Next Update Edition: Apr. 9
Next regular issue: Apr. 30
DIVERGENT COURSES
By Gordon Pape, Editor & Publisher
When it comes to monetary policy, Canada and the U.S. usually move in the same direction. But not this year. While the Bank of Canada contemplates another interest rate cut in the spring, the U.S. Federal Reserve Board has signaled that its key rate will likely start moving up in June. The federal funds rate has effectively been at zero since the crash of 2008-09, so this is a big deal.
Why this unusual divergence in direction? Blame it on oil. The collapse in the price of crude is taking a heavy toll on the Canadian economy. Alberta has been especially hard-hit by lower revenue and spending cutbacks, but the ripple effect has been felt right across the country. The expected export boom, which was supposed to be fuelled by a cheap loonie, has yet to materialize, leaving our near-term economic prospects in a perilous state.
In response, the Bank of Canada shocked everyone by cutting its overnight rate by a quarter of a percentage point in January, to 0.75%. It held that level at its March setting but left the door open for another cut in April or May if conditions do not improve.
In a March 12 statement before the House of Commons Finance Committee, Deputy Chief of the Bank of Canada’s Canadian Economic Analysis Department Rhys Mendes stated flatly that “the sizable decline in the price of oil since June 2014 is unambiguously negative for the Canadian economy.”
Meanwhile, the U.S. Federal Reserve Board dropped the word “patient” from its latest statement, setting off a wave of speculation that an interest rate hike is just around the corner. It won’t happen in April, but June is a real possibility. The pace of rate increases will be slow, but by year-end, the federal funds rate is expected to be at 0.625%. It’s feasible the Bank of Canada rate could be lower at that point.
What does this all mean in terms of your money? Here are some things to expect.
More loonie losses. The main force behind the decline of our dollar has been the collapse in the price of oil. However, a divergence between U.S. and Canadian interest rates will exacerbate that, driving our currency even lower. If the Bank of Canada cuts again, we could see our dollar down in the US$0.70-US$0.72 range. The obvious way to mitigate the decline in our dollar is to invest a larger portion of your portfolio in carefully-selected U.S. dollar securities.
Lower returns on Canadian GICs. Did you notice what happened after the Bank of Canada cut its rate in January? First, the major banks were unusually slow to follow the BoC lead. They held off cutting their prime rate for several days, and when they finally acted they did not match the BoC’s 25 basis point drop. Prime is currently 2.85%, down only 15 basis points. However, the big banks slashed their posted rates on five-year GICs by as much as half a percent. They’re now offering only 1.5% on average, although you can get more at smaller financial institutions. If the BoC cuts again, GICs will yield even less.
Pressure on stock markets. Generally, when the Federal Reserve Board is in a rate-raising phase, it puts pressure on stock markets. A recent report published by HSBC found that U.S. stocks gained an average of 25% in the year prior to the start of Fed rate hikes but only 5% in the 12 months after the first upward move. Interest-sensitive stocks, such as utilities, are especially vulnerable.
Setback for emerging markets. A strong U.S. dollar fuelled by higher interest rates is bad news for emerging markets. The Bank for International Settlements reports that non-financial borrowers in emerging markets are carrying about $4.5 trillion in U.S. dollar debt. As the greenback rises, the local currency cost of servicing that debt increases as well. A report issued on March 20 by RBC Wealth Management concluded that “the dollar’s ascent means emerging nations’ economic and corporate earnings outlook could deteriorate further.”
Diverging bond yields. The HSBC report found that while U.S. bond yields rise as the Fed starts to tighten, the effect is more pronounced at the shorter end of the spectrum. So, for example, yields on two-year Treasuries would increase more than on five- or seven-year issues, resulting in a flattening of the yield curve. As yields move up, bond prices will decline.
We could see the opposite effect here in Canada. Bond yields fell sharply after the BoC cut its rate in January, which pushed prices higher. The yield on the benchmark two-year Government of Canada bond dipped from around 0.85% to close to 0.4% almost immediately. It’s still below 0.5%. Longer-term bonds also saw their yields drop, but not as sharply.
What this boils down to is that there appears to be more upside for Canadian bonds than for U.S. issues over the rest of this year.
The bottom line is that the best prospects for income investors over the next 12 months appear to be in carefully-selected U.S. dividend stocks and Canadian fixed-income securities. Avoid GICs and be aware that short-term bond funds, while safe, will provide very low returns. Steer clear of emerging markets.
We’re in a highly unusual period. Extra caution is the order of the day.
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OIL SHOCK HITS HIGH-YIELD PORTFOLIO
By Gordon Pape
The precipitous plunge in the price of oil hit our High-Yield Portfolio hard with our two energy positions, Freehold Royalties and Baytex Energy, recording big losses during the latest review period.
Despite this, the overall portfolio managed to record a small gain for the period and is still well ahead of our target rate of return.
The portfolio was launched in March 2012 for readers seeking above-average cash flow and who were willing to live with a higher level of risk. This is a 100% equity portfolio; there are no bonds to cushion losses when stock markets retreat. Therefore it is not suitable for very conservative investors or for RRIFs where capital preservation is important.
The portfolio consists mainly of small/mid-cap companies with one exception (Sun Life). All the stocks are Canadian except for FLY Leasing, which is an Irish-based ADR that trades in New York.
This portfolio is best suited for non-registered accounts where any capital losses can be deducted from taxable capital gains. Also, a high percentage of the payments from this portfolio will receive favourable tax treatment as eligible dividends or return of capital.
Here is a rundown of the securities we own and how they have performed in the six months since our last review in November.
The Keg Royalties Income Fund (TSX: KEG.UN, OTC: KRIUF). This fund is the leading operator and franchisor of steakhouse restaurants in Canada and has a substantial presence in select regional markets in the United States. It was added to this portfolio in April 2013 when it was trading at $15.25. At the time of the last review, it was up to $17.30, and it has added $2.50 since. In March, The Keg implemented a dividend increase of 2.5%, to $0.082 per month ($0.984 annually). The shares yield just under 5% at the current price. This security was recommended by Gavin Graham.
DH Corporation (TSX: DH, OTC: DHIFF). This is another Gavin Graham pick. The company used to derive most of its revenue from cheque printing, but it has successfully diversified into other areas. The stock has performed very well for us, and the shares are up almost $4 since our last review in November. We also received two quarterly dividends of $0.32 per share each. DH has now more than doubled in value since the portfolio was created.
Freehold Royalties (TSX: FRU, OTC: FRHLF). It’s a rough time for energy stocks, and Freehold has seen its share price drop by more than $5 since we last looked at the portfolio in November. And there’s more bad news – the monthly dividend was cut to $0.09 at the start of the year from $0.14 a share. It will be a while before this sector comes back.
Baytex Energy (TSX, NYSE: BTE). If the results from Freehold have been bad, this heavy oil producer has been brutal. The share price is down more than $12 since our last review and the monthly dividend has been slashed to $0.10 from $0.24. Overall, we’re down 54% since this stock was added to the portfolio. That’s obviously not what we need to see.
FLY Leasing (NYSE: FLY). We’ve seen a turnaround in this Irish-based airplane-leasing firm, which was added to the portfolio in October 2013. It had been gradually losing ground but since November it has regained almost US$2 a share. The quarterly dividend is US$0.25.
Premium Brands Holding Corp. (TSX: PBH, OTC: PRBZF). This specialty food manufacturer and distributor was also added to this portfolio in October 2013, and it has done well. The shares are up $1.80 since the November review, and the quarterly dividend has been increased to $0.345 from $0.3125, effective with the March payment.
Morneau Shepell Inc. (TSX: MSI, OTC: MSIXF). Morneau Shepell Inc. is the largest Canadian-based firm offering benefits and pension consulting, outsourcing, as well as health management services. The shares have gained $0.54 since the last update, and we continue to receive good cash flow from the monthly dividend of $0.065 ($0.78 a year).
