Ryan Bushell, vice president and portfolio manager at Leon Frazer & Associates

Focus: Canadian dividend-paying equities
_______________________________________________________________

MARKET OUTLOOK
So far 2017 has been a little frustrating for Canadian investors, ourselves included. Against a backdrop of improving economic fundamentals, the Canadian stock market has underperformed. Surely the worries about housing, oil prices and NAFTA have all factored into this performance in some proportion. However, we fail to see much fundamental backing. 

On housing, there was no fundamental reason to fear the Home Capital news; mortgage delinquencies remain at negligible levels and interest rates continue to reset lower for both fixed and variable payers. It seems many international participants were simply looking for an opportunity to sell/short the Canadian housing market and used the Home Capital investor relations investigation by the OSC as their reason, taking a healthy chunk of Canadian bank valuations with them. Hopefully the recent investment by Warren Buffