825.00

$160.50
BIP.UN

13.3

90

$30.26

$2,723.40

$54.99

$4,949.10

$316.08
Cash

1.3

$468.45

$468.45

Totals

100.0

$28,079.34

$37,113.50

$902.05
Inception

$25,031.92

Follow Gordon Pape on Twitter @GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney

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GORDON PAPE’S UPDATES

Google Inc. (NDQ: GOOGL)

Originally recommended on March 9/14 (#21410) at $607.40. Closed Friday at $689.37. (All figures in U.S. dollars.)

Background: I updated this stock just last week but there have been new developments that require a revisit.

Recent developments: On Aug. 10, the company announced a major restructuring. A new holding company named Alphabet will be set up and current Google shareholders will receive one share of stock in the new company for each current share. The ticker symbols will remain the same: GOOGL and GOOG.

In making the announcement, CEO Larry Page said the new structure will make the company “cleaner and more accountable”. Each segment of the business, of which Google (the search engine operation) itself will be one, will operate autonomously with its own CEO. Investors and analysts will be able to see exactly how money is being spent on all parts of the business, including the so-called “moonshots”, and judge for themselves the effectiveness of the financial commitments being made.

The restructuring will be phased in over the next few months and it is not yet clear exactly which entities will receive stand-alone status. However, besides Google itself they are likely to include YouTube, Android, Chrome, Play, Google X, Calico (a biotechnology company), and Nest, which is in the home automation business.

Analysts immediately rushed to praise the move. Bloomberg quoted Morgan Stanley’s Brian Nowak as saying: “We see the increasedtransparency from the creation of Alphabet Inc. as a positive step to betterunderstanding both core Google profitability and the company’s loss generatinginvestment projects (Google X, Fiber, Calico, Google Ventures, etc.).”

Scott Devitt of Stifel Financial, a brokerage and investment banking firm, said the move transforms Google into “the Berkshire Hathaway of the Internet”. He raised his target price on the stock to $850.

Critics have warned that the restructuring effectively transforms Google into a conglomerate. That’s become a dirty word for many investors because it implies a lack of focus on core products and allows weak components to dilute earnings. However, Google was already a conglomerate in fact if not in name, with its many moving parts. At least now we should be able to see how well each operation is doing and better assess whether the money being spent on moonshots is being poured down a black hole or has a reasonable probability of paying off.

On a day when markets tumbled following the devaluation of the Chinese yuan, GOOGL shares jumped $27.16 (4.1%) to $690.30. They ended the week at $689.37.

Conclusion: This move makes Google even more attractive for long-term investors. It should be a core holding in your portfolio.

Action now: Buy.

Fortis Inc. (TSX: FTS, OTC: FRTSF)

Originally recommended on Aug. 15/05 (#2531) at C$20.80 (split-adjusted). Closed Friday at C$38.70, US$29.57.

Background: Fortis is an electricity and natural gas distribution utility. It is based in St. John’s and has operations across Canada as well as in the U.S. and Caribbean. Its regulated utilities serve more than three million customers. Fortis also owns long-term contracted hydroelectric generation assets in British Columbia and Belize.

Recent developments: The company had a strong second quarter, delivering earnings of $244 million ($0.88 per share), well up from $47 million ($0.22 a share) in the same period last year and in line with analysts’ estimates. The strong results were bolstered by one-time gains associated with the sale of Fortis Properties’ commercial real estate assets and non-regulated hydroelectric generation assets in New York. Stripping out these one-time items, net profit was $123 million ($0.44 per share), an increase of $58 million ($0.14 per share) from the second quarter of 2014.
Revenue for the quarter came in at just over $1.5 billion, up 46% from the second quarter of 2014. For the first half of the fiscal year, revenue was just under $3.5 billion, up 37.5% year-over-year.

During the quarter, Fortis completed its $900 million, 335-megawatt Waneta Expansion in British Columbia, six weeks ahead of schedule and on budget. It is the corporation’s largest capital project to date.

