In This Issue

JAPAN GOES NEGATIVE

By Gordon Pape, Editor and Publisher

A few evenings ago I had dinner with an American economist. Naturally, the discussion quickly turned to investing and the rocky start for stocks in 2016. We spent some time analysing why equities had plunged so far so fast when the underlying fundamentals hadn’t changed dramatically. Our conclusion was that the correction was sparked by four factors: an overpriced market, the Fed’s decision to raise its key interest rate, the continuing rout in oil prices, and investor nervousness over China.

The market still looks overpriced today, although clearly not as much so as at the start of the year. The Fed seems to be quickly backing away from the idea of another rate hike soon (see article elsewhere in this issue). Oil prices firmed last week amid reports that OPEC and Russia were considering production cuts. China still remains a huge question mark, but overall we agreed that the tone of the stock markets should be somewhat better in February.

Our talk then shifted to bonds and I expressed the view that I have written about here that the fixed-income bull market still has some room to run. Negative interest rates are increasingly common in Europe, I noted, a fact that seemed to catch my friend off guard. The European Central Bank is now charging 0.3% on deposits placed with it by other banks. The yields on two-year German bonds have been in negative territory for some time. You’ll also find negative returns for some bonds issued by Switzerland, Denmark, Sweden, and some other strong European economies.

Now Japan has gone negative as well. The Bank of Japan shocked just about everyone on Friday by announcing that it will now charge 0.1% on excess deposits and warned it may cut rates further if required. Predictably, the yen fell in value, good news for Japanese exporters and bad news for North American carmakers. Bond markets around the world rallied sharply as yields fell.

Some people are puzzled by the inverse relationship between bond prices and yields. Look at it this way. A government issues a 10-year bond with a 2% coupon. So for every $1,000 face value, an investor receives $20 a year in interest. Then rates drop to the point where new 10-year bonds are only paying 1.5%, or $15 per $1,000 invested. The old bond, with its $20 annual payment, is now worth about $1,333, the price at which it would generate the same yield as the new issue. (This is a simplified illustration; the actual price would depend on several factors including time left to maturity.)

Now imagine what would happen if interest rates went negative. The price of that 2% bond would soar because it would be paying a positive return while new issues were charging investors for the privilege of holding them.

That’s exactly what has occurred in some parts of the world and there is no reason it can’t happen here as well if economic conditions don’t improve. The move by the Bank of Japan was unthinkable, until it wasn’t.

Why are we seeing this unusual phenomenon? Essentially because global growth is weak, deflation is a greater threat than inflation in many developed countries, and central banks increasingly feel a need to take dramatic action. Negative interest rates qualify.

The effect has been to propel bond prices higher this year, in contrast to the gloom in the stock markets. As of the close on Jan. 28, the Morningstar U.S. Core Bond Total Return Index was ahead 1.13% year-to-date. Treasuries were even stronger with the U.S. Government Total Return Bond Index up by 1.78%. The gains in Canada weren’t as dramatic but bonds were still on the plus side with the FTSE TMX Federal Bond Index ahead by 0.79% for 2016.

The move by the Bank of Japan should be seen as a strong signal that central banks are going to do everything they can to stimulate growth and fight deflation. That should be positive news for the stock markets, which posted strong gains on Friday. But it also reinforces the case for continuing to make bonds an important part of your overall portfolio.

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

 

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PARSING THE FED

By Gordon Pape

If you’re wondering why stock markets are in such turmoil, look no farther than last week’s commentary from the U.S. Federal Reserve Board. What it boils down to is that these financial geniuses don’t have a clue what is going on in the world economy. If they don’t know, with all the sophisticated data at their disposal, is it any wonder the rest of us are dazed and confused?

Just over a month ago, the Fed raised its key lending rate for the first time in nine years and signalled that we should expect as many as four more hikes in 2016. Now it’s backpedalling away from that hawkish stance in the face of plunging global stock markets, more trouble out of China, downward revisions of growth prospects, and a soaring U.S. dollar.

Of course, no one at the Fed would express this in such blunt terms. That’s not the way things are done. But take a close read of the nuances in the December and January statements and the implications are clear. “Committee” refers to the Fed’s Open Market Committee, which sets monetary policy.

December: “…economic activity has been expanding at a moderate pace.”

January: “…economic growth slowed late last year.”

Interpretation: In the six weeks between the Dec. 16 and Jan. 27 meetings, something serious enough happened to cause the Fed to make a significant change in its wording on economic activity. The sharp stock market correction may have contributed but there had to be other factors involved.

December: “Household spending and business fixed investment have been increasing at solid rates in recent months…”

January: “Household spending and business fixed investment have been increasing at moderate rates in recent months…”

Interpretation: In December, the Fed used the word “solid” to describe growth in these key sectors. In January, that was softened to “moderate”.

December: “…net exports have been soft.”

January: “…net exports have been soft and inventory investment slowed.”

Interpretation: Inventory investment becomes another negative for investors to chew on.

December:  “Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced.” 

January: “The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.”

Interpretation: The Fed is becoming increasingly concerned that there may be more downside risk to the global economy than previously believed. Dropping the word “balanced” is especially significant.

December: “The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.” 

January: No comparable statement.

Interpretation: The omission of such positive words as “considerable improvement” and “reasonably confident” says it all.

December: “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”

January: No change.

Interpretation: The Fed is keeping its options open but based on the language elsewhere in the January statement the odds are growing against four increases in 2016.

The big Wall Street indexes, which are highly sensitive to any hint of interest rate increases, plunged after the Open Market Committee released its statement. Despite the stand-pat decision on rates, investors were obviously concerned about the more pessimistic tone about the state of the U.S. economy.

The fact that the U.S. is not an economic island finally seems to be sinking in. For the past couple of years, the prevailing attitude in Washington seemed to be that the American economy is strong enough to pull up the rest of the world with it. That view is now rapidly dissipating.

As of the close of trading on Friday, the TSX was handily outperforming all the major U.S. indexes so far in 2016. Who would have expected that back on New Year’s Day?

