In This Issue

WHAT COULD GO RIGHT?

By Gordon Pape

What’s the biggest contributor to global warming these days? How about all the hot air coming out of Washington?

As the stand-off over the budget continues in the U.S. Congress, the finger-pointers are vying with the doomsayers for media attention. It’s hard to say who’s winning at this stage but both are getting more than their fair share of exposure.

The Democrats blame the Republicans, specifically the Tea Party faction, for the partial shutdown of U.S. government services. As you might expect, the Republicans and their mouthpiece, Fox News, accuse the Democratic-controlled Senate and President Obama of obstructing reasonable proposals to end the dispute, all of which involve some sort of attack on the President’s health care program. So far, the public opinion polls suggest the Democrats are getting their message across more effectively.

As the shutdown grinds on, attention is increasingly focused on stage two of this drama, which occurs on Oct. 17 when the U.S. hits its debt ceiling. If Congress fails to pass legislation to raise the ceiling, the American government could be placed in the position of defaulting on its debt. That, said the Treasury Department last week, would be “catastrophic” for both the U.S. and the global economies.

The Treasury hauled out its heaviest verbal artillery, raising the spectre of a repeat of 2008 if Congress doesn’t find a solution. “Credit markets could freeze, the value of the U.S. dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse,” the statement said. I’m surprised they didn’t add that the sky might fall too.

Of course, the Treasury Department is part of the executive branch of the U.S. Government, with its Secretary appointed by the President so it’s not exactly impartial in this dispute. It’s also worth noting the number of times the words “could” and “might” are embedded in the statement (six, if you didn’t go back and count). The plain fact is that no one really knows what would happen if Congress doesn’t raise the debt ceiling on time since this is uncharted territory.

Christine Lagarde, the head of the International Monetary Fund (IMF), agrees that failure to raise the debt ceiling would harm the global economic recovery and said it was “mission critical” for U.S. legislators to get their act together. But her tone was more sombre than strident. Unlike the U.S. Treasury, she didn’t warn of the possibility of another 2008 or the end of the financial world as we know it.

In fact, such a dire outcome is highly improbable, as the behaviour of the markets since the shutdown began on Oct. 1 has indicated. Yes, the Dow and the S&P 500 were down on the week, by 1.22% and 0.07% respectively. But that’s hardly panic territory and both indexes were up on Friday.

The price of gold was an even more significant indication that investors don’t take the doom-and-gloom rhetoric overly seriously. In times of economic and financial crisis, gold is a traditional safe haven. That’s doubly so when the U.S. dollar is expected to decline. But what did we see last week? Bullion fell in value. The precious metal lost US$31.25 per ounce, falling on the London Exchange from US$1,341 as of the Sept. 27 close to US$1,309.75 on Oct. 4. If we are really hurtling towards disaster, we should have seen a big spike in the bullion price.

A few weeks ago I wrote a column titled “What could go wrong?” in which I warned of the possibility of the Washington showdown we are now experiencing. So perhaps it’s time to turn that around and ask: “What could go right?” The answer is the Democrats and Republicans could find some face-saving compromise to end the crisis.

Stock markets would rally, consumer confidence would be given a boost as the run-up to Christmas begins, and the economy could get on with the slow task of recovery.

What are the chances of that happening? Actually, reasonably good. There are currently 232 Republicans in the House of Representatives (versus 200 Democrats). Of those, only 49 are members of the Tea Party caucus. They are concentrated in three areas of the U.S., the southwest (New Mexico and Texas), the plains states (Kansas, Iowa, and Nebraska), and the south (Louisiana, Georgia, South Carolina, and Tennessee).

In short, what we have right now is a situation in which the shrill Tea Party tail is wagging the Republican dog – and, judging from reports from Washington, the dog is becoming increasingly irritated.

Philosophically, all Republicans agree on the principles of smaller government and lower taxes. But many veteran members of the House also recognize that politics is the art of the possible and a campaign to destroy Obamacare by holding the U.S. economy to ransom isn’t going to fly. Moreover, the longer this drags on the more the party risks alienating voters in such key areas as the north-east and far west in the upcoming 2014 mid-term elections.

This suggests that a compromise in the next couple of weeks is the most likely outcome. The possibility of the U.S. going over the cliff can’t be ruled out, of course. But my hunch is they’ll work it out and we’ll see a late October stock market rally as a result.

 

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DEFENSIVE PORTFOLIO UPDATE

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In the lead article of last week’s issue I wrote that it has become clear that the defensive investment strategy that worked so well since the crash of 2008-09 has run its course. For evidence, we need look no farther than the performance of the IWB Defensive Portfolio.

This was the first model portfolio we ever created. It was launched in March 2008 as a result of our growing concern that stock markets were getting too pricy. We were a little early but the crash began a few months later and continued to drag down share prices until early March 2009. Our portfolio, which was designed to protect capital while providing good cash flow and reasonable growth potential, didn’t escape scot-free. But the loss of 15.6% was much better than the plunge of close to 50% in the TSX. Since then, the portfolio has done very well – until now, that is.

When we last reviewed the portfolio in late March, the market value of all our securities was $14,280.82. Since then, every single one of them has lost ground. At the close of trading on Sept. 30, the market value was down to $13,630.80. We made up a little of that through dividends/distributions of $264.11 but the net result is that the portfolio’s total value fell 2.4%. That’s not a disaster, but it’s a sign of the new times we’re living in.

The original asset mix of this portfolio was 40% bonds and 60% blue-chip stocks, with a valuation of $10,000. Over time, the strong performance of the equities in the portfolio changed the balance and in September 2012 the bond portion had dropped to 33.3%. We did some rebalancing at that point to bring it closer to the original target. The components of the revised portfolio were:

iShares DEX Universe Bond Fund (TSX: XBB).
Walmart (NYSE: WMT)
Fortis (TSX: FTS, OTC: FRTSF)
Enbridge (TSX, NYSE: ENB)
BCE Inc. (TSX, NYSE: BCE)
TransCanada Corp. (TSX, NYSE: TRP)
Bank of Nova Scotia (TSX, NYSE: BNS)

Here are the latest results, based on returns to the close of trading on Sept. 30. Brokerage commissions have not been taken into account and the Canadian and U.S. dollars are deemed to be at par for tracking purposes. Fractional shares are shown for greater accuracy.

IWB Defensive Portfolio
(as of Sept. 30/13)

Security
Weight
%
Total
Shares
Average
Cost
Book
Value
Current
Price
Market
Value
Cash
Flow
Gain/
Loss %
XBB
38.4
174.00
$29.65
$5,159.10
$30.06
$5,230.44
$791.52
+16.7
WMT
11.0
20.19
$75.14
$1,517.08
$73.96
$1,493.25
$27.29
+0.02
FTS
9.7
42.46
$23.55
$999.93
$31.29
$1,328.57
$220.37
+54.9
ENB
10.4
33.00
$20.44
$674.52
$43.02
$1,419.66
$280.32
+152.1
BCE
9.0
28.00
$25.41
$711.48
$44.02
$1,232.56
$362.29
+124.2
TRP
10.4
31.19
$32.06
$999.95
$45.25
$1,411.35
$247.65
+65.9
BNS
11.0
25.45
$56.57
$1,439.71
$59.00
$1,501.55
$137.75
+13.9
Interest
0.1
$13.42
Totals
100.0
$11,501.77
$13,630.80
$2,067.19
+36.5
Inception
$10,000.00
+56.8

Comments: The market value of the portfolio now stands at $13,630.80. Add the $2,067.10 that we received in dividends/distributions and the total value is now $15,697.99. Despite the latest setback, the portfolio has gained 56.8% from the original $10,000 investment. That works out to an average annual compound rate of return of 8.54% in the five and a half years since this portfolio was created. That’s down from our last review in March, but it is still very good in the context of a defensive portfolio.

The question is what to do now? This is a defensive portfolio by definition and we can’t change its fundamental mandate. However, we can reduce our exposure to the new risks to defensive securities to some extent.

We’ll begin by selling our entire position in iShares DEX Universe Bond Fund. Including accumulated cash, that will give us $6,021.96. We will also sell our position in TransCanada Inc. for a total of $1,659, including accumulated distributions. Until now, we have had two pipeline companies in the portfolio, Enbridge being the other. This is too much exposure to that sector in the circumstances. Our total amount available for reinvestment is therefore $7,680.96.

We will invest $5,696 in 200 units of the iShares DEX Short Term Bond Fund (TSX: XSB) which closed on Sept. 30 at $28.48. This fund is not immune from interest-rate risk but it is more defensive in nature than XBB.

I’ve been saying for some time that the U.S. market is better positioned than the TSX for the current economic conditions. However, we only have one U.S. stock in our portfolio, Walmart. We will add more U.S. exposure by purchasing 48 shares of Wells Fargo (NYSE: WFC) at a price of $41.32 for an investment of $1,983.36. That leaves us with cash of $1.60, which we will add to the accumulated interest.

Here’s a look at the revised portfolio.

IWB Defensive Portfolio
(revised Sept. 30/13)

Security
Weight
%
Total
Shares
Average
Cost
Book
Value
Current
Price
Market
Value
Cash
Flow
XSB
38.8
200.00
$28.48
$5,696.00
$28.28
$5,696.00
0
WMT
10.2
20.19
$75.14
$1,517.08
$73.96
$1,493.25
$27.29
FTS
9.1
42.46
$23.55
$999.93
$31.29
$1,328.57
$220.37
ENB
9.7
33.00
$20.44
$674.52
$43.02
$1,419.66
$280.32
BCE
8.4
28.00
$25.41
$711.48
$44.02
$1,232.56
$362.29
WFC
13.5
48.00
$41.32
$1,983.36
$41.32
$1,983.36
0
BNS
10.2
25.45
$56.57
$1,439.71
$59.00
$1,501.55
$137.75
Interest
0.1
$15.02
$15.02
Totals
100.0
$13,037.10
$14,669.97
$1,028.02
Inception
$10,000.00

We will invest the accumulated dividends and interest of $1,043.04 in a high-interest savings account paying 1.35%. I’ll review the portfolio again in March. – G.P.

 

IS THE STOCK MARKET EXPENSIVE OR CHEAP?

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Contributing editor Ryan Irvine is back with us this week with an analysis of the U.S. stock market and an update on one of his most successful recommendations. Ryan is the CEO of Keystone Financial (www.KeyStocks.com) and one of Canada’s leading experts on small-cap securities. Here is his report.

Ryan Irvine writes:

With the S&P 500 up over 18% year-to-date and about 34% since the beginning of 2012, it is fair to ask if broader North American markets should be considered overvalued. Anecdotally, it is certainly more difficult to identify striking value than it has been over the past several years. But it’s not impossible as growth has picked up in select areas.

We have seen this notably in Western Canadian infrastructure with companies like Macro Industries (TSX-V: MCR, OTC: MCESF). Macro is a recent addition to our research coverage – it was recommended in June and is up 65% since then. This is a company that operates in a true pocket of strength.

One of the most popular (but not necessarily best) ways of measuring a market’s valuation is the price/earnings ratio.

While no one disagrees about what the “p” is when calculating the ratio, there is no consensus on how to define the “e” – earnings per share. One point of dispute is on whether to use analysts’ earnings estimates for the coming year or reported company earnings from the previous 12 months (trailing earnings). For the record, we consider both as well as a number of other factors.

Consider the S&P 500’s current p/e based on trailing earnings. For the four quarters through June 30, the index’s earnings per share amounted to $91.16, according to S&P Dow Jones Indices. That translates into a p/e ratio of 19.31, which is higher than 79% of comparable readings since 1871, according to a database maintained by Yale University professor Robert Shiller. This paints a bearish near-term perspective.

Current S&P 500 PE Ratio: 19.31

Oct-13    
Mean:
15.5
Median:
14.51
Min:
5.31
(Dec 1917)
Max:
123.79
(May 2009)

PE since 1871

Of course, bulls will point out that forward estimates for earnings call for strong growth in 2014. According to FactSet Data Systems, the consensus from Wall Street analysts is that earnings from companies in the S&P 500 will be $121.95 a share next year, which translates into a p/e ratio of 13.6. That is 6% less than the 14.5 median of historical p/e ratios in Prof. Shiller’s database.

Bears will counter-punch with the widely acknowledged fact that Wall Street analysts, many from the sell side, are forever too optimistic. In addition, analysts’ estimates focus on what’s known as “operating earnings,” a looser category than the actual reported earnings used to calculate the average of past p/e ratios. Thus, they are often adjusted higher.

This leaves us in a formidable tug-of-war in terms of broader market valuations.

If we take a look at the p/e on the S&P over the past 20-years, we get an average of 25.23 which paints the current p/e of 18.2-18.8 in a bullish light. However, one must remember that from a historical perspective, the last 20 years have boasted some of the highest multiples on record including the 2009 mark of 70.89 following the credit crisis and the tech bubble induced mark of 46.18 in 2002 which have skewed the multiple higher. Remove these two years and the average drops considerably to 21.53, but this still remains well above the historical mean of 15.5.