Pembina Pipeline Corp. (TSX: PPL, OTC: PBNPF). Pembina shares are down almost $3 since November as the pipeline company has been sideswiped by the downturn in the oil price. However, the monthly dividend of $0.145 a share ($1.74 a year) remains intact.
Sun Life Financial (TSX, NYSE: SLF). This blue-chip insurance company has been marking time since our last portfolio review. The shares are down $0.66, but that was offset by the two dividends totaling $0.72 that we received.
Chemtrade Logistics Income Fund (TSX: CHE.UN, OTC: CGIFF). Chemtrade is one of the world’s largest suppliers of sulphuric acid, liquid sulphur dioxide, and sodium chlorate. It’s one of the few income trusts still remaining and was originally recommended in The Income Investor by former contributing editor Tom Slee. The share price moved higher by $1.29 since the last update. Distributions are $0.10 per unit monthly ($1.20 a year).
Here’s what the portfolio looked like as of the close of trading on March 20. The weighting is the percentage of the market value of the security in relation to the total market value of the portfolio. Sales commissions are not taken into account, and the U.S. and Canadian dollars are treated as being at par. Note that the original book value was $24,947.30. The return since inception is based on that amount. We received interest on our cash position of $3.24 during the latest period.
Income Investor High Yield Portfolio ? a/o March 20/15
| Security |
Weight%
|
Loss %
KEG.UN
DH
FRU
BTE
FLY
PBH
MSI
PPL
SLF
CHE.UN
Cash
Total
Inception
Comments: The sharp drop in value of our energy positions, Baytex and Freehold, offset gains in other sectors of the portfolio. The net result was more or less breakeven over the latest review period – a fractional gain of just 0.75%.
Since the launch of the portfolio in March 2012, we have recorded a total return of 43.2%, based on the book value at inception. That works out to an average annual compound rate of return of 12.7%. That’s still well above our target range of 7% to 8% annually; however, the relatively weak performance recently requires some adjustments in the securities we hold.
Changes: Our two energy positions are dragging us down, with Baytex especially disappointing. We should have at least one energy stock in the portfolio, but I prefer one with more international exposure in the current environment. Therefore, we will sell both Freehold and Baytex for a total of $3,739.50. Adding accumulated dividends, we have a total of $3,840.90 to invest.
We will use the money to buy 70 shares of Vermilion Energy Inc. (TSX, NYSE: VET) at $53.84 for a total cost of $3,768.80. That will leave surplus cash of $72.10. Vermilion is a recommendation of our companion Internet Wealth Builder newsletter. The company is based in Calgary but has extensive overseas oil interests in Europe (France, Netherlands, Germany) and Australia. It also holds an 18.5% working interest in the Corrib gas field in Ireland and recently completed an $11.1 million transaction, which marks its first acquisition in the United States, a low-cost entry position in the prolific Powder River Basin of northeastern Wyoming.
The shares pay a monthly dividend of $0.215 ($2.58 a year), and Vermilion is one of a handful of mid-size oil and gas producers that has not cut its dividend in the wake oil’s price plunge. The company has a strong commitment to maintain the dividend at the current level, and the market appears convinced it can achieve that, judging by the relatively low yield of 4.8%.
Here are the other adjustments we will make.
DH – This stock has performed very well for us, but at 15.8% its weighting in the total portfolio is too high. We will therefore sell 25 shares for $1,009.25. This will reduce our position to 110 shares.
FLY – We’ll bulk up our position here by purchasing 70 more shares at $15.18 for a total cost of $1,062.60. We will pay for that by using $90.50 from FLY’s accrued dividends and drawing the rest from funds generated by the sale of DH shares. That will leave cash of $37.15 from the DH sale.
Our total cash including retained dividends is now $1,255.70. This will be invested in a high interest savings account paying 1.1%.
Here is a look at the revised portfolio. I will review it again in September.