 

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BE GREEDY WHEN OTHERS ARE FEARFUL

Contributing editor Ryan Irvine is with us today to share his thoughts on the opportunities he sees in the market this year. Ryan is the CEO of KeyStone Financial (www.KeyStocks.com) and is one of the country’s top experts in small cap stocks. He is based in the Vancouver area. Here is his report.

Ryan Irvine writes:

This year began with the largest percentage point losses on North American markets in history. The volatility has investors running scared, but we see opportunity. For the first time in several years, value is beginning to creep back into our research. The trouble is that investors treat stocks differently than almost any other purchases they make.

Think about it. When a desired TV, boat, or pair of shoes goes on sale, most people get that happy feeling and scramble to make the purchase, congratulating themselves for getting 20% off. When stocks take a 20% haircut, many investors panic and sell or become fearful to buy anything at all. When you own good stocks, this strategy is dead wrong. Remember, savvy investors become greedy when others are fearful.

In KeyStone’s Fall 2015 quarterly update and as the markets corrected, we reiterated a stance we have taken for well over a year now: there was no hurry to jump into the market. Broader valuations have been high and due for a correction. At the time, KeyStone’s Small-Cap Growth Stock Portfolio was holding an approximate 40% cash position, a level we maintained for much of 2015 and remain at today. In fact, we continue to advocate only select buying given the volatility.

If you are looking to take advantage of the downtrend that started 2016, begin with “half positions” in good companies and keep a higher level of cash on the sidelines than we typically advocate. This has and will continue to set us up very well for some long-term buying opportunities that will inevitably develop. We remain patient in that regard as almost always the market overshoots underlying fundamentals to the up and downside.

Corrections like we are currently witnessing are precisely why we recommend investors build their 10-12 stock small-cap growth and income portfolios slowly over a 12- to 18-month period. This disciplined approach will help prevent you from buying all your key assets at what might be the top in a given year or market cycle. Perhaps most importantly, it will leave you with capital on the sidelines that can be used to buy quality stocks when they inevitably come on sale during a 12-18 month period. This is likely what we are witnessing now.

Mistakes are made when investors feel the absolute need to jump in (almost like they are “missing out”) and buy 10-12 stocks in a month’s time. Sure, it would be great if you hit a one- or two-year market low but the likelihood of that occurring is remote. While today’s correction appears like an opportunity, “the bottom” may or may not have been reached.

Quick strategies

Corrections or bear markets do not last forever. In fact, the pain can be violent and swift, quickly cutting the fat off the market and leaving in its wake a period of consolidation. That’s when most investors are fearful but great investors should become greedy. However, greed does not mean you should buy indiscriminately. Here are a couple of strategies to employ when buying in down markets.

Layer into positions. When deciding to buy a stock, particularly one you are purchasing for its solid long-term fundamentals, you do not have to fill your full position in a single trade. You have the option of breaking up the trade into two or more pieces. Picking a bottom is often a fool’s game. If you are comfortable with the long-term outlook and the stock is trading at reasonable to cheap valuations, beginning with a partial position in a volatile market can be prudent. For example, say you want to buy $10,000 worth of XYZ company. Start with a $5,000 position and add to it in a month or so. You may be paying more or less, but you have may have allowed the volatility to settle and stability to return.

Create a watch list. KeyStone has a list of great companies, with solid growth and strong balance sheets that we constantly monitor for attractive entry points. I suggest any good investor should do the same. For the better part of 2015, most companies on our monitor list appeared expensive, but with the market correcting we are starting to see value. Some of these stocks we will buy today, some in the future, and some will never hit an appropriate entry point. We are disciplined and patient with these stocks and choose to buy quality at reasonable to great prices, rather than quantity.

 

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RYAN IRVINE’S UPDATES

High Arctic Energy Services Inc. (TSX: HWO, OTC: HGHAF)

Originally recommended on Sept. 2/13 (#21332) at C$2.85, US$2.55. Closed Friday at C$3.36, US$2.26.

Background: High Arctic Energy is an international oil and gas services company with operations in both Papua New Guinea (PNG) and Western Canada. High Arctic’s substantial operation in Papua New Guinea is comprised of contract drilling, specialized well completion services, and a rentals business, which includes rig matting, camps and drilling support equipment.

Recent developments: The company reported 2015 third-quarter adjusted EBITDA of $18.7 million, which was almost double that of the prior year ($9.8 million). Revenue jumped 42% to $58.5 million from the $41.3 million earned in the same period in 2014.

Management expects its investments in two modern heli-portable drilling rigs to continue to deliver contracted growth with large independents and major E&P companies.

As part of its growth strategy, High Arctic intends to be an active participant in the consolidation of the oilfield services market. During the third quarter, the company commenced investing in select public companies that it believes are strategic opportunities. With continued soft markets, it may add to these positions.

Dividend: High Arctic declared dividends totalling $8.2 million during the first nine months of 2015 representing a trailing twelve-month dividend payout of 23% of funds provided from operations. That compared to a payout of $6.7 million (21%) the year before. The stock pays a monthly dividend of $0.0165 ($0.198 per year) to yield 6.2%.

Conclusion: From an operations standpoint, High Arctic continues to perform incredibly well, particularly given the complete collapse of energy prices worldwide within the past two years. At a time when energy service stocks are posting 50%-85% decreases in revenues and negative cash flows, High Arctic reported its best set of quarterly numbers ever. Perhaps more importantly, management says that HWO’s contracted status in Papua New Guinea, the strong U.S. dollar exchange rate, continued delivery of high quality service, and similar year-over-year demand in Canada should result in further EBITDA growth in 2016.

Once again, from a fundamental perspective, High Arctic remains attractively valued. We have upped our estimate for Adjusted EBITDA in 2015 to $60 million, or approximately $1.09 per share, which leaves High Arctic’s price at 3.08 times this figure. This is very low compared to its peers, particularly considering that the company is looking for growth in 2016, whereas most energy service stocks are facing severe declines. The company trades at 2.2 times 2015 expected EBITDA after removing the net approximate $0.46 per share in cash and short-term investments (EV/EBITDA).

Action now: We continue to avoid the energy segment generally, but given the strong numbers and its potential as a takeover target, we continue to rank High Arctic as a Buy. One caveat we see here is management’s recent use of cash to purchase shares in TSX listed energy service stocks. We are not in favour of this move and are not in favour of a near-term takeover in this segment by the company and have voiced our opinion to management in this regard.

Espial Group Inc. (TSX: ESP, OTC: ESPAF)

Originally recommended on Jan. 31/15 (#21505) at C$2.52, US$1.92. Closed Friday at C$2.00, US$1.18 (Jan. 20).

Background: Espial is a leading supplier of digital TV and IPTV software and solutions to cable MSOs and telecommunications operators as well as to consumer electronics manufacturers. This is a cash rich company with a high risk/potentially high performance profile.

One of KeyStone’s themes heading into 2015 was the massive changes in the way we are choosing to consume media: from fixed to mobile and from unflexible packages to byte sized content that viewers actually want. In the media delivery world, companies like Netflix have completely altered a landscape that was stagnant for decades in the space of a couple of years. And incumbent cable/telco companies are running scared.

While cable companies have the content, their delivery systems are largely out of date: slow, antiquated, and nothing close to what today’s consumers demand in terms of user experience and choice. As subscribers erode, these companies are pressed to implement new user-friendly experiences under modified models.

This is one of the major reasons we recommended Espial. It provides cable and telco companies with software that essentially gives their clients a Netflix type experience.

Stock performance: We introduced Espial to IWB readers in January of last year with the shares trading in the $2.50 range. The stock has been on a wild ride over the past 12 months, trading as high as $4 before closing this week at $2.

Conclusion: Espial currently has a pipeline of approximately 60 potential cable/telco customers in North America and Europe with one million subscribers or greater. The company is engaged with 25 and has a deeper engagement with six, which the company believes do not need a proof-of-concept (POC) or deployment in the field to sign a contract. The remaining potential clients are not considered early adopters and would require a field deployment before making a decision. As Espial’s RDK based software is relatively new, this is normal.

Of the six deeper engagements, Espial has two MSA (master services agreements) with what are considered the top 5-10 cable companies in North America. Both are moving along well. These two small initial MSA contracts are for general consulting services regarding RDK as a possible solution. The deal(s) could potentially open the door to developing a very significant relationship going forward, but right now the relationships are only in their infancy and we do not expect a significant announcement any time soon.

We see the recent drop in the company’s shares as overdone. The potential loss of the company’s North American contract is real and certainly not positive, however the situation is complex and nothing is certain at this time. In any event, the possible contract loss appears to be already priced into the stock and there seems to be no upside factored in for another contract win over the next year. While there is increased risk, we see it as a buying opportunity.

If we just look at Espial from a fundamental perspective moving into 2016, the shares appear relatively cheap. The consensus earnings estimate for 2016 is $0.15. While this is attainable, we see it as aggressive. If the company was to make $0.10 (a reasonable estimate and over 30% less than the optimistic consensus), with $1.28 in cash per share in the bank and zero debt, the company’s forward looking price-to-earnings multiple with cash removed is 7.2 ($2.00 – $1.28 cash = $0.72/$0.10 = 7.2). This is a low multiple for a software provider, given the growth and the fact that the real story is the potential for further large contract wins.

Action now: We view the stock as a higher risk, but a potentially higher reward type situation for investors with an above average tolerance for risk. Taking that into account, the stock remains a speculative Buy.

Firan Technology Group Corporation (TSX: FTG, OTC: FTGFF)

Originally recommended on Nov. 7/15 (#21540) at C$2.11, US$1.77. Closed Friday at C$2.65, US$1.75 (Dec. 4).

Background: FTG is a leading global supplier of aerospace and defense electronic products and subsystems. With facilities in Canada, the United States, and Tianjin, China, FTG provides prototype development and manufacturing services complemented by quick turnaround production runs. FTG has two operating segments: FTG Aerospace and FTG Circuits.

Recent developments: The company reported record third-quarter results.
Revenue increased to $18.2 million, up 23% from the prior year. Profit was $1.6 million, an increase of 647% compared to 2014. Trailing 12-month earnings per share (diluted) are now $0.21. Cash flow from operations in the quarter was $2.6 million.

Conclusion: Over 80% of the company’s business is in U.S. dollars so it benefits from a weak loonie. Fundamentally, the company has earned around $0.21 per share over the past 12 months, a figure that would have grown by over $0.02 if various one-time costs were removed from the first quarter results. Removing the rolling hedges would have increased earnings by $0.028 in the second quarter and by $0.038 in the third quarter. Based on this, FTG trades at around seven times normalized trailing earnings, which is relatively attractive for a company with the potential to produce growth into 2016. The company’s Enterprise Value to EBITDA ratio of 5.4 is also relatively attractive.

Earnings before interest, tax, depreciation and amortization (EBITDA) for the trailing 12 months is $7.1 million, a significant increase from $5.6 million from the previous quarter. Looking forward, the company has a solid order book and we expect material growth. The company is set to release its year-end numbers this coming Monday.

We encourage readers to continue to pay attention to the opportunities that take advantage of Canada’s low currency relative to the U.S. dollar in 2016. Firan falls into that category.

Action now: We reiterate our Buy recommendation on the stock.

– end Ryan Irvine

 

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GORDON PAPE’S FUND UPDATES

Templeton Growth Fund (TML700)

Originally recommended on July 22/13 (#21327) at $12.35. Closed Thursday at $15.66.

This venerable fund has been around since 1954. It has had its ups and downs over the years but has been strong recently under the direction of the Bahamas-based team of James Harper, Heather Arnold, Tucker Scott, and Norman Boersma.

The fund’s mandate allows it to invest around the world and that’s exactly what the managers are doing. As of the end of October, about 38% of the assets were in U.S. stocks, with a focus on large-cap giants like Alphabet (Google), Amgen, Citigroup, and Microsoft.

Other large geographic positions include the U.K. (13%), France (7.6%), Japan (6%), with smaller positions under 5% in a number of other countries.

The fund was an above average performer in every year from 2011 to 2015. As of Dec. 31, the A units showed a five-year average annual compound rate of return of 12.3%, well above the category average of 9.4%. The latest one-year gain was 11.2% compared to 9.7% for the peer group.

The MER is a high 2.52% but in this case the returns justify the cost. Moreover, this fund is positioned where equity investors should be at the present time: on the global spectrum with virtually no exposure to Canada (Suncor is the only domestic stock the managers own) and a large position in the U.S.

Action now: Buy. The recent global sell-off has brought down the NAV to a more realistic level.

TD Advantage Balanced Income Portfolio (TDB2060)

Originally recommended on Feb. 13/12 (#21206) at $11.01. Closed Thursday at $12.07.

I recommended this fund of funds in 2012 as a good choice for conservative investors, and especially suitable for RRSPs. At the time, it was invested in five other TD funds; it now holds eight. The largest single component at 58% of total assets is the TD Canadian Core Plus Bond Fund Series O.

The asset mix is very defensive with 65% of the fund in fixed income securities and another 7% in cash and equivalents. On the equity side, the geographic distribution is 10% in Canada, 9% in the U.S., and 8% international.

The fund shows above average returns for all time frames out to five years. The five-year average annual compound rate of return is 5.5% compared to a 4.1% figure for the Canadian Fixed Income Balanced category. In 2015, the gain was a shade under 3%.

Especially important to low-risk investors is the fact the fund has never lost money over a 12-month period since it was launched in 2009.

You’ll never get rich with this one because of the nature of the portfolio but it’s still a fine choice for conservative investors generally and RRSPs in particular.

Action now: Buy.

Steadyhand Founders Fund (SIF125)

Originally recommended on Feb. 25/13 (#21308) at $10.73. Closed Thursday at $11.90.

This is a portfolio fund that invests in the five funds offered by the small Vancouver-based Steadyhand boutique house. Company founder and CEO Tom Bradley decides the composition of the portfolio, using a tactical asset allocation approach.

As of year-end, the fund was 59% invested in stocks, 25% in bonds, and 16% in cash and short-term securities. Canadian assets made up 44% of the total with 37% overseas and 19% in the U.S.

The fund is managed in a very conservative way with asset preservation one of Mr. Bradley’s main priorities. So far, he’s been very successful in protecting investors’ money, as the fund has never had a losing 12-month period since its launch in early 2012.

However, that low-risk approach also means relatively low returns. The fund posted a gain of 3.9% in 2015. That may seem unimpressive but keep in mind the TSX was down 11% for the year. The fund also outperformed the peer group, which only added 0.9%.

The three-year average annual compound rate of return to Dec. 31 was 8.6% compared to a category average of 7.3%. The MER is on the low side for a mutual fund at 1.34%. However, the minimum investment per fund is $10,000.

Action now: Buy.

Steadyhand Income Fund (SIF120)

Originally recommended on Jan. 23/12 (#21203) at $10.56. Closed Thursday at $10.63.

Although this fund is 75% invested in bonds, it experienced a down year in 2015, losing 1.2%. The reason is that the other 25% of the assets are held in dividend-paying stocks and REITs, two categories that struggled last year. Despite the blip, the fund still shows a five-year average annual compound rate of return of almost 6%, well ahead of the 4.1% peer group average. The MER is a reasonable 1.04% and there is no sales commission, however there is a $10,000 minimum. This is still a good choice for low-risk investors.

Action now: Buy.

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

Originally recommended on May 8/05 (#2518) at $10.96. Closed Thursday at $11.53.

We recommended this as a core bond fund over a decade ago. It has lived up to its promise of being one of the best of its type and continues to do so. The ten-year average annual compound rate of return of 4.8% (D units) is well ahead of the category average of 3.5%. The gain in 2015 was 3.2% compared to less than 1% for the peer group. The fund rarely loses money, even in difficult years. Its worst 12-month decline was in the period ending Sept. 30, 2013 when it slipped 1.01%.

I strongly recommend holding some fixed income securities during these turbulent times and this fund is an excellent way to do that. The MER for the no-load D units, which I recommend, is only 0.59% making this one of the best value-for-money mutual funds you’ll find.

Action now: Buy.

Mawer U.S. Equity Fund (MAW108)

Originally recommended on Feb. 25/13 (#21308) at $22.04. Closed Thursday at $35.64.

The Calgary-based Mawer organization is frequently overlooked by investors despite the fact it offers low-cost funds that consistently outperform.

This fund, which I first recommended about three years ago, is an example. It invests in a portfolio of mainly large cap stocks, including such names as Alphabet, JPMorgan Chase, Comcast, Oracle, and Johnson & Johnson. The assets are well diversified by sector, with no heavy overweighting. Information technology tops the list at 22% with financials at 20%, consumer discretionary at 15%, healthcare at 12%, and industrials at 10%. Energy stocks only make up 5% of the assets.

Performance has been excellent. The three-year average annual compound rate of return to Dec. 31 was 26.9% compared to a peer group average of 21.9%. Over the latest 12 months the fund gained 19.3%, again handily beating the average.

Since this is a pure stock fund, with minimal cash holdings, there is risk, of course. As of Jan. 28, the fund was showing a year-to-date loss of 6.1%, reflecting the correction in the U.S. market. However, based on past experience I believe this is just a hiccup.

This is a core U.S. stock fund with a very reasonable MER of 1.21%. If you are underweighted in the American market and can afford the $5,000 minimum investment, this is a very good choice.

Action now: Buy.

 

That’s it for this week. We’ll be back on Feb. 8.

Best regards,
Gordon Pape

In This Issue

JAPAN GOES NEGATIVE

By Gordon Pape, Editor and Publisher

A few evenings ago I had dinner with an American economist. Naturally, the discussion quickly turned to investing and the rocky start for stocks in 2016. We spent some time analysing why equities had plunged so far so fast when the underlying fundamentals hadn’t changed dramatically. Our conclusion was that the correction was sparked by four factors: an overpriced market, the Fed’s decision to raise its key interest rate, the continuing rout in oil prices, and investor nervousness over China.

The market still looks overpriced today, although clearly not as much so as at the start of the year. The Fed seems to be quickly backing away from the idea of another rate hike soon (see article elsewhere in this issue). Oil prices firmed last week amid reports that OPEC and Russia were considering production cuts. China still remains a huge question mark, but overall we agreed that the tone of the stock markets should be somewhat better in February.

Our talk then shifted to bonds and I expressed the view that I have written about here that the fixed-income bull market still has some room to run. Negative interest rates are increasingly common in Europe, I noted, a fact that seemed to catch my friend off guard. The European Central Bank is now charging 0.3% on deposits placed with it by other banks. The yields on two-year German bonds have been in negative territory for some time. You’ll also find negative returns for some bonds issued by Switzerland, Denmark, Sweden, and some other strong European economies.

Now Japan has gone negative as well. The Bank of Japan shocked just about everyone on Friday by announcing that it will now charge 0.1% on excess deposits and warned it may cut rates further if required. Predictably, the yen fell in value, good news for Japanese exporters and bad news for North American carmakers. Bond markets around the world rallied sharply as yields fell.

Some people are puzzled by the inverse relationship between bond prices and yields. Look at it this way. A government issues a 10-year bond with a 2% coupon. So for every $1,000 face value, an investor receives $20 a year in interest. Then rates drop to the point where new 10-year bonds are only paying 1.5%, or $15 per $1,000 invested. The old bond, with its $20 annual payment, is now worth about $1,333, the price at which it would generate the same yield as the new issue. (This is a simplified illustration; the actual price would depend on several factors including time left to maturity.)

Now imagine what would happen if interest rates went negative. The price of that 2% bond would soar because it would be paying a positive return while new issues were charging investors for the privilege of holding them.

That’s exactly what has occurred in some parts of the world and there is no reason it can’t happen here as well if economic conditions don’t improve. The move by the Bank of Japan was unthinkable, until it wasn’t.

Why are we seeing this unusual phenomenon? Essentially because global growth is weak, deflation is a greater threat than inflation in many developed countries, and central banks increasingly feel a need to take dramatic action. Negative interest rates qualify.

The effect has been to propel bond prices higher this year, in contrast to the gloom in the stock markets. As of the close on Jan. 28, the Morningstar U.S. Core Bond Total Return Index was ahead 1.13% year-to-date. Treasuries were even stronger with the U.S. Government Total Return Bond Index up by 1.78%. The gains in Canada weren’t as dramatic but bonds were still on the plus side with the FTSE TMX Federal Bond Index ahead by 0.79% for 2016.

The move by the Bank of Japan should be seen as a strong signal that central banks are going to do everything they can to stimulate growth and fight deflation. That should be positive news for the stock markets, which posted strong gains on Friday. But it also reinforces the case for continuing to make bonds an important part of your overall portfolio.

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

 

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PARSING THE FED

By Gordon Pape

If you’re wondering why stock markets are in such turmoil, look no farther than last week’s commentary from the U.S. Federal Reserve Board. What it boils down to is that these financial geniuses don’t have a clue what is going on in the world economy. If they don’t know, with all the sophisticated data at their disposal, is it any wonder the rest of us are dazed and confused?

Just over a month ago, the Fed raised its key lending rate for the first time in nine years and signalled that we should expect as many as four more hikes in 2016. Now it’s backpedalling away from that hawkish stance in the face of plunging global stock markets, more trouble out of China, downward revisions of growth prospects, and a soaring U.S. dollar.

Of course, no one at the Fed would express this in such blunt terms. That’s not the way things are done. But take a close read of the nuances in the December and January statements and the implications are clear. “Committee” refers to the Fed’s Open Market Committee, which sets monetary policy.

December: “…economic activity has been expanding at a moderate pace.”

January: “…economic growth slowed late last year.”

Interpretation: In the six weeks between the Dec. 16 and Jan. 27 meetings, something serious enough happened to cause the Fed to make a significant change in its wording on economic activity. The sharp stock market correction may have contributed but there had to be other factors involved.

December: “Household spending and business fixed investment have been increasing at solid rates in recent months…”

January: “Household spending and business fixed investment have been increasing at moderate rates in recent months…”

Interpretation: In December, the Fed used the word “solid” to describe growth in these key sectors. In January, that was softened to “moderate”.

December: “…net exports have been soft.”

January: “…net exports have been soft and inventory investment slowed.”

Interpretation: Inventory investment becomes another negative for investors to chew on.

December:  “Overall, taking into account domestic and international developments, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced.” 

January: “The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.”

Interpretation: The Fed is becoming increasingly concerned that there may be more downside risk to the global economy than previously believed. Dropping the word “balanced” is especially significant.

December: “The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.” 

January: No comparable statement.

Interpretation: The omission of such positive words as “considerable improvement” and “reasonably confident” says it all.

December: “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”

January: No change.

Interpretation: The Fed is keeping its options open but based on the language elsewhere in the January statement the odds are growing against four increases in 2016.

The big Wall Street indexes, which are highly sensitive to any hint of interest rate increases, plunged after the Open Market Committee released its statement. Despite the stand-pat decision on rates, investors were obviously concerned about the more pessimistic tone about the state of the U.S. economy.

The fact that the U.S. is not an economic island finally seems to be sinking in. For the past couple of years, the prevailing attitude in Washington seemed to be that the American economy is strong enough to pull up the rest of the world with it. That view is now rapidly dissipating.