There are of course other methods based on earnings which we can employ to value the state of the broader market. One method which has proven successful in identifying market extremes (both over and undervalued) is the Shiller p/e ratio or cyclically adjusted price-to-earnings ratio, commonly known as CAPE. Developed by Robert Shiller and built off the work of legendary value investors Benjamin Graham and David Dodd, CAPE is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of 10 years of earnings, adjusted for inflation.

The central theme behind the CAPE is simple. Taking a multiple of one year’s earnings is misleading because stock markets naturally adjust when investors believe profits are cyclically high or cyclically low. Compare prices instead to the average of earnings over 10 years (Prof. Shiller also corrects for inflation) and it becomes clearer whether stock markets are overvalued or undervalued.

For over a century, extremes in the CAPE have coincided with favourable times to buy and sell. By staying far above its long-term average during the 2003 to 2007 rebound that followed the Internet bust, the CAPE also provided a warning that the rally was not to be trusted – ahead of the far worse crisis of 2007-09.

Prof. Shiller and the CAPE are sounding the alarm once again, recently implying that the U.S. market is 62% overvalued and more expensive than any other big stock market.

Current Shiller PE Ratio: 24.22

Oct-13    
Mean:
16.49
Median:
15.89
Min:
4.78
(Dec 1920)
Max:
44.2
(Dec 1999)

Shiller PE Since 1871

Economics without debate is like politics without scandal. It’s not going to happen. It should be no surprise that the CAPE is under attack from another renowned economist, Jeremy Siegel, who contends that it is based on faulty data. Many on Wall Street discount CAPE, but most have a vested interest.

Prof. Siegel of the University of Pennsylvania’s Wharton School has produced a new version of the CAPE, which he says corrects Prof. Shiller’s mistakes. His version of the CAPE suggests that the U.S. stock market is sending a different signal – stocks are cheap.

Many investors, both short and long term, will contend that outside of the few days of the market crash in March 2009 when the CAPE fell briefly below its long-term average, Shiller’s indicator has shown that U.S. stocks have been overvalued for over 20 years. Yet the benchmark S&P 500 has more than doubled since March 2009. It also doubled between 2003 and 2007. In total, the benchmark is up over 275% over the past 20 years.

Yes, the most recent “great recession” saw the largest drop in corporate profits on record. But consumer debt levels remain near record highs in the developed world and domestic growth is still muted at best. Supporters of CAPE will point out that casting doubt on metrics is a classic symptom of bubbles. Back in the tech bubble, analysts went from valuing companies based on price-to-earnings to price to-eyeballs or “Internet site impressions.”

Quite frankly, we do not see anything close to this type of mania at present. Corporate balance sheets continue to strengthen and profits are trending in the right direction. Total U.S. household debt fell another $78 billion, or 0.7%, in the third quarter of this year. Since peaking in the third quarter of 2008, American households have reduced their debt burdens by $1.53 trillion, or 12%. Deleveraging is a positive story of the last few years. The shift is even more dramatic relative to the size of the overall economy; household debt totaled 85% of GDP in the third quarter of 2008 and was down to 67% in the second quarter of 2013.

But there is plenty of reason to worry broadly about the economy including public (unfunded pension liabilities included) and private (consumer) debt. While U.S. consumer debt has been headed in the right direction, levels still remain historically high. U.S. unemployment is also a big concern.

Within Canada, our relative insulation from the great recession has unfortunately spared us a valuable lesson and consumer debt has not been paid down. In fact, Canadians are borrowing more, piling on consumer debt – credit cards, conventional bank loans, car loans, and lines of credit. At some point this ends and a spending vacuum could limit growth.

Perhaps this partially justifies the S&P/TSX Composite’s poor performance on a relative basis, being up a scant 2.6% this year and about 7% since the start of 2012. Slumping commodity prices are also a major contributor to the underperformance of the resource-laden TSX.

So where does this epic tug-o-war leave us? Which one of these statements is true: “The stock market is overvalued” or “The stock market is undervalued”? Every day you can find pundits with a strong opinion either way.

From our perspective, both statements are simplistic and most often irrelevant. It is a market of stocks, not a stock market.

We do not recommend you buy “the market,” when you look to beat the market. Our clients create their Small-Cap Growth Stock Portfolios with discipline by purchasing 8-12 cash producing stocks over a 12-18 month period. Our holding periods are typically from one to five years and beyond.

Over that period, the broader market will have its ups, when it is likely overvalued based on a number of metrics, and downs, when it may show as undervalued based on those same metrics. What is important to us and to you is whether your 8-12 stocks are continuing to create shareholder value through a number of company-specific metrics including cash flow increases, growth, a higher return of capital (dividends), and an improving balance sheet.

Outside of this, Mr. Market will create a great deal of “noise” on a day-to-day basis. Try not to pay too much attention – it will allow you to sleep far better each night.

RYAN IRVINE UPDATES ENGHOUSE SYSTEMS

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Enghouse Systems Limited (TSX: ESL, OTC: EGHSF)

Originally recommended on March 7/11 (#21109) at C$9.10. Closed Friday at C$26.45, US$24.89 (Sept. 23).

Enghouse Systems was introduced to the IWB in March 2011 when the stock traded at $9.10. In our July IWB update with the stock at $23.74, we maintained our near and long-term ratings at Hold. While we continue to like the business long-term, the near-term rating change was strictly based on valuations which appeared to be closer to fair market price. Today, with the stock reaching new all-time highs in the $26-$27 range, we review the company’s recently released third-quarter results and our rating on the stock.

Enghouse develops enterprise software solutions for a variety of vertical markets. The company is organized around two business segments: the Interaction Management Group (IMG), which accounted for 78% of third-quarter revenue, and the Asset Management Group (AMG) which generated 22%.

On Sept. 10, Enghouse reported its financial results for the quarter ended July 31. Revenue was $46.3 million, an increase of 31% over last year, with incremental revenue coming primarily from acquisitions. Adjusted EBITDA for the quarter was $12.2 million ($0.46 per share, fully diluted) compared to $9.2 million ($0.35 per share) in last year’s third quarter. Net income was $6.3 million ($0.24 per share) compared to the prior year’s net income of $4.3 million ($0.16 per share).

On a year-to-date basis, revenue was $132.7 million compared to $97.4 million, an increase of 36%. Adjusted EBITDA was $32.5 million ($1.23 per share) compared to $24.9 million ($0.96 per share).