Construction continues on FortisBC’s Tilbury liquefied natural gas (LNG) expansion at an estimated total cost of approximately $440 million, which is the largest capital project ongoing. Tilbury will add 950,000 mmBtus of storage and 34,000 mmBtus daily of liquefaction when the second LNG tank and new liquefier come in service, which is expected to occur by the end of 2016.

Conclusion: Fortis is a core holding for low-risk investors. The stock does not have a lot of upside growth potential but the downside risk is relatively low and the quarterly dividend of $0.34 per share ($1.36 annually) provides an attractive yield of 3.5%.

Action now: Buy. – G.P.

Phillips, Hager & North Total Return Bond Fund (RBF1340)

Type:Fixed income mutual fund
Code:RBF1340 (Series D)
Current price: $11.97
Originally recommended:Jan. 20/09 at $10.59
Annual payout:$0.363 (trailing 12 months)
Yield:3%
Risk Rating:Lower risk
Recommended by:Gordon Pape
Website: www.phn.com

Comments: The PH&N fixed income team is one of the best in the country and this fund has outperformed its peer group over every time period from six months to 10 years. Over the 12 months to July 31, the fund gained 6.8%. The 10-year average annual compound rate of return to that time was 5%.

What makes this fund especially attractive is the low risk. The worst 12-month period since its inception in July 2000 was a loss of 1.01% in the year ending Sept. 30, 2013. That’s the kind of stabilizing entity every portfolio needs.

The latest one-year return looks good but don’t expect a similar performance over the next 12 months. U.S. interest rates are poised to rise, perhaps as early as September and the Bank of Canada will certainly want to increase its target rate as soon as our economy starts to improve.

What this fund brings is good management, low volatility, and steady if modest cash flow. It acts as a stabilizing force in a tumultuous world.

Action now: Buy. – G.P.

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FOLLOW-UP: CRESCENT POINT

In last week’s issue, energy expert Michael Corcoran warned of the likelihood of a dividend cut by Crescent Point Energy (TSX, NYSE: CPG) and advised staying on the sidelines. Just a few days later, on Aug. 12, the company announced a 57% dividend reduction and suspended its dividend reinvestment plan. The new monthly dividend is $0.10 a share ($1.20 annually) for a yield of 7.2% based on Friday’s closing price of C$16.64, US$12.71. We’ll continue to monitor the stock. – G.P.

 

That wraps things up for today. We’ll be back on Aug. 24.

Best regards,
Gordon Pape

In This Issue

CHINA JOINS THE CURRENCY WARS

By Gavin Graham, Contributing Editor

On Tuesday, Aug. 11, the Peoples’ Bank of China (PBoC) shocked world markets by announcing a 1.9% devaluation of the Chinese yuan, otherwise known as the renminbi, from US$1=CNY6.21 to US$1=CNY6.32. That was followed up the next day with another surprise cut, with the yuan weakening another 2% to US$1=CNY6.44. The net effect was a devaluation of about 4% over two days.

While the PBoC lowered the official fixing rate by 1.6% on Wednesday, the currency has been allowed to trade in a band 2% either side of the official fix since 2012, and traders are speculating that the authorities wish to see the yuan weaken further. Bloomberg reported that the yuan was trading 2.7% lower at US$1=CNY6.57 at close of trade in Hong Kong on Wednesday, where it trades freely. It had previously been as much as 3.2% lower before intervention by the Chinese erased some of the losses.

Despite all of the claims being made by Donald Trump and other U.S. politicians that this amounts to unfair currency manipulation, this is actually the largest devaluation by China in 20 years. Until last week’s move, the yuan had appreciated by 25% against the U.S. dollar over the past decade and by 9% in the last five years.

Effectively, China has been operating a U.S. dollar peg for 10 years. As the greenback appreciated against other currencies over the last 18 months, so has the yuan. In fact, the yuan’s real effective exchange rate has climbed 13% over the last four quarters. That’s because the end of Quantitative Easing (QE) by the U.S. Federal Reserve and the increased likelihood of the first increase in U.S. short-term rates in seven years has driven the U.S. dollar higher against other currencies, pulling the yuan along with it.

This has contributed to the growing weakness in China’s economy. GDP growth for the first two quarters of 2015 was 7%, the lowest since 2009. Both imports and exports for July fell by over 8% from a year earlier, against forecasts of a 1.5% decline. Industrial output rose 6.2%, retail sales were up 10.2%, and fixed investment increased 11.5% but these numbers were below estimates.

China has lowered interest rates four times since November 2014 and reduced reserve requirements for its banks in a bid to stimulate domestic demand and ease the credit crunch it introduced last year.

As well, the government encouraged Chinese domestic investors to switch from bank deposits to investing in the stock market, which rose into bubble territory in the first half of 2015. The Shanghai Composite Index, comprised of A shares that can only be bought by domestic investors and qualified foreign institutions, rose by 50% in the second half of 2014 from the 2,000 level, which it had traded at for the previous two years. It closed the year at about 3,000. Then it really took off, fuelled by a wave of individual investors buying stocks because “they always go up”, as one Shanghai housewife told Bloomberg, hitting 5,166 in mid-June. This represented a 150% increase in a year and led to ridiculous valuations that rivaled the lunacies of the dot-com bubble. When the authorities moved to rein in the speculation in June, prices collapsed. Many of the listed stocks were suspended and the index fell almost 30% to 3,666 in six weeks, a full-fledged bear market.

The intention of the Chinese authorities is clear. They are attempting to move the Chinese economy away from its reliance on manufacturing for exports and capital investment. That has resulted in a misallocation of resources into ghost (unoccupied) cities and bridges to nowhere, carried out by loss-making state owned enterprises that then have to be bailed out by the government. Instead, Premier Li Keqiang and his colleagues are aiming to grow domestic consumer demand to offset the slowing pace of exports, although last week’s devaluation will help temper that export slowdown.

Of course, as the Asian currency crisis of 1997-98 showed, it is important for countries that are contemplating devaluing to reduce their hard currency borrowings before they begin the process, otherwise the cost of servicing and repaying those debts becomes much more expensive. It’s therefore not surprising that China’s foreign exchange reserves declined by $315 billion to $3.65 trillion in the first half of the year, according to statistics from the Hong Kong Monetary Authority, as Chinese companies and governments reduced their foreign currency exposure. Chinese companies have at least $8.5 billion in U.S. dollar and euro denominated loans coming due in the next six months.

The Chinese authorities evidently hope that the package of measures that includes lower interest rates, reduced reserve requirements, allowing local governments to use municipal bonds as collateral, and the currency devaluation will help counteract weak growth.

That’s asking a lot in the face of the latest numbers. Weaker than expected industrial production and retail sales demonstrate widespread weakness, with Bloomberg’s monthly GDP estimate falling to 6.6% growth in July from 6.9% in June. Steel output was down 4.6%, shoes produced were down 8%, and auto output was off 26.3%, although this latter figure is unsurprising with car sales hitting a 17-month low in July. Electricity output, regarded as one of the more reliable indicators, was down 2% year-over-year.

China’s slowdown and devaluation is bad news for its Asian competitors and suppliers. If Canadian investors need any explanation of why commodity prices such as nickel, copper, and aluminum hit six-year lows last week, as did bulk commodities such as iron ore and metallurgical coal, then the fact that 36% of Australia’s exports in 2014 went to China is a simple explanation. In 2014, over 30% of Taiwan’s exports and 25% of South Korea’s also went to China, as did 20% of Japan’s and New Zealand’s. It’s no surprise that Asian currencies fell sharply last week, with those operating a managed float such as Vietnam specifically mentioning China’s devaluation as a reason for widening their trading bands.