Income Investor High Yield Portfolio – revised March 20/15
| Security |
Weight %
|
Total Shares
|
Average Price
|
Book Value
|
Current Price
|
Market Value
|
Retained Dividends
|
| KEG.UN |
9.4
|
165
|
$15.35
|
$2,533.30
|
$19.80
|
$3,267.00
|
$56.23
|
| DH |
12.8
|
110
|
$19.39
|
$2,132.90
|
$40.37
|
$4,440.70
|
$201.70
|
| VET |
10.9
|
70
|
$53.84
|
$3,768.80
|
$53.84
|
$3,768.80
|
0
|
| FLY |
10.1
|
230
|
$14.58
|
$3,353.60
|
$15.18
|
$3,491.40
|
0
|
| PBH |
9.6
|
130
|
$19.49
|
$2,534.25
|
$27.15
|
$3,329.50
|
$75.13
|
| MSI |
11.5
|
230
|
$12.23
|
$2,813.60
|
$17.28
|
$3,974.40
|
$146.05
|
| PPL |
11.1
|
95
|
$29.09
|
$2,763.60
|
$40.71
|
$3,867.45
|
$248.58
|
| SLF |
13.5
|
115
|
$24.82
|
$2,853.80
|
$40.88
|
$4,701.20
|
$111.40
|
| CHE.UN |
10.4
|
170
|
$17.06
|
$2,899.40
|
$21.31
|
$3,622.70
|
$170.00
|
| Cash |
0.7
|
$246.61
|
$246.61
|
||||
| Total |
100.0
|
$25,899.86
|
$34,709.76
|
$1,009.09
|
|||
| Inception |
$24,947.30
|
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TOP PICKS
Here are our Top Picks for this month. Prices are as of the close of trading on March 23 unless otherwise indicated.
Canadian Western Bank (TSX: CWB; OTC: CBWBF)
Type: Common stock
Trading symbol: CWB, CBWBF
Exchanges: TSX, Pink Sheets
Current price: C$27.71, US$22.06
Entry level: Current Price
Annual payout: $0.84
Yield: 3.03%
Risk: Moderate risk
Recommended by: Gavin Graham
Website: www.cwbankgroup.com
The industry: Canadian banks came through the Great Recession of 2008-09 in much better shape than virtually any other developed country, with no government bailouts required and not even a dividend cut. While analysts have turned cautious on the Canadian banks because of the steep decline in oil prices and its knock-on effect on the resource-dependent economies of B.C. and the Prairies, the slide in CWB’s price seems an over-reaction, as the bank’s provision for credit losses as a percentage of its total loans never rose above 0.25% in either 2001-02, when oil hit US$20 a barrel, or in 2008-09 when it touched US$50. This compares with the Canadian banking industry as a whole, where credit losses reached 1% in 2001-02 and above 0.9% in the last recession.
The business: Canadian Western Bank (CWB) is the eighth-largest bank in Canada after the Big Six and Laurentian Bank. It has 41 branches and C$21 billion in assets, but has been amongst the fastest-growing and most highly rated, principally due to its exposure to the booming Western Canadian provinces.
CWB had loans outstanding of $18.1 billion at end January 2015, deposits of $17.9 billion, 2,150 employees, and was rated A (low) by DBRS. It also had $9.2 billion in assets under administration and $1.9 billion in assets under management in Canadian Western Financial, its wealth management subsidiary.
The majority of the bank’s loan business is divided between Alberta (42%) and B.C. (34%), with the remainder mostly in Ontario. The bank’s exposure to the oil and gas production sector is limited, with only 2% ($300 million) of its loans in that business. Some 40% of the bank’s exposure is divided equally in general commercial loans and commercial mortgages. Equipment financing and leasing, personal loans and mortgages, and real estate project loans make up another 51% of the bank’s exposure, with general corporate loans accounting for the remainder.
CWB also operates trust businesses under the Canadian Western Trust and Valiant Trust brands.
The security: With 80 million shares outstanding, CWB has a market capitalization of $2.1 billion, making it one of the 200 largest companies in Canada. It trades between 80,000 and 100,000 shares a day in Toronto. Liquidity on the OTC market is very limited.
Why we like it: Despite increasing revenues by 8% and its earnings by 11% annually over the last three years – both double the industry growth rates – CWB has underperformed dramatically over the last year as concerns over its Western Canadian focus have overwhelmed the evidence of its resilient performance in the last two energy bear markets.
With a book value of $19.99 at its year-end of October 2014, the bank is selling for a price-book valuation of only 1.3 times, its lowest in a decade apart from the Great Recession of 2008-09. With management targets for 2014-15 of 10%-12% growth in loans, 5%-8% growth in adjusted earnings per share, 1.07%-1.12% return on assets, and 14%-15% return on equity, CWB is well placed to deliver respectable growth in earnings and book value despite a potential pick-up of 0.17%-0.22% in credit losses as a percentage of loans. Meanwhile, CWB is still one of the best run Canadian banks, with its efficiency ratio of non-interest costs as a percentage of revenues at 48%.
Financial highlights: The quarter ended Jan. 31, 2015, saw loans grow 12%, to $18.1 billion, well above the target 12% growth, while revenues expanded 4%, to $159.9 million, and both net income and earnings per share rose 3%, to $54.2 million and $0.69, respectively.
Risks: CWB’s experience in managing the oil patch commodity cycle for the past 30 years and its low credit losses in the last two oil price collapses are evidence that management adopts a conservative approach to lending. If oil prices remain at their present low levels for a prolonged period, CWB’s growth may be affected and its loan losses could climb above previous levels. However, even a doubling of CWB’s loan losses would still leave them below the banking industry as a whole.
Distribution policy: The quarterly dividend is $0.21 per share, giving CWB a yield of 3.2%. CWB has raised its dividend by either $0.01 or $0.02 every year since 2010, when it was $0.11 a share. Dividends qualify for the dividend tax credit for Canadians in non-registered accounts, and are subject to 15% withholding for U.S. citizens.
Who it’s for: CWB is for investors who are willing to accept a slightly lower yield than other Canadian banks, but want to own one of best-managed and the fastest-growing financial institutions in Canada.
Recent developments: In February, CWB sold its property and casualty insurance business, Canadian Direct Insurance, to Intact Insurance (TSX: IFC) for $197 million, for estimated after-tax proceeds of $1.25 per share, adding 70 basis points to the bank’s Tier 1 common equity capital. And in March it also sold the stock transfer business of Valiant Trust to Computershare for $33 million in March.
Summing up: The recent selloff, which has taken CWB back to its 2012 level, is a great opportunity to buy a premier company at a cheap valuation (9.8 times 2014 earnings).
Action now: Buy at the current price.
Labrador Iron Ore Royalty Corp. (TSX: LIF; OTC: LIFZF)
Type: Common stock
Trading symbols: LIF, LIFZF
Exchanges: TSX, Pink Sheets
Current price: C$15.86, US$12.69
Entry level: Current price
Annual payout: $1.00
Yield: 6.3%
Risk rating: Higher risk
Recommended by: Gordon Pape
Website: www.labradorironore.com
Background: This is not a good time for commodity stocks. Sluggish global growth has suppressed demand, and the strong U.S. dollar has added to the woes of producers. That’s because commodities are priced in U.S. currency, so the higher the greenback rises, the more expensive the products become to non-U.S. buyers.
However, with share prices near multi-year lows some commodity companies are starting to look attractive to yield-hungry investors who are willing to assume an above-average degree of risk. This is one of them.
The business: Labrador Iron Ore Royalty Corp. (LIORC) holds a 15.1% equity interest in Iron Ore Company of Canada (IOC) directly and through its wholly owned subsidiary, Hollinger-Hanna Limited. The company, which was formerly an income trust, receives a 7% gross overriding royalty and a commission of $0.10 per tonne on all iron ore products produced, sold, and shipped by IOC.