Once again, we were pleased with Enghouse’s results which came in slightly above consensus estimates on an adjusted basis. The quarter saw organic growth of a solid 4%. However, we continue to expect low single-digit organic growth going forward given the tepid improvement in the company’s main markets. The general economic climate continues to present challenges to the business, particularly in Europe.

The real story with Enghouse, as it has been since day one, is the strong free cash flow generation and growth via smart accretive acquisitions. Both continued in the first nine months of fiscal 2013. The near-term and mid-term environment continues to be favourable for the later.

We estimate Enghouse could generate over $45 million in EBITDA this year and over $55 million in 2014 without further acquisitions. This will provide plenty of fuel to fund a combination of acquisitions and ongoing dividend hikes. We have seen the dividend grow at a rate of greater than 20% over the past five years yet the stock currently yields a modest 1.2% due to the strong share price appreciation.

At first glance, with a trailing p/e of just above 32, Enghouse does not appear cheap. Indeed, with the share price up 190% since our original recommendation, the stock is no longer what we would consider a bargain. In fact, in the near term, we believe the company is at its fair value in its current range.

However, when we dig a little deeper we find that the company’s consensus EPS 2014 estimate is in the range of $1.15. If we strip out the $3.55 per share in cash and just look at the base business, the forward-looking p/e is a more reasonable 20. On a cash flow basis, the stock no longer trades at a discount to its peers.

In the near term, we believe organic growth will be challenging but recent acquisitions will provide decent overall growth. The market is now finally catching up to the Enghouse story and is more willing to pay a premium for the strong free cash flow and earnings power going forward. Enghouse trades at 13 times 2014 expected EBITDA.

Action now: We maintain our near- and long-term ratings at Hold as the stock is close to fair value at present. The company is well run and continues to hold above average upside potential over the next two to three years. Enghouse is on target over the next 12 months to reach a revenue run rate of approximately $200 million. Long term, we project the company will become more widely followed in the Canadian broker community due to the strong track record management its building.

GORDON PAPE’S UPDATES

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Trinidad Drilling (TSX: TDG, OTC: TDGCF)

Originally recommended on April 11/11 (#21114) at C$10, US$10.44. Closed Friday at C$10.01, US$9.71.

Trinidad Drilling continued its upsurge over the summer, trading as high as $10.84 in late September before pulling back to its current level, which is close to our original recommended price. This is a remarkable comeback for a stock that got as low as the $5 range in June 2012 and then bounced around the $7 level for the better part of a year. However, as I noted in my last update in March, the company’s decent financial results gave us good reason to retain our positions.

It was therefore somewhat surprising that the stock continued to climb even after the company released second-quarter returns (to June 30) that were disappointing. Revenue for the period was off 5.1% year-over-year to $165.4 million. Even worse, adjusted net income plunged from $13.1 million ($0.11 a share) in 2012 to a mere $2.6 million ($0.02 a share) this year. The company blamed reduced U.S. and international activity and a delay from the first to the second quarter of repairs and maintenance costs for the deterioration in results.

Year-to-date, adjusted net earnings as of June 30 were $38.2 million ($0.32 a share), down from $55.8 million ($0.46 a share) a year ago.

Looking ahead, management does not foresee a major upsurge in activity but is looking for some modest improvement in 2014. They believe that the company’s modern equipment will keep it in a strong competitive position.

“Trinidad expects that industry conditions will remain relatively stable in 2013 and is seeing early indications of increased activity levels in 2014,” management said in its outlook statement. “The company expects that its modern, high performance equipment will continue to be in demand; however, unless commodity prices increase there will be limited demand for less modern equipment. Approximately three-quarters of Trinidad’s fleet are considered high performance; these rigs have demonstrated their ability to continue to meet customers’ needs by achieving high activity levels and stable dayrates. Trinidad currently has approximately 50% of its fleet under long-term, take-or-pay contracts with an average term remaining of approximately 1.5 years, providing the company with significant revenue stability.”

So why has the stock moved up by about 40% since March? Part of the surge can be attributed to the Sept. 3 announcement of a joint venture with U.S. energy services giant Halliburton (NYSE: HAL) to provide and operate drilling rigs for Halliburton’s international integrated projects. Under the arrangement, to be called Trinidad Drilling International, the joint venture will get first crack at providing drilling rigs for all of Halliburton’s onshore projects outside Canada and the U.S. The initial emphasis will be on Saudi Arabia and Mexico.

The first deal will be to provide four rigs for a three-year project, plus one year optional, in Saudi Arabia. Trinidad, which is the majority (60%) partner in the joint venture, will invest $72 million in this initial project.

“We see this agreement as a significant milestone for Trinidad in international markets” said company CEO Lyle Whitmarsh. “By aligning ourselves with a major oilfield services company, such as Halliburton, we are able to open the doors to a new level of international growth. Trinidad will benefit from Halliburton’s international operating experience and infrastructure and will gain access to the integrated project management market. In return, we can provide Halliburton with high-performance drilling services and strong operating performance that will enhance their ability to win future integrated projects.”

It remains to be seen how profitable this new venture will be over time but the initial reaction of the markets was positive, with the shares rising by more than a dollar in the week after the news came out.

RBC Capital Markets said the deal offers a “tremendous long-term growth opportunity” but does not expect any positive impact on the bottom line until 2015.

Action now: Buy below $10. Note that this stock is only suitable for investors who can handle risk.

MEMBERS’ CORNER

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U.S. withholding tax

Follow-up: Last week I commented on an e-mail from a member who was wondering about the withholding tax on dividends from U.S. companies paid to TFSAs and RESPs. He asked whether there were any products that could be used to avoid this. I said I wasn’t aware of any.

Right after that appeared, Globe and Mail personal finance columnist Rob Carrick wrote a column in which he mentioned swap-based exchange-traded funds (ETFs). In it, he noted that the Horizons S&P 500 Index ETF (TSX: HXS) is structured in such a way that no dividends are actually received, and therefore the withholding tax is not applied. All profits are in the form of capital gains. That makes this ETF more tax-efficient for TFSAs, RESPs, and non-registered accounts.

As of the close of trading on Sept. 30, the fund was showing a year-to-date gain of 21.2%. The S&P 500 was up 17.9% in the same period so this ETF is actually outperforming the index to this point. The management fee is a very reasonable 0.15%. – G.P.

 

That’s it for this issue. We’ll be back on Tuesday Oct. 15. Happy Thanksgiving to all.

Best regards,

Gordon Pape

In This Issue

WHAT COULD GO RIGHT?

By Gordon Pape

What’s the biggest contributor to global warming these days? How about all the hot air coming out of Washington?

As the stand-off over the budget continues in the U.S. Congress, the finger-pointers are vying with the doomsayers for media attention. It’s hard to say who’s winning at this stage but both are getting more than their fair share of exposure.

The Democrats blame the Republicans, specifically the Tea Party faction, for the partial shutdown of U.S. government services. As you might expect, the Republicans and their mouthpiece, Fox News, accuse the Democratic-controlled Senate and President Obama of obstructing reasonable proposals to end the dispute, all of which involve some sort of attack on the President’s health care program. So far, the public opinion polls suggest the Democrats are getting their message across more effectively.

As the shutdown grinds on, attention is increasingly focused on stage two of this drama, which occurs on Oct. 17 when the U.S. hits its debt ceiling. If Congress fails to pass legislation to raise the ceiling, the American government could be placed in the position of defaulting on its debt. That, said the Treasury Department last week, would be “catastrophic” for both the U.S. and the global economies.

The Treasury hauled out its heaviest verbal artillery, raising the spectre of a repeat of 2008 if Congress doesn’t find a solution. “Credit markets could freeze, the value of the U.S. dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse,” the statement said. I’m surprised they didn’t add that the sky might fall too.

Of course, the Treasury Department is part of the executive branch of the U.S. Government, with its Secretary appointed by the President so it’s not exactly impartial in this dispute. It’s also worth noting the number of times the words “could” and “might” are embedded in the statement (six, if you didn’t go back and count). The plain fact is that no one really knows what would happen if Congress doesn’t raise the debt ceiling on time since this is uncharted territory.

Christine Lagarde, the head of the International Monetary Fund (IMF), agrees that failure to raise the debt ceiling would harm the global economic recovery and said it was “mission critical” for U.S. legislators to get their act together. But her tone was more sombre than strident. Unlike the U.S. Treasury, she didn’t warn of the possibility of another 2008 or the end of the financial world as we know it.

In fact, such a dire outcome is highly improbable, as the behaviour of the markets since the shutdown began on Oct. 1 has indicated. Yes, the Dow and the S&P 500 were down on the week, by 1.22% and 0.07% respectively. But that’s hardly panic territory and both indexes were up on Friday.

The price of gold was an even more significant indication that investors don’t take the doom-and-gloom rhetoric overly seriously. In times of economic and financial crisis, gold is a traditional safe haven. That’s doubly so when the U.S. dollar is expected to decline. But what did we see last week? Bullion fell in value. The precious metal lost US$31.25 per ounce, falling on the London Exchange from US$1,341 as of the Sept. 27 close to US$1,309.75 on Oct. 4. If we are really hurtling towards disaster, we should have seen a big spike in the bullion price.

A few weeks ago I wrote a column titled “What could go wrong?” in which I warned of the possibility of the Washington showdown we are now experiencing. So perhaps it’s time to turn that around and ask: “What could go right?” The answer is the Democrats and Republicans could find some face-saving compromise to end the crisis.

Stock markets would rally, consumer confidence would be given a boost as the run-up to Christmas begins, and the economy could get on with the slow task of recovery.

What are the chances of that happening? Actually, reasonably good. There are currently 232 Republicans in the House of Representatives (versus 200 Democrats). Of those, only 49 are members of the Tea Party caucus. They are concentrated in three areas of the U.S., the southwest (New Mexico and Texas), the plains states (Kansas, Iowa, and Nebraska), and the south (Louisiana, Georgia, South Carolina, and Tennessee).

In short, what we have right now is a situation in which the shrill Tea Party tail is wagging the Republican dog – and, judging from reports from Washington, the dog is becoming increasingly irritated.

Philosophically, all Republicans agree on the principles of smaller government and lower taxes. But many veteran members of the House also recognize that politics is the art of the possible and a campaign to destroy Obamacare by holding the U.S. economy to ransom isn’t going to fly. Moreover, the longer this drags on the more the party risks alienating voters in such key areas as the north-east and far west in the upcoming 2014 mid-term elections.

This suggests that a compromise in the next couple of weeks is the most likely outcome. The possibility of the U.S. going over the cliff can’t be ruled out, of course. But my hunch is they’ll work it out and we’ll see a late October stock market rally as a result.

 

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DEFENSIVE PORTFOLIO UPDATE

In the lead article of last week’s issue I wrote that it has become clear that the defensive investment strategy that worked so well since the crash of 2008-09 has run its course. For evidence, we need look no farther than the performance of the IWB Defensive Portfolio.

This was the first model portfolio we ever created. It was launched in March 2008 as a result of our growing concern that stock markets were getting too pricy. We were a little early but the crash began a few months later and continued to drag down share prices until early March 2009. Our portfolio, which was designed to protect capital while providing good cash flow and reasonable growth potential, didn’t escape scot-free. But the loss of 15.6% was much better than the plunge of close to 50% in the TSX. Since then, the portfolio has done very well – until now, that is.

When we last reviewed the portfolio in late March, the market value of all our securities was $14,280.82. Since then, every single one of them has lost ground. At the close of trading on Sept. 30, the market value was down to $13,630.80. We made up a little of that through dividends/distributions of $264.11 but the net result is that the portfolio’s total value fell 2.4%. That’s not a disaster, but it’s a sign of the new times we’re living in.

The original asset mix of this portfolio was 40% bonds and 60% blue-chip stocks, with a valuation of $10,000. Over time, the strong performance of the equities in the portfolio changed the balance and in September 2012 the bond portion had dropped to 33.3%. We did some rebalancing at that point to bring it closer to the original target. The components of the revised portfolio were:

iShares DEX Universe Bond Fund (TSX: XBB).
Walmart (NYSE: WMT)
Fortis (TSX: FTS, OTC: FRTSF)
Enbridge (TSX, NYSE: ENB)
BCE Inc. (TSX, NYSE: BCE)
TransCanada Corp. (TSX, NYSE: TRP)
Bank of Nova Scotia (TSX, NYSE: BNS)

Here are the latest results, based on returns to the close of trading on Sept. 30. Brokerage commissions have not been taken into account and the Canadian and U.S. dollars are deemed to be at par for tracking purposes. Fractional shares are shown for greater accuracy.