In its defense, China can point to Japan’s adoption of Abenomics in 2012 as a reason for its move. Since late 2012, the Bank of Japan has let the yen slide from US$1=Y78 to US$1=Y124, a 35% depreciation. That was done in an attempt to stimulate exports and produce positive nominal inflation to defeat Japan’s long running deflation. As a result, Japanese exports have become notably more competitive against China’s. So have Korean, Taiwanese, and European exports as their central banks implemented QE programs. This has led to weaker Chinese growth, lower demand for commodities, and falling prices. So the Chinese can be relaxed about inflationary pressures caused by the devaluation, as commodities are so much cheaper in yuan terms than a year ago.

As for winners and losers from China’s move, commodity prices seem set to remain depressed for a while longer, as the devaluation makes them more expensive to China. Companies selling into China will see weaker demand. They include consumer goods companies such as my recommendations Unilever and Diageo, both off 5% last week, automakers and auto component stocks such as Honda and Linamar, and beneficiaries of Chinese tourism such as airlines, gaming, and cruise companies.

Interestingly, investments perceived as safe havens, such as developed countries’ government bonds, have seen prices rise. Bond guru Bill Gross, formerly of Pimco, now at Janus, sees U.S. Treasuries as the main beneficiary of the Chinese devaluation.

Gold and gold miners have risen 2% over the last week. The Chinese and Indians continue to regard gold as an attractive store of value, especially when their own currencies weaken. Although gold may be 4% more expensive in yuan terms than a week ago, it’s still 40% cheaper than it was four years ago.

Gavin Graham has had a long and successful career in money management and is a specialist in international securities. He held senior positions in financial organizations in London, Hong Kong, and Toronto. He currently is chief strategy officer at Integris Pension Management, a provider of personal pension plans for incorporated individuals. He divides his time between Toronto and the U.K.

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GAVIN GRAHAM’S UPDATES

Home Capital Group (TSX: HCG, OTC: HMCBF)

Originally recommended on Aug. 19/13 (#21330) at C$31.35, US$31.76. Closed Friday at C$29.02, US$23.52.

Background: Home Capital, through its mortgage lender Home Trust Co., makes loans that the banks normally refuse. These are usually to borrowers with credit histories that do not match the banks’ criteria. They include recent immigrants, the self-employed, and those who work in sectors such as entertainment and media, which do not have as much perceived job security as other professions.

Recent developments: Home Capital saw its share price plummet from $42.40 at the end of June to $28.40 at the end of July, before rebounding slightly to about $29 at time of writing. The sell-off came after the company revealed in early July that its mortgage originations for the second quarter (to June 30) would be well below those in the same quarter of 2014.

Specifically, traditional single-family mortgage originations were $1.29 billion against $1.53 billion in 2014 (down 15.4%) and just under $1 billion in the first quarter of 2015. Insured single family mortgage originations were $280 million against $619.6 million in the same quarter of 2014 (down 54.9%).

Home Capital revealed the reason for the dramatic decline in the insured mortgage category when it released its second-quarter earnings on July 29. In late 2014, an external source (i.e. a whistleblower) alerted the board of directors to possible discrepancies in income verification information submitted by certain mortgage brokers. As a result, the company statement said: “during the period September 2014 to March 2015, (it) had suspended its relationship with 18 independent mortgage brokers and two brokerages, for a total of approximately 45 individual mortgage brokers.”

Home Capital immediately retained independent professional advisers to investigate the allegations, overseen by its independent directors. They determined that there had been falsification of income information but not property valuations or credit scores. The company concluded that it is unlikely that there will be credit losses. It also conducted a wider test to ensure that income falsification is not an issue in its portfolio, as well as splitting its sales and underwriting functions and putting additional controls in place.

CEO Gerald Soloway said there was no evidence that any of the fraudulent applications were from people trying to defraud the company. None of them have defaulted, said Soloway, adding: “These are not people who set out to get something, who didn’t want to make the payments and comply…The value of the home…and the credit score was accurate and that’s why they’re performing so well.”

As far as the effect on its financials is concerned, Home Capital noted that mortgages originated by the suspended group of brokers accounted for $6 million (2%) of its $313 million of net income in 2014. The group originated $960.4 million worth of single-family mortgages in 2014, or 5.3% of its $20.5 billion of assets.

For the second quarter of 2015, Home Capital reported net income of $72.3 million ($1.03 per share), down 1.9% compared to $73.7 million ($1.05 per share) in the comparable quarter in 2014. For the first half of this year, net income was up 0.8% to $144.6 million ($2.05 per share) against $143.7 million ($2.04 per share) in 2014.

Non-performing loans as percentage of total loans was 0.33% at the end of the quarter against 0.32% in 2014, return on capital was 19.1%, and the dividend was maintained at $0.22 a quarter, compared to $0.16 in the same quarter in 2014. Based on the current price the yield is 3%.

The news was embarrassing for management and some investors felt more detail could have been given when the initial statement on lower originations was made in July. President Martin Reid acknowledged that point. However, long-term investors such as Mawer Investment Management’s Jeff Mo described the company’s actions “as exactly the type we would want the management to take when dealing with an issue like this.”

The fall in the share price means Home Capital is selling at only 1.33 times its book value of $21.87. That’s the lowest since the financial crisis, from which Home Capital emerged unscathed, a tribute to its conservative underwriting and strong capital base.

On Aug. 10, Home Capital announced it had bought CFF Bank of Oakville Ontario for approximately $15 million, adding $1.5 billion in loans and $235 million in assets. CEO Gerald Soloway said “the deal represents a major step towards realizing our long-term plan to achieve greater funding diversification”. Analysts feel the purchase furthers Home Capital’s goal of becoming a Schedule 1 lender, having applied for a license last year. Mr. Reid said the deal won’t “impede our efforts to manage the recently disclosed situation” (with fraudulent mortgage originations).

Conclusion: With a price/earnings ratio of 7.8 times 2015 forecast earnings and a yield of 3%, Home Capital is very cheap. However, it becomes a Hold until it is apparent that confidence in its ability to grow earnings is restored.

Action now: Hold. – G.G.

 

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MARKING TIME: RRSP PORTFOLIO UPDATE

By Gordon Pape, Editor and Publisher

I know that most people aren’t thinking about RRSPs in the middle of August but we try to update our model portfolios every six months. Since the last review of the IWB RRSP Portfolio was in early February, it’s that time again.

Our RRSP Portfolio has two main goals. The first is capital preservation – as with any pension plan, you don’t want to lose money. The second is to earn a higher rate of return than you could get from a GIC.

I’ve therefore constructed the portfolio to include bonds and defensive securities in order to reduce risk. But I also added some growth-oriented securities including mutual funds that offer exposure to the Canadian, U.S., and international equity markets. The securities were chosen from the Recommended Lists of our three newsletters: the IWB, The Income Investor, and Mutual Funds/ETFs Update. The portfolio contains a mix of ETFs, mutual funds, common stocks, and limited partnerships. This means that readers who wish to replicate it must have a self-directed RRSP with a brokerage firm.

The portfolio was launched in February 2012 with an initial value of $25,031.92.

These are the securities currently in the portfolio with some comments on how they have performed since the last review.

iShares DEX Short Term Corporate Universe + Maple Bond Index Fund (TSX: XSH). This exchange-traded fund invests primarily in bonds that mature in five years or less, so it is basically a short-term bond fund. The bonds may be issued by Canadian companies or by foreign corporations in Canadian currency (the Maple Bonds). Short-term bond funds are essentially defensive positions so returns are low. Over the latest six-month period this fund lost $0.21 per unit in market value but we received about $0.32 in distributions for a small net gain.

iShares Canadian Bond Index ETF (TSX: XBB). We added this ETF to the portfolio in February and so far we have incurred a small loss. The unit price is down from $32.70, where we bought it, to $32.11. We received distributions of about $0.45 per share but that wasn’t quite enough to offset the loss in market value. However, this type of portfolio requires a fixed income allocation so we will continue to hold this position and add to it at opportune times.

Fidelity Canadian Large Cap Fund B units (FID231). It was a rough six months for Canadian stocks and this fund didn’t escape, posting a small loss of $0.45 per share or just over 1%. There were no offsetting distributions as the fund only makes one payment annually, in December. Despite the setback, we are ahead more than 36% on this one.