IOC is Canada’s largest iron ore producer, operating a mine, concentrator, and pellet plant at Labrador City in the province of Newfoundland and Labrador. It has been producing and processing iron ore concentrate and pellets since 1954 and is among the top five producers of iron ore pellets in the world.
The security: I am recommending the common stock of LIORC, which trades on the Toronto Stock Exchange under the symbol LIF and on the U.S. over-the-counter Pink Sheets as LIFZF. For full disclosure, I personally own shares in the company.
Why we like it: This is a case of business being bad but not awful. The company is going through difficult times as iron ore demand is slack worldwide. However, LIORC still manages to generate adequate cash flow to finance its quarterly dividend of $0.25 a share plus the occasional special dividend. As a result, the yield of 6.6% looks safe, and the stock has upside potential if the global economy recovers and demand for iron ore increases.
Financial highlights: For 2014, royalty revenue dropped to $115.7 million compared with $137.6 million in 2013, because of lower iron ore sales (14.3 million tonnes versus 14.8 million in 2013) and a sharp decline in the U.S. dollar price of iron ore. That started in the summer and by year-end had declined almost 50% to levels not seen in over five years. Harsh weather conditions and a two-week railway interruption to the plant also contributed to the reduced revenue.
All this resulted in a big drop to net income, which came in at $104.1 million ($1.63 per share) compared with $148.8 million ($2.33 per share) in 2013. Adjusted cash flow was $113.6 million ($1.77 per share) compared with $115.4 million ($1.80 per share) in 2013. Still, the 2014 numbers were more than enough to cover the regular dividend plus four special dividends totaling $0.65 a share.
Risks: LIORC’s income is entirely dependent on IOC, as the only assets of company and its subsidiary are related to IOC and its operations. So if anything happens to reduce or suspend IOC’s production, such as strikes, temporary shutdowns, etc., LIORC would have its cash flow cut off.
Any further drop in the price of iron ore would have a negative effect on revenue and cash flow. CEO Bruce Bone believes that absent a recovery in iron ore prices, LIORC’s royalty revenue will be lower than in 2014, but should still be “satisfactory.”
Distribution policy: Dividends of $0.25 a share are paid quarterly in January, April, July, and October. Special dividends are declared at the time of the regular dividend announcement.
Tax implications: Payments are eligible for the dividend tax credit if held in Canadian non-registered accounts. Dividends paid to U.S. residents will be subject to a 15% withholding tax.
Who it’s for: This stock is suitable only for investors who can tolerate above-average risk. The reward is a higher-than-normal cash flow.
How to buy: The shares trade actively on the TSX, and you should have no trouble being filled. Volume on OTC Pink Sheets is light, so place a limit order.
Summing up: This is a higher-risk situation but one that I believe has more upside than downside at this stage.
Action now: Buy. – G.P.
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MARCH UPDATES
Diageo Plc (NYSE: DEO)
Type: ADR
Trading Symbol: DEO
Exchange: NYSE
Current price: US$115.34
Originally recommended: June 22/11 at US$81.25
Annual payout: US$3.36
Yield: 2.9%
Risk: Moderate risk
Recommended by: Gavin Graham
Website: www.diageo.com
Comments: Conditions remained challenging in the six months ending Dec. 31, 2014 (Diageo has a June 30 year-end), for global spirits maker Diageo, whose brands include Johnnie Walker scotch, Smirnoff vodka, and Guinness.
The Chinese government clampdown on excessive expenditure by government officials, including the purchase of high-end spirits, saw sales in the important Asia Pacific region down 7.4%, while Venezuela’s descent into near hyperinflation required a big writedown, leaving sales in Latin America and the Caribbean off 1.4%, similar to low-growth Europe. Only North America, with a 0.1% increase, and Africa (excluding South Africa), with a 9% rise, saw increases. As a result, overall organic revenues fell 0.1% to