IWB Defensive Portfolio
(as of Sept. 30/13)

Security
Weight
%
Total
Shares
Average
Cost
Book
Value
Current
Price
Market
Value
Cash
Flow
Gain/
Loss %
XBB
38.4
174.00
$29.65
$5,159.10
$30.06
$5,230.44
$791.52
+16.7
WMT
11.0
20.19
$75.14
$1,517.08
$73.96
$1,493.25
$27.29
+0.02
FTS
9.7
42.46
$23.55
$999.93
$31.29
$1,328.57
$220.37
+54.9
ENB
10.4
33.00
$20.44
$674.52
$43.02
$1,419.66
$280.32
+152.1
BCE
9.0
28.00
$25.41
$711.48
$44.02
$1,232.56
$362.29
+124.2
TRP
10.4
31.19
$32.06
$999.95
$45.25
$1,411.35
$247.65
+65.9
BNS
11.0
25.45
$56.57
$1,439.71
$59.00
$1,501.55
$137.75
+13.9
Interest
0.1
$13.42
Totals
100.0
$11,501.77
$13,630.80
$2,067.19
+36.5
Inception
$10,000.00
+56.8

Comments: The market value of the portfolio now stands at $13,630.80. Add the $2,067.10 that we received in dividends/distributions and the total value is now $15,697.99. Despite the latest setback, the portfolio has gained 56.8% from the original $10,000 investment. That works out to an average annual compound rate of return of 8.54% in the five and a half years since this portfolio was created. That’s down from our last review in March, but it is still very good in the context of a defensive portfolio.

The question is what to do now? This is a defensive portfolio by definition and we can’t change its fundamental mandate. However, we can reduce our exposure to the new risks to defensive securities to some extent.

We’ll begin by selling our entire position in iShares DEX Universe Bond Fund. Including accumulated cash, that will give us $6,021.96. We will also sell our position in TransCanada Inc. for a total of $1,659, including accumulated distributions. Until now, we have had two pipeline companies in the portfolio, Enbridge being the other. This is too much exposure to that sector in the circumstances. Our total amount available for reinvestment is therefore $7,680.96.

We will invest $5,696 in 200 units of the iShares DEX Short Term Bond Fund (TSX: XSB) which closed on Sept. 30 at $28.48. This fund is not immune from interest-rate risk but it is more defensive in nature than XBB.

I’ve been saying for some time that the U.S. market is better positioned than the TSX for the current economic conditions. However, we only have one U.S. stock in our portfolio, Walmart. We will add more U.S. exposure by purchasing 48 shares of Wells Fargo (NYSE: WFC) at a price of $41.32 for an investment of $1,983.36. That leaves us with cash of $1.60, which we will add to the accumulated interest.

Here’s a look at the revised portfolio.

IWB Defensive Portfolio
(revised Sept. 30/13)

Security
Weight
%
Total
Shares
Average
Cost
Book
Value
Current
Price
Market
Value
Cash
Flow
XSB
38.8
200.00
$28.48
$5,696.00
$28.28
$5,696.00
0
WMT
10.2
20.19
$75.14
$1,517.08
$73.96
$1,493.25
$27.29
FTS
9.1
42.46
$23.55
$999.93
$31.29
$1,328.57
$220.37
ENB
9.7
33.00
$20.44
$674.52
$43.02
$1,419.66
$280.32
BCE
8.4
28.00
$25.41
$711.48
$44.02
$1,232.56
$362.29
WFC
13.5
48.00
$41.32
$1,983.36
$41.32
$1,983.36
0
BNS
10.2
25.45
$56.57
$1,439.71
$59.00
$1,501.55
$137.75
Interest
0.1
$15.02
$15.02
Totals
100.0
$13,037.10
$14,669.97
$1,028.02
Inception
$10,000.00

We will invest the accumulated dividends and interest of $1,043.04 in a high-interest savings account paying 1.35%. I’ll review the portfolio again in March. – G.P.

 

IS THE STOCK MARKET EXPENSIVE OR CHEAP?

Contributing editor Ryan Irvine is back with us this week with an analysis of the U.S. stock market and an update on one of his most successful recommendations. Ryan is the CEO of Keystone Financial (www.KeyStocks.com) and one of Canada’s leading experts on small-cap securities. Here is his report.

Ryan Irvine writes:

With the S&P 500 up over 18% year-to-date and about 34% since the beginning of 2012, it is fair to ask if broader North American markets should be considered overvalued. Anecdotally, it is certainly more difficult to identify striking value than it has been over the past several years. But it’s not impossible as growth has picked up in select areas.

We have seen this notably in Western Canadian infrastructure with companies like Macro Industries (TSX-V: MCR, OTC: MCESF). Macro is a recent addition to our research coverage – it was recommended in June and is up 65% since then. This is a company that operates in a true pocket of strength.

One of the most popular (but not necessarily best) ways of measuring a market’s valuation is the price/earnings ratio.

While no one disagrees about what the “p” is when calculating the ratio, there is no consensus on how to define the “e” – earnings per share. One point of dispute is on whether to use analysts’ earnings estimates for the coming year or reported company earnings from the previous 12 months (trailing earnings). For the record, we consider both as well as a number of other factors.

Consider the S&P 500’s current p/e based on trailing earnings. For the four quarters through June 30, the index’s earnings per share amounted to $91.16, according to S&P Dow Jones Indices. That translates into a p/e ratio of 19.31, which is higher than 79% of comparable readings since 1871, according to a database maintained by Yale University professor Robert Shiller. This paints a bearish near-term perspective.

Current S&P 500 PE Ratio: 19.31

Oct-13    
Mean:
15.5
Median:
14.51
Min:
5.31
(Dec 1917)
Max:
123.79
(May 2009)

PE since 1871

Of course, bulls will point out that forward estimates for earnings call for strong growth in 2014. According to FactSet Data Systems, the consensus from Wall Street analysts is that earnings from companies in the S&P 500 will be $121.95 a share next year, which translates into a p/e ratio of 13.6. That is 6% less than the 14.5 median of historical p/e ratios in Prof. Shiller’s database.

Bears will counter-punch with the widely acknowledged fact that Wall Street analysts, many from the sell side, are forever too optimistic. In addition, analysts’ estimates focus on what’s known as “operating earnings,” a looser category than the actual reported earnings used to calculate the average of past p/e ratios. Thus, they are often adjusted higher.

This leaves us in a formidable tug-of-war in terms of broader market valuations.

If we take a look at the p/e on the S&P over the past 20-years, we get an average of 25.23 which paints the current p/e of 18.2-18.8 in a bullish light. However, one must remember that from a historical perspective, the last 20 years have boasted some of the highest multiples on record including the 2009 mark of 70.89 following the credit crisis and the tech bubble induced mark of 46.18 in 2002 which have skewed the multiple higher. Remove these two years and the average drops considerably to 21.53, but this still remains well above the historical mean of 15.5.