Beutel Goodman American Equity Fund D units (BTG774). Fortunately, this well-run U.S. equity fund helped to compensate for the weakness in the Canadian market that we experienced. The net asset value (NAV) gained $0.89 per unit during the period for a return of 6.6%. There were no distributions.

Black Creek International Equity Fund A units (CIG11118). We added this international fund to the portfolio in September 2013. It got off to a strong start with a total return of 16.4% in the first six months, then slackened off for a while. It made a nice recovery in the latest six-month period, with an increase of $1.29 (6.3%) in the NAV. Here again, there were no distributions.

Brookfield Renewable Energy Partners LP (TSX: BEP.UN, NYSE: BEP). This Bermuda-based limited partnership owns a range of renewable power installations (mainly hydroelectric) in North America and Brazil. After a strong run last year, it has been pretty much marking time, with the share price down $0.55 since the last update. However, we received two quarterly distributions of US$0.415 (US$0.83 total) for a small net gain for the period.

Brookfield Infrastructure Partners LP (TSX: BIP.UN, NYSE: BIP). This limited partnership has also been marking time. It invests in infrastructure projects around the world so it faces some global economic headwinds. The share price is down $0.51 from our last review but we received two distributions totaling about US$1.06 to offset that. This is the top performer in the portfolio with a total return of just over 93%.

Capital Power Corporation (TSX: CPX). We added 60 shares of this company in February 2014 as a replacement for Firm Capital. The stock started strongly, gaining 24.5% in the first six months after being added. But it has regressed badly since, with the shares losing $5.78 in the latest six-month period. Not good.

Interest. We invested cash holdings and the accumulated distributions of $1,091.29 in a Tangerine high interest savings account paying 1.05%. That provided $5.73 in interest during the latest period.

Here is how the RRSP Portfolio stood as of the afternoon of Aug. 13 (mutual fund prices are as of the close of trading on Aug. 12). Commissions have not been factored in and Canadian and U.S. currencies are treated at par for ease of tracking.

IWB RRSP Portfolio (as of Aug. 13/15)

Security

Weight
%

Shares

AveragePrice

Book
Value

Current
Price

Market
Value

Cash
Retained

Gain/Loss
%
XSH

16.7

310

$19.65

$6,091.50

$19.94

$6,181.40

$198.87

+ 4.7
XBB

3.9

45

$32.70

$1,471.50

$32.11

$1,444.95

$20.38

– 0.4
FID231

20.9

185

$31.08

$5,750.47

$41.76

$7,725.60

$119.18

+36.4
BTG774

20.9

540

$8.42

$4,549.03

$14.31

$7,727.40

0

+69.9
CIG11118

9.5

160

$18.28

$2,924.30

$21.92

$3,507.20

$87.04

+22.9
BEP.UN

10.4

100

$27.86

$2,786.02

$38.25

$3,825.00

$160.50

+43.1
BIP.UN

13.4

90

$30.26

$2,723.40

$54.99

$4,949.10

$316.08

+93.3
CPX

3.3

60

$22.92

$1,375.20

$20.33

$1,219.80

$119.40

– 2.6
Cash

1.0

$407.92

$413.65

Totals

100.0

$28,079.34

$36,994.10

$1,021,45

+35.4
Inception

$25,031.92

+51.9

Comments: We eked out a gain of 1.1% during the latest six months, thanks mainly to good performances from the Beutel Goodman American Equity Fund and the Black Creek International Equity Fund. This shows the importance of geographic diversification; if all our equity assets had been in Canada the portfolio would have been in the red for the period.

Since inception, we have a total return of 51.9%. That works out to an average annual compound rate of return of 12.7%. That’s down from 14.5% in February but well ahead of our target of between 6% and 8%.

Changes: Capital Power has run into some serious problems, despite a 7.4% dividend increase. The company reported a loss attributable to shareholders of $34 million ($0.39 per share) in the second quarter, primarily due to an unplanned 28-day outage at one of its power plants. CEO Brian Vaasjo said the plant is now back on line but investors were also rattled by changes in carbon emission regulations by the new Alberta government and the possible impact on the company’s future profitability. Given the uncertainty surrounding the stock, we will sell our position for a total of $1,339.20, including accumulated dividends.

We will use some of that money to add to our position in XBB, buying 40 shares at a cost of $1,284.40. That will bring our total holding to 85 shares and leave $54.80 to add to our cash reserve. That cash plus accumulated dividends totals $1,370.50. The interest rate on our Tangerine account is now 0.8%. The rest of the portfolio will remain intact for now.

Here is a look at the revised portfolio. I’ll review it again in February.

IWB RRSP Portfolio (revised Aug. 13/15)

Security

Weight
%

Shares

Average
Price

Book
Value

Current
Price

Market
Value

Cash
Retained
XSH

16.7

310

$19.65

$6,091.50

$19.94

$6,181.40

$198.87
XBB

7.4

85

$32.42

$2,755.90

$32.11

$2,729.35

$20.38
FID231

20.8

185

$31.08

$5,750.47

$41.76

$7,725.60

$119.18
BTG774

20.8

540

$8.42

$4,549.03

$14.31

$7,727.40

0
CIG11118

9.4

160

$18.28

$2,924.30

$21.92

$3,507.20

$87.04
BEP.UN

10.3

100

$27.86

$2,786.02

$38.25

$3,825.00

$160.50
BIP.UN

13.3

90

$30.26

$2,723.40

$54.99

$4,949.10

$316.08
Cash

1.3

$468.45

$468.45

Totals

100.0

$28,079.34

$37,113.50

$902.05
Inception

$25,031.92

Follow Gordon Pape on Twitter @GPUpdates and on Facebook at www.facebook.com/GordonPapeMoney

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GORDON PAPE’S UPDATES

Google Inc. (NDQ: GOOGL)

Originally recommended on March 9/14 (#21410) at $607.40. Closed Friday at $689.37. (All figures in U.S. dollars.)

Background: I updated this stock just last week but there have been new developments that require a revisit.

Recent developments: On Aug. 10, the company announced a major restructuring. A new holding company named Alphabet will be set up and current Google shareholders will receive one share of stock in the new company for each current share. The ticker symbols will remain the same: GOOGL and GOOG.

In making the announcement, CEO Larry Page said the new structure will make the company “cleaner and more accountable”. Each segment of the business, of which Google (the search engine operation) itself will be one, will operate autonomously with its own CEO. Investors and analysts will be able to see exactly how money is being spent on all parts of the business, including the so-called “moonshots”, and judge for themselves the effectiveness of the financial commitments being made.

The restructuring will be phased in over the next few months and it is not yet clear exactly which entities will receive stand-alone status. However, besides Google itself they are likely to include YouTube, Android, Chrome, Play, Google X, Calico (a biotechnology company), and Nest, which is in the home automation business.

Analysts immediately rushed to praise the move. Bloomberg quoted Morgan Stanley’s Brian Nowak as saying: “We see the increasedtransparency from the creation of Alphabet Inc. as a positive step to betterunderstanding both core Google profitability and the company’s loss generatinginvestment projects (Google X, Fiber, Calico, Google Ventures, etc.).”

Scott Devitt of Stifel Financial, a brokerage and investment banking firm, said the move transforms Google into “the Berkshire Hathaway of the Internet”. He raised his target price on the stock to $850.

Critics have warned that the restructuring effectively transforms Google into a conglomerate. That’s become a dirty word for many investors because it implies a lack of focus on core products and allows weak components to dilute earnings. However, Google was already a conglomerate in fact if not in name, with its many moving parts. At least now we should be able to see how well each operation is doing and better assess whether the money being spent on moonshots is being poured down a black hole or has a reasonable probability of paying off.

