Brian Madden, senior vice president and portfolio manager at Goodreid Investment Counsel

Focus: Canadian equities and fixed income
_______________________________________________________________

MARKET OUTLOOK
The second quarter of 2017 saw the S&P/TSX Composite Index giving up 1.6 per cent in total return terms. Canadian bonds, as measured by the FTSE TMX Canada Short Term bond index drifted 0.4 per cent lower, and Canadian preferred shares as measured by the Solactive Laddered Preferred share index mustered a total return of 1.3 per cent.

The Canadian dollar reversed a steep five-cent April-early May selloff, to end the quarter up 2.7 per cent against the greenback as Bank of Canada officials made an abrupt 180 degree turn in their assessment of the economy. Deputy Governor Carolyn Wilkins in early June suggested that interest rate hikes may occur much sooner than markets were expecting. And indeed, just this morning, the Bank of Canada announced their first interest rate hike since 2010, matching the 25 basis point rate hike that the U.S. Federal Reserve enacted in June.

It’s sometimes said that markets move so as to cause the maximum amount of pain to the maximum number of people, and the sharp reversal in the Canadian dollar illustrates this, with all-time record short positions in the loonie as of early June when the Bank of Canada officials made their surprising remarks. 

Canadian energy stocks are still plumbing fresh lows with both oil and natural gas oversupplied after a warm winter and U.S. shale producers happily infilling the supply vacancy created by recent OPEC output cuts. We have seen considerable deal activity in the Canadian oil patch with large American and internationally owned oil sands properties being sold back into domestic hands. The $64,000 question, of course, is whether the foreign money is the “smart money,” abandoning a sector struggling under the weight of onerous royalty increases in Alberta, the spectre of federal carbon pricing and the general headwind of weak commodity prices, or whether the local operators will be proven to be the astute contrarian buyers of these ultra-long life bitumen reserves.

Big Canadian banks have been cooling off and correcting after steep uptrends since the Brexit-induced lows a year ago.  Quietly though, outside the limelight of these large and important sectors, many Canadian companies have been diligently executing against their business plans and investors have been steadily ratcheting up their shares prices in recognition of this. While absolute levels of market volatility remain very low with investors doggedly shrugging off North Korean, Middle Eastern, European, Russian and yes, even American Oval Office induced geopolitical risks, episodes like the brief but sharp selloff in “crowded trade” tech stocks we saw on an otherwise quiet Friday afternoon in June illustrate the fickle hands that stocks are sometimes held in and the attendant risks of holding an undiversified portfolio of thematically similar stocks.

Digging past the ebbs and flows of market psychology and delving deeper into market fundamentals, we see strong economic conditions in Canada with GDP growing at a 3.7 per cent annualized pace in the first quarter. Job creation has been robust with 186,000 net new jobs created year-to-date here in Canada and with corporate profits growing 12.4 per cent year-over-year in the first quarter for the S&P/TSX Index constituents.  Much has been made of the large and growing gap between “hard” economic data like jobs, retail sales, foreign trade figures, etc. versus the “soft” economic data like CEO and consumer confidence surveys, purchasing managers’ surveys, etc. in the United States.

Broadly, the hard data is coming in below investors’ expectations, whereas the soft data is still looking relatively strong.  We attribute the gap between reality and expectation to the ongoing beliefs and hopes that surveys’ participants seem to have with regards to the Trump administration’s pro-growth agenda (corporate and personal tax cuts, infrastructure spending, red tape reduction, regulatory rollback). To the extent the administration continues to struggle in building consensus and in advancing their policies, economic growth and consumer and business confidence are at risk, and we’re accordingly ratcheting downwards our own expectations the agenda will be significantly enacted. 