As of the close of trading on Friday, the TSX was handily outperforming all the major U.S. indexes so far in 2016. Who would have expected that back on New Year’s Day?

 

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BE GREEDY WHEN OTHERS ARE FEARFUL

Contributing editor Ryan Irvine is with us today to share his thoughts on the opportunities he sees in the market this year. Ryan is the CEO of KeyStone Financial (www.KeyStocks.com) and is one of the country’s top experts in small cap stocks. He is based in the Vancouver area. Here is his report.

Ryan Irvine writes:

This year began with the largest percentage point losses on North American markets in history. The volatility has investors running scared, but we see opportunity. For the first time in several years, value is beginning to creep back into our research. The trouble is that investors treat stocks differently than almost any other purchases they make.

Think about it. When a desired TV, boat, or pair of shoes goes on sale, most people get that happy feeling and scramble to make the purchase, congratulating themselves for getting 20% off. When stocks take a 20% haircut, many investors panic and sell or become fearful to buy anything at all. When you own good stocks, this strategy is dead wrong. Remember, savvy investors become greedy when others are fearful.

In KeyStone’s Fall 2015 quarterly update and as the markets corrected, we reiterated a stance we have taken for well over a year now: there was no hurry to jump into the market. Broader valuations have been high and due for a correction. At the time, KeyStone’s Small-Cap Growth Stock Portfolio was holding an approximate 40% cash position, a level we maintained for much of 2015 and remain at today. In fact, we continue to advocate only select buying given the volatility.

If you are looking to take advantage of the downtrend that started 2016, begin with “half positions” in good companies and keep a higher level of cash on the sidelines than we typically advocate. This has and will continue to set us up very well for some long-term buying opportunities that will inevitably develop. We remain patient in that regard as almost always the market overshoots underlying fundamentals to the up and downside.

Corrections like we are currently witnessing are precisely why we recommend investors build their 10-12 stock small-cap growth and income portfolios slowly over a 12- to 18-month period. This disciplined approach will help prevent you from buying all your key assets at what might be the top in a given year or market cycle. Perhaps most importantly, it will leave you with capital on the sidelines that can be used to buy quality stocks when they inevitably come on sale during a 12-18 month period. This is likely what we are witnessing now.

Mistakes are made when investors feel the absolute need to jump in (almost like they are “missing out”) and buy 10-12 stocks in a month’s time. Sure, it would be great if you hit a one- or two-year market low but the likelihood of that occurring is remote. While today’s correction appears like an opportunity, “the bottom” may or may not have been reached.

Quick strategies

Corrections or bear markets do not last forever. In fact, the pain can be violent and swift, quickly cutting the fat off the market and leaving in its wake a period of consolidation. That’s when most investors are fearful but great investors should become greedy. However, greed does not mean you should buy indiscriminately. Here are a couple of strategies to employ when buying in down markets.

Layer into positions. When deciding to buy a stock, particularly one you are purchasing for its solid long-term fundamentals, you do not have to fill your full position in a single trade. You have the option of breaking up the trade into two or more pieces. Picking a bottom is often a fool’s game. If you are comfortable with the long-term outlook and the stock is trading at reasonable to cheap valuations, beginning with a partial position in a volatile market can be prudent. For example, say you want to buy $10,000 worth of XYZ company. Start with a $5,000 position and add to it in a month or so. You may be paying more or less, but you have may have allowed the volatility to settle and stability to return.

Create a watch list. KeyStone has a list of great companies, with solid growth and strong balance sheets that we constantly monitor for attractive entry points. I suggest any good investor should do the same. For the better part of 2015, most companies on our monitor list appeared expensive, but with the market correcting we are starting to see value. Some of these stocks we will buy today, some in the future, and some will never hit an appropriate entry point. We are disciplined and patient with these stocks and choose to buy quality at reasonable to great prices, rather than quantity.

 

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RYAN IRVINE’S UPDATES

High Arctic Energy Services Inc. (TSX: HWO, OTC: HGHAF)

Originally recommended on Sept. 2/13 (#21332) at C$2.85, US$2.55. Closed Friday at C$3.36, US$2.26.

Background: High Arctic Energy is an international oil and gas services company with operations in both Papua New Guinea (PNG) and Western Canada. High Arctic’s substantial operation in Papua New Guinea is comprised of contract drilling, specialized well completion services, and a rentals business, which includes rig matting, camps and drilling support equipment.

Recent developments: The company reported 2015 third-quarter adjusted EBITDA of $18.7 million, which was almost double that of the prior year ($9.8 million). Revenue jumped 42% to $58.5 million from the $41.3 million earned in the same period in 2014.

Management expects its investments in two modern heli-portable drilling rigs to continue to deliver contracted growth with large independents and major E&P companies.

As part of its growth strategy, High Arctic intends to be an active participant in the consolidation of the oilfield services market. During the third quarter, the company commenced investing in select public companies that it believes are strategic opportunities. With continued soft markets, it may add to these positions.

Dividend: High Arctic declared dividends totalling $8.2 million during the first nine months of 2015 representing a trailing twelve-month dividend payout of 23% of funds provided from operations. That compared to a payout of $6.7 million (21%) the year before. The stock pays a monthly dividend of $0.0165 ($0.198 per year) to yield 6.2%.

Conclusion: From an operations standpoint, High Arctic continues to perform incredibly well, particularly given the complete collapse of energy prices worldwide within the past two years. At a time when energy service stocks are posting 50%-85% decreases in revenues and negative cash flows, High Arctic reported its best set of quarterly numbers ever. Perhaps more importantly, management says that HWO’s contracted status in Papua New Guinea, the strong U.S. dollar exchange rate, continued delivery of high quality service, and similar year-over-year demand in Canada should result in further EBITDA growth in 2016.

Once again, from a fundamental perspective, High Arctic remains attractively valued. We have upped our estimate for Adjusted EBITDA in 2015 to $60 million, or approximately $1.09 per share, which leaves High Arctic’s price at 3.08 times this figure. This is very low compared to its peers, particularly considering that the company is looking for growth in 2016, whereas most energy service stocks are facing severe declines. The company trades at 2.2 times 2015 expected EBITDA after removing the net approximate $0.46 per share in cash and short-term investments (EV/EBITDA).