There are of course other methods based on earnings which we can employ to value the state of the broader market. One method which has proven successful in identifying market extremes (both over and undervalued) is the Shiller p/e ratio or cyclically adjusted price-to-earnings ratio, commonly known as CAPE. Developed by Robert Shiller and built off the work of legendary value investors Benjamin Graham and David Dodd, CAPE is a valuation measure usually applied to broad equity markets. It is defined as price divided by the average of 10 years of earnings, adjusted for inflation.

The central theme behind the CAPE is simple. Taking a multiple of one year’s earnings is misleading because stock markets naturally adjust when investors believe profits are cyclically high or cyclically low. Compare prices instead to the average of earnings over 10 years (Prof. Shiller also corrects for inflation) and it becomes clearer whether stock markets are overvalued or undervalued.

For over a century, extremes in the CAPE have coincided with favourable times to buy and sell. By staying far above its long-term average during the 2003 to 2007 rebound that followed the Internet bust, the CAPE also provided a warning that the rally was not to be trusted – ahead of the far worse crisis of 2007-09.

Prof. Shiller and the CAPE are sounding the alarm once again, recently implying that the U.S. market is 62% overvalued and more expensive than any other big stock market.

Current Shiller PE Ratio: 24.22

Oct-13    
Mean:
16.49
Median:
15.89
Min:
4.78
(Dec 1920)
Max:
44.2
(Dec 1999)

Shiller PE Since 1871

Economics without debate is like politics without scandal. It’s not going to happen. It should be no surprise that the CAPE is under attack from another renowned economist, Jeremy Siegel, who contends that it is based on faulty data. Many on Wall Street discount CAPE, but most have a vested interest.

Prof. Siegel of the University of Pennsylvania’s Wharton School has produced a new version of the CAPE, which he says corrects Prof. Shiller’s mistakes. His version of the CAPE suggests that the U.S. stock market is sending a different signal – stocks are cheap.

Many investors, both short and long term, will contend that outside of the few days of the market crash in March 2009 when the CAPE fell briefly below its long-term average, Shiller’s indicator has shown that U.S. stocks have been overvalued for over 20 years. Yet the benchmark S&P 500 has more than doubled since March 2009. It also doubled between 2003 and 2007. In total, the benchmark is up over 275% over the past 20 years.

Yes, the most recent “great recession” saw the largest drop in corporate profits on record. But consumer debt levels remain near record highs in the developed world and domestic growth is still muted at best. Supporters of CAPE will point out that casting doubt on metrics is a classic symptom of bubbles. Back in the tech bubble, analysts went from valuing companies based on price-to-earnings to price to-eyeballs or “Internet site impressions.”

Quite frankly, we do not see anything close to this type of mania at present. Corporate balance sheets continue to strengthen and profits are trending in the right direction. Total U.S. household debt fell another $78 billion, or 0.7%, in the third quarter of this year. Since peaking in the third quarter of 2008, American households have reduced their debt burdens by $1.53 trillion, or 12%. Deleveraging is a positive story of the last few years. The shift is even more dramatic relative to the size of the overall economy; household debt totaled 85% of GDP in the third quarter of 2008 and was down to 67% in the second quarter of 2013.

But there is plenty of reason to worry broadly about the economy including public (unfunded pension liabilities included) and private (consumer) debt. While U.S. consumer debt has been headed in the right direction, levels still remain historically high. U.S. unemployment is also a big concern.

Within Canada, our relative insulation from the great recession has unfortunately spared us a valuable lesson and consumer debt has not been paid down. In fact, Canadians are borrowing more, piling on consumer debt – credit cards, conventional bank loans, car loans, and lines of credit. At some point this ends and a spending vacuum could limit growth.

Perhaps this partially justifies the S&P/TSX Composite’s poor performance on a relative basis, being up a scant 2.6% this year and about 7% since the start of 2012. Slumping commodity prices are also a major contributor to the underperformance of the resource-laden TSX.

So where does this epic tug-o-war leave us? Which one of these statements is true: “The stock market is overvalued” or “The stock market is undervalued”? Every day you can find pundits with a strong opinion either way.

From our perspective, both statements are simplistic and most often irrelevant. It is a market of stocks, not a stock market.

We do not recommend you buy “the market,” when you look to beat the market. Our clients create their Small-Cap Growth Stock Portfolios with discipline by purchasing 8-12 cash producing stocks over a 12-18 month period. Our holding periods are typically from one to five years and beyond.

Over that period, the broader market will have its ups, when it is likely overvalued based on a number of metrics, and downs, when it may show as undervalued based on those same metrics. What is important to us and to you is whether your 8-12 stocks are continuing to create shareholder value through a number of company-specific metrics including cash flow increases, growth, a higher return of capital (dividends), and an improving balance sheet.

Outside of this, Mr. Market will create a great deal of “noise” on a day-to-day basis. Try not to pay too much attention – it will allow you to sleep far better each night.

RYAN IRVINE UPDATES ENGHOUSE SYSTEMS

Enghouse Systems Limited (TSX: ESL, OTC: EGHSF)

Originally recommended on March 7/11 (#21109) at C$9.10. Closed Friday at C$26.45, US$24.89 (Sept. 23).

Enghouse Systems was introduced to the IWB in March 2011 when the stock traded at $9.10. In our July IWB update with the stock at $23.74, we maintained our near and long-term ratings at Hold. While we continue to like the business long-term, the near-term rating change was strictly based on valuations which appeared to be closer to fair market price. Today, with the stock reaching new all-time highs in the $26-$27 range, we review the company’s recently released third-quarter results and our rating on the stock.

Enghouse develops enterprise software solutions for a variety of vertical markets. The company is organized around two business segments: the Interaction Management Group (IMG), which accounted for 78% of third-quarter revenue, and the Asset Management Group (AMG) which generated 22%.

On Sept. 10, Enghouse reported its financial results for the quarter ended July 31. Revenue was $46.3 million, an increase of 31% over last year, with incremental revenue coming primarily from acquisitions. Adjusted EBITDA for the quarter was $12.2 million ($0.46 per share, fully diluted) compared to $9.2 million ($0.35 per share) in last year’s third quarter. Net income was $6.3 million ($0.24 per share) compared to the prior year’s net income of $4.3 million ($0.16 per share).

On a year-to-date basis, revenue was $132.7 million compared to $97.4 million, an increase of 36%. Adjusted EBITDA was $32.5 million ($1.23 per share) compared to $24.9 million ($0.96 per share).