On a day when markets tumbled following the devaluation of the Chinese yuan, GOOGL shares jumped $27.16 (4.1%) to $690.30. They ended the week at $689.37.

Conclusion: This move makes Google even more attractive for long-term investors. It should be a core holding in your portfolio.

Action now: Buy.

Fortis Inc. (TSX: FTS, OTC: FRTSF)

Originally recommended on Aug. 15/05 (#2531) at C$20.80 (split-adjusted). Closed Friday at C$38.70, US$29.57.

Background: Fortis is an electricity and natural gas distribution utility. It is based in St. John’s and has operations across Canada as well as in the U.S. and Caribbean. Its regulated utilities serve more than three million customers. Fortis also owns long-term contracted hydroelectric generation assets in British Columbia and Belize.

Recent developments: The company had a strong second quarter, delivering earnings of $244 million ($0.88 per share), well up from $47 million ($0.22 a share) in the same period last year and in line with analysts’ estimates. The strong results were bolstered by one-time gains associated with the sale of Fortis Properties’ commercial real estate assets and non-regulated hydroelectric generation assets in New York. Stripping out these one-time items, net profit was $123 million ($0.44 per share), an increase of $58 million ($0.14 per share) from the second quarter of 2014.
Revenue for the quarter came in at just over $1.5 billion, up 46% from the second quarter of 2014. For the first half of the fiscal year, revenue was just under $3.5 billion, up 37.5% year-over-year.

During the quarter, Fortis completed its $900 million, 335-megawatt Waneta Expansion in British Columbia, six weeks ahead of schedule and on budget. It is the corporation’s largest capital project to date.

Construction continues on FortisBC’s Tilbury liquefied natural gas (LNG) expansion at an estimated total cost of approximately $440 million, which is the largest capital project ongoing. Tilbury will add 950,000 mmBtus of storage and 34,000 mmBtus daily of liquefaction when the second LNG tank and new liquefier come in service, which is expected to occur by the end of 2016.

Conclusion: Fortis is a core holding for low-risk investors. The stock does not have a lot of upside growth potential but the downside risk is relatively low and the quarterly dividend of $0.34 per share ($1.36 annually) provides an attractive yield of 3.5%.

Action now: Buy. – G.P.

Phillips, Hager & North Total Return Bond Fund (RBF1340)

Type:Fixed income mutual fund
Code:RBF1340 (Series D)
Current price: $11.97
Originally recommended:Jan. 20/09 at $10.59
Annual payout:$0.363 (trailing 12 months)
Yield:3%
Risk Rating:Lower risk
Recommended by:Gordon Pape
Website: www.phn.com

Comments: The PH&N fixed income team is one of the best in the country and this fund has outperformed its peer group over every time period from six months to 10 years. Over the 12 months to July 31, the fund gained 6.8%. The 10-year average annual compound rate of return to that time was 5%.

What makes this fund especially attractive is the low risk. The worst 12-month period since its inception in July 2000 was a loss of 1.01% in the year ending Sept. 30, 2013. That’s the kind of stabilizing entity every portfolio needs.

The latest one-year return looks good but don’t expect a similar performance over the next 12 months. U.S. interest rates are poised to rise, perhaps as early as September and the Bank of Canada will certainly want to increase its target rate as soon as our economy starts to improve.

What this fund brings is good management, low volatility, and steady if modest cash flow. It acts as a stabilizing force in a tumultuous world.

Action now: Buy. – G.P.

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FOLLOW-UP: CRESCENT POINT

In last week’s issue, energy expert Michael Corcoran warned of the likelihood of a dividend cut by Crescent Point Energy (TSX, NYSE: CPG) and advised staying on the sidelines. Just a few days later, on Aug. 12, the company announced a 57% dividend reduction and suspended its dividend reinvestment plan. The new monthly dividend is $0.10 a share ($1.20 annually) for a yield of 7.2% based on Friday’s closing price of C$16.64, US$12.71. We’ll continue to monitor the stock. – G.P.

 

That wraps things up for today. We’ll be back on Aug. 24.

Best regards,
Gordon Pape