Action now: We continue to avoid the energy segment generally, but given the strong numbers and its potential as a takeover target, we continue to rank High Arctic as a Buy. One caveat we see here is management’s recent use of cash to purchase shares in TSX listed energy service stocks. We are not in favour of this move and are not in favour of a near-term takeover in this segment by the company and have voiced our opinion to management in this regard.

Espial Group Inc. (TSX: ESP, OTC: ESPAF)

Originally recommended on Jan. 31/15 (#21505) at C$2.52, US$1.92. Closed Friday at C$2.00, US$1.18 (Jan. 20).

Background: Espial is a leading supplier of digital TV and IPTV software and solutions to cable MSOs and telecommunications operators as well as to consumer electronics manufacturers. This is a cash rich company with a high risk/potentially high performance profile.

One of KeyStone’s themes heading into 2015 was the massive changes in the way we are choosing to consume media: from fixed to mobile and from unflexible packages to byte sized content that viewers actually want. In the media delivery world, companies like Netflix have completely altered a landscape that was stagnant for decades in the space of a couple of years. And incumbent cable/telco companies are running scared.

While cable companies have the content, their delivery systems are largely out of date: slow, antiquated, and nothing close to what today’s consumers demand in terms of user experience and choice. As subscribers erode, these companies are pressed to implement new user-friendly experiences under modified models.

This is one of the major reasons we recommended Espial. It provides cable and telco companies with software that essentially gives their clients a Netflix type experience.

Stock performance: We introduced Espial to IWB readers in January of last year with the shares trading in the $2.50 range. The stock has been on a wild ride over the past 12 months, trading as high as $4 before closing this week at $2.

Conclusion: Espial currently has a pipeline of approximately 60 potential cable/telco customers in North America and Europe with one million subscribers or greater. The company is engaged with 25 and has a deeper engagement with six, which the company believes do not need a proof-of-concept (POC) or deployment in the field to sign a contract. The remaining potential clients are not considered early adopters and would require a field deployment before making a decision. As Espial’s RDK based software is relatively new, this is normal.

Of the six deeper engagements, Espial has two MSA (master services agreements) with what are considered the top 5-10 cable companies in North America. Both are moving along well. These two small initial MSA contracts are for general consulting services regarding RDK as a possible solution. The deal(s) could potentially open the door to developing a very significant relationship going forward, but right now the relationships are only in their infancy and we do not expect a significant announcement any time soon.

We see the recent drop in the company’s shares as overdone. The potential loss of the company’s North American contract is real and certainly not positive, however the situation is complex and nothing is certain at this time. In any event, the possible contract loss appears to be already priced into the stock and there seems to be no upside factored in for another contract win over the next year. While there is increased risk, we see it as a buying opportunity.

If we just look at Espial from a fundamental perspective moving into 2016, the shares appear relatively cheap. The consensus earnings estimate for 2016 is $0.15. While this is attainable, we see it as aggressive. If the company was to make $0.10 (a reasonable estimate and over 30% less than the optimistic consensus), with $1.28 in cash per share in the bank and zero debt, the company’s forward looking price-to-earnings multiple with cash removed is 7.2 ($2.00 – $1.28 cash = $0.72/$0.10 = 7.2). This is a low multiple for a software provider, given the growth and the fact that the real story is the potential for further large contract wins.

Action now: We view the stock as a higher risk, but a potentially higher reward type situation for investors with an above average tolerance for risk. Taking that into account, the stock remains a speculative Buy.

Firan Technology Group Corporation (TSX: FTG, OTC: FTGFF)

Originally recommended on Nov. 7/15 (#21540) at C$2.11, US$1.77. Closed Friday at C$2.65, US$1.75 (Dec. 4).

Background: FTG is a leading global supplier of aerospace and defense electronic products and subsystems. With facilities in Canada, the United States, and Tianjin, China, FTG provides prototype development and manufacturing services complemented by quick turnaround production runs. FTG has two operating segments: FTG Aerospace and FTG Circuits.

Recent developments: The company reported record third-quarter results.
Revenue increased to $18.2 million, up 23% from the prior year. Profit was $1.6 million, an increase of 647% compared to 2014. Trailing 12-month earnings per share (diluted) are now $0.21. Cash flow from operations in the quarter was $2.6 million.

Conclusion: Over 80% of the company’s business is in U.S. dollars so it benefits from a weak loonie. Fundamentally, the company has earned around $0.21 per share over the past 12 months, a figure that would have grown by over $0.02 if various one-time costs were removed from the first quarter results. Removing the rolling hedges would have increased earnings by $0.028 in the second quarter and by $0.038 in the third quarter. Based on this, FTG trades at around seven times normalized trailing earnings, which is relatively attractive for a company with the potential to produce growth into 2016. The company’s Enterprise Value to EBITDA ratio of 5.4 is also relatively attractive.

Earnings before interest, tax, depreciation and amortization (EBITDA) for the trailing 12 months is $7.1 million, a significant increase from $5.6 million from the previous quarter. Looking forward, the company has a solid order book and we expect material growth. The company is set to release its year-end numbers this coming Monday.

We encourage readers to continue to pay attention to the opportunities that take advantage of Canada’s low currency relative to the U.S. dollar in 2016. Firan falls into that category.

Action now: We reiterate our Buy recommendation on the stock.

– end Ryan Irvine

 

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GORDON PAPE’S FUND UPDATES

Templeton Growth Fund (TML700)

Originally recommended on July 22/13 (#21327) at $12.35. Closed Thursday at $15.66.

This venerable fund has been around since 1954. It has had its ups and downs over the years but has been strong recently under the direction of the Bahamas-based team of James Harper, Heather Arnold, Tucker Scott, and Norman Boersma.

The fund’s mandate allows it to invest around the world and that’s exactly what the managers are doing. As of the end of October, about 38% of the assets were in U.S. stocks, with a focus on large-cap giants like Alphabet (Google), Amgen, Citigroup, and Microsoft.

Other large geographic positions include the U.K. (13%), France (7.6%), Japan (6%), with smaller positions under 5% in a number of other countries.

The fund was an above average performer in every year from 2011 to 2015. As of Dec. 31, the A units showed a five-year average annual compound rate of return of 12.3%, well above the category average of 9.4%. The latest one-year gain was 11.2% compared to 9.7% for the peer group.

The MER is a high 2.52% but in this case the returns justify the cost. Moreover, this fund is positioned where equity investors should be at the present time: on the global spectrum with virtually no exposure to Canada (Suncor is the only domestic stock the managers own) and a large position in the U.S.

Action now: Buy. The recent global sell-off has brought down the NAV to a more realistic level.

TD Advantage Balanced Income Portfolio (TDB2060)

Originally recommended on Feb. 13/12 (#21206) at $11.01. Closed Thursday at $12.07.

I recommended this fund of funds in 2012 as a good choice for conservative investors, and especially suitable for RRSPs. At the time, it was invested in five other TD funds; it now holds eight. The largest single component at 58% of total assets is the TD Canadian Core Plus Bond Fund Series O.

The asset mix is very defensive with 65% of the fund in fixed income securities and another 7% in cash and equivalents. On the equity side, the geographic distribution is 10% in Canada, 9% in the U.S., and 8% international.

The fund shows above average returns for all time frames out to five years. The five-year average annual compound rate of return is 5.5% compared to a 4.1% figure for the Canadian Fixed Income Balanced category. In 2015, the gain was a shade under 3%.

Especially important to low-risk investors is the fact the fund has never lost money over a 12-month period since it was launched in 2009.

You’ll never get rich with this one because of the nature of the portfolio but it’s still a fine choice for conservative investors generally and RRSPs in particular.

Action now: Buy.

Steadyhand Founders Fund (SIF125)

Originally recommended on Feb. 25/13 (#21308) at $10.73. Closed Thursday at $11.90.

This is a portfolio fund that invests in the five funds offered by the small Vancouver-based Steadyhand boutique house. Company founder and CEO Tom Bradley decides the composition of the portfolio, using a tactical asset allocation approach.

As of year-end, the fund was 59% invested in stocks, 25% in bonds, and 16% in cash and short-term securities. Canadian assets made up 44% of the total with 37% overseas and 19% in the U.S.

The fund is managed in a very conservative way with asset preservation one of Mr. Bradley’s main priorities. So far, he’s been very successful in protecting investors’ money, as the fund has never had a losing 12-month period since its launch in early 2012.

However, that low-risk approach also means relatively low returns. The fund posted a gain of 3.9% in 2015. That may seem unimpressive but keep in mind the TSX was down 11% for the year. The fund also outperformed the peer group, which only added 0.9%.

The three-year average annual compound rate of return to Dec. 31 was 8.6% compared to a category average of 7.3%. The MER is on the low side for a mutual fund at 1.34%. However, the minimum investment per fund is $10,000.

Action now: Buy.

Steadyhand Income Fund (SIF120)

Originally recommended on Jan. 23/12 (#21203) at $10.56. Closed Thursday at $10.63.

Although this fund is 75% invested in bonds, it experienced a down year in 2015, losing 1.2%. The reason is that the other 25% of the assets are held in dividend-paying stocks and REITs, two categories that struggled last year. Despite the blip, the fund still shows a five-year average annual compound rate of return of almost 6%, well ahead of the 4.1% peer group average. The MER is a reasonable 1.04% and there is no sales commission, however there is a $10,000 minimum. This is still a good choice for low-risk investors.

Action now: Buy.

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

Originally recommended on May 8/05 (#2518) at $10.96. Closed Thursday at $11.53.

We recommended this as a core bond fund over a decade ago. It has lived up to its promise of being one of the best of its type and continues to do so. The ten-year average annual compound rate of return of 4.8% (D units) is well ahead of the category average of 3.5%. The gain in 2015 was 3.2% compared to less than 1% for the peer group. The fund rarely loses money, even in difficult years. Its worst 12-month decline was in the period ending Sept. 30, 2013 when it slipped 1.01%.

I strongly recommend holding some fixed income securities during these turbulent times and this fund is an excellent way to do that. The MER for the no-load D units, which I recommend, is only 0.59% making this one of the best value-for-money mutual funds you’ll find.

Action now: Buy.

Mawer U.S. Equity Fund (MAW108)

Originally recommended on Feb. 25/13 (#21308) at $22.04. Closed Thursday at $35.64.

The Calgary-based Mawer organization is frequently overlooked by investors despite the fact it offers low-cost funds that consistently outperform.

This fund, which I first recommended about three years ago, is an example. It invests in a portfolio of mainly large cap stocks, including such names as Alphabet, JPMorgan Chase, Comcast, Oracle, and Johnson & Johnson. The assets are well diversified by sector, with no heavy overweighting. Information technology tops the list at 22% with financials at 20%, consumer discretionary at 15%, healthcare at 12%, and industrials at 10%. Energy stocks only make up 5% of the assets.

Performance has been excellent. The three-year average annual compound rate of return to Dec. 31 was 26.9% compared to a peer group average of 21.9%. Over the latest 12 months the fund gained 19.3%, again handily beating the average.

Since this is a pure stock fund, with minimal cash holdings, there is risk, of course. As of Jan. 28, the fund was showing a year-to-date loss of 6.1%, reflecting the correction in the U.S. market. However, based on past experience I believe this is just a hiccup.

This is a core U.S. stock fund with a very reasonable MER of 1.21%. If you are underweighted in the American market and can afford the $5,000 minimum investment, this is a very good choice.

Action now: Buy.

 

That’s it for this week. We’ll be back on Feb. 8.

Best regards,
Gordon Pape