Once again, we were pleased with Enghouse’s results which came in slightly above consensus estimates on an adjusted basis. The quarter saw organic growth of a solid 4%. However, we continue to expect low single-digit organic growth going forward given the tepid improvement in the company’s main markets. The general economic climate continues to present challenges to the business, particularly in Europe.

The real story with Enghouse, as it has been since day one, is the strong free cash flow generation and growth via smart accretive acquisitions. Both continued in the first nine months of fiscal 2013. The near-term and mid-term environment continues to be favourable for the later.

We estimate Enghouse could generate over $45 million in EBITDA this year and over $55 million in 2014 without further acquisitions. This will provide plenty of fuel to fund a combination of acquisitions and ongoing dividend hikes. We have seen the dividend grow at a rate of greater than 20% over the past five years yet the stock currently yields a modest 1.2% due to the strong share price appreciation.

At first glance, with a trailing p/e of just above 32, Enghouse does not appear cheap. Indeed, with the share price up 190% since our original recommendation, the stock is no longer what we would consider a bargain. In fact, in the near term, we believe the company is at its fair value in its current range.

However, when we dig a little deeper we find that the company’s consensus EPS 2014 estimate is in the range of $1.15. If we strip out the $3.55 per share in cash and just look at the base business, the forward-looking p/e is a more reasonable 20. On a cash flow basis, the stock no longer trades at a discount to its peers.

In the near term, we believe organic growth will be challenging but recent acquisitions will provide decent overall growth. The market is now finally catching up to the Enghouse story and is more willing to pay a premium for the strong free cash flow and earnings power going forward. Enghouse trades at 13 times 2014 expected EBITDA.

Action now: We maintain our near- and long-term ratings at Hold as the stock is close to fair value at present. The company is well run and continues to hold above average upside potential over the next two to three years. Enghouse is on target over the next 12 months to reach a revenue run rate of approximately $200 million. Long term, we project the company will become more widely followed in the Canadian broker community due to the strong track record management its building.

GORDON PAPE’S UPDATES

Trinidad Drilling (TSX: TDG, OTC: TDGCF)

Originally recommended on April 11/11 (#21114) at C$10, US$10.44. Closed Friday at C$10.01, US$9.71.

Trinidad Drilling continued its upsurge over the summer, trading as high as $10.84 in late September before pulling back to its current level, which is close to our original recommended price. This is a remarkable comeback for a stock that got as low as the $5 range in June 2012 and then bounced around the $7 level for the better part of a year. However, as I noted in my last update in March, the company’s decent financial results gave us good reason to retain our positions.

It was therefore somewhat surprising that the stock continued to climb even after the company released second-quarter returns (to June 30) that were disappointing. Revenue for the period was off 5.1% year-over-year to $165.4 million. Even worse, adjusted net income plunged from $13.1 million ($0.11 a share) in 2012 to a mere $2.6 million ($0.02 a share) this year. The company blamed reduced U.S. and international activity and a delay from the first to the second quarter of repairs and maintenance costs for the deterioration in results.

Year-to-date, adjusted net earnings as of June 30 were $38.2 million ($0.32 a share), down from $55.8 million ($0.46 a share) a year ago.

Looking ahead, management does not foresee a major upsurge in activity but is looking for some modest improvement in 2014. They believe that the company’s modern equipment will keep it in a strong competitive position.

“Trinidad expects that industry conditions will remain relatively stable in 2013 and is seeing early indications of increased activity levels in 2014,” management said in its outlook statement. “The company expects that its modern, high performance equipment will continue to be in demand; however, unless commodity prices increase there will be limited demand for less modern equipment. Approximately three-quarters of Trinidad’s fleet are considered high performance; these rigs have demonstrated their ability to continue to meet customers’ needs by achieving high activity levels and stable dayrates. Trinidad currently has approximately 50% of its fleet under long-term, take-or-pay contracts with an average term remaining of approximately 1.5 years, providing the company with significant revenue stability.”

So why has the stock moved up by about 40% since March? Part of the surge can be attributed to the Sept. 3 announcement of a joint venture with U.S. energy services giant Halliburton (NYSE: HAL) to provide and operate drilling rigs for Halliburton’s international integrated projects. Under the arrangement, to be called Trinidad Drilling International, the joint venture will get first crack at providing drilling rigs for all of Halliburton’s onshore projects outside Canada and the U.S. The initial emphasis will be on Saudi Arabia and Mexico.

The first deal will be to provide four rigs for a three-year project, plus one year optional, in Saudi Arabia. Trinidad, which is the majority (60%) partner in the joint venture, will invest $72 million in this initial project.

“We see this agreement as a significant milestone for Trinidad in international markets” said company CEO Lyle Whitmarsh. “By aligning ourselves with a major oilfield services company, such as Halliburton, we are able to open the doors to a new level of international growth. Trinidad will benefit from Halliburton’s international operating experience and infrastructure and will gain access to the integrated project management market. In return, we can provide Halliburton with high-performance drilling services and strong operating performance that will enhance their ability to win future integrated projects.”

It remains to be seen how profitable this new venture will be over time but the initial reaction of the markets was positive, with the shares rising by more than a dollar in the week after the news came out.

RBC Capital Markets said the deal offers a “tremendous long-term growth opportunity” but does not expect any positive impact on the bottom line until 2015.

Action now: Buy below $10. Note that this stock is only suitable for investors who can handle risk.

MEMBERS’ CORNER

U.S. withholding tax

Follow-up: Last week I commented on an e-mail from a member who was wondering about the withholding tax on dividends from U.S. companies paid to TFSAs and RESPs. He asked whether there were any products that could be used to avoid this. I said I wasn’t aware of any.

Right after that appeared, Globe and Mail personal finance columnist Rob Carrick wrote a column in which he mentioned swap-based exchange-traded funds (ETFs). In it, he noted that the Horizons S&P 500 Index ETF (TSX: HXS) is structured in such a way that no dividends are actually received, and therefore the withholding tax is not applied. All profits are in the form of capital gains. That makes this ETF more tax-efficient for TFSAs, RESPs, and non-registered accounts.

As of the close of trading on Sept. 30, the fund was showing a year-to-date gain of 21.2%. The S&P 500 was up 17.9% in the same period so this ETF is actually outperforming the index to this point. The management fee is a very reasonable 0.15%. – G.P.

 

That’s it for this issue. We’ll be back on Tuesday Oct. 15. Happy Thanksgiving to all.

Best regards,

Gordon Pape