With respect to stock market valuations, the old adage “it’s not a stock market, but a market of stocks,” ties in with our view that active management is due for a renaissance of sorts. Nevertheless, we’re mindful of the level of valuations with the TSX Composite trading at 20.9 times earnings versus a ten-year average of 18.7 times and offering a dividend yield of 2.79 per cent versus a ten-year average yield of 2.89 per cent. The somewhat higher-than-normal valuations and the advanced stage of the current economic cycle serve to temper our return expectations over the upcoming several years. Neither of these valuation metrics on their own sounds any alarm bells and valuation is neither a necessary nor a sufficient condition for either a recession or a bear market, but it does highlight the importance of selectivity as investors can less count upon the proverbial rising tide that lifts all boats to bolster their investment returns. We remain, as always, resolved to be that selective investor — investing only in those scarce companies whom our research indicates have superior profitability and growth prospects, backstopped by above-average financial strength and proven, credible management teams. This disciplined approach has guided us successfully through many cycles.

TOP PICKS

ALIMENTATION COUCHE-TARD (ATDb.TO) – Last purchased on June 27, 2017 at $64.88
Alimentation Couche-Tard is North America’s largest independent convenience store operator with nearly 10,000 stores and 2,800 further locations in Europe. The company earns returns on equity in excess of 20 per cent, and has grown earnings per share at a 21 per cent pace over the last decade.  Their business approach has been to use procurement scale to price sharply on fuel, thus drawing traffic to their sites and then luring shoppers into attractive, modern and well-merchandised stores where merchandise gross margins are three to five times higher than the profit margins available on gasoline.

The company has also been a very capable serial acquirer, with a demonstrated pattern of realizing significant synergies from acquired businesses, in this still highly fragmented industry. Their largest deal to date, the $5.2-billion purchase of CST Brands, just closed in late June and another sizable deal for 522 stores was announced yesterday. Noth should be meaningfully accretive to earnings.

ENBRIDGE (ENB.TO) – Last purchased on July 5, 2017 at $51.61
Enbridge is the largest pipeline company in Canada, best known for its crown jewel asset, the Mainline/Lakehead system, which carries roughly two thirds of the oil produced in western Canada to consumption markets. Enbridge processes 12 per cent of all North American natural gas, transports 20 per cent of all natural gas and transports 28 per cent of all oil production.  These highly strategic assets offer excellent earnings visibility via long-term service contracts that are largely free of any commodity price or volume risk.

After the recent $42-billion acquisition of Spectra Energy, Enbridge has a much larger and better diversified base of business with assets and expansion projects well positioned in major production basins like the Marcellus and Utica shale gas basins in the eastern U.S., and the Montney basin in western Canada. With a dividend yield of 4.8 per cent and plans for annual dividend increases of 10 to 12 per cent between now and 2021, Enbridge offers an attractive combination of current income and very secure and visible medium term growth prospects. 

TD BANK (TD.TO) – Last purchased on June 26, 2017 at $65.68
TD is Canada’s second-largest bank and the second-largest company in any industry. It’s also increasingly a force to be reckoned with in U.S. banking. TD earns a 14-per-cent return on shareholder’s equity and has grown earnings per share at a 7 per cent rate over the last decade, with commensurate increases in its dividend. With over 35 per cent of its revenues originating in the U.S., TD should benefit from recent hikes to interest rates in that country.

Trading at 11.5 times 2018 expected earnings and with shares recently  having found support near its rising 200-day moving average, TD looks well poised to continue its consistent pattern of outperforming the TSX — a feat that it, along with other members of the Canadian banking oligopoly, has accomplished in 18 of the last 25 years.
 

PAST PICKS: AUGUST 29, 2016

ALIMENTATION COUCHE-TARD (ATDb.TO)

• Then: $67.63
• Now: $62.40
• Return: -7.73%
• TR: -7.35%

MAGNA INTERNATIONAL (MG.TO)

• Then: $52.59
• Now: 61.02
• Return: +16.02%
• TR: +18.20%

CCL INDUSTRIES (CCLb.TO)

• Then: $48.07
• Now: $61.70
• Return: +28.35%
• TR: +29.36%

TOTAL RETURN AVERAGE: +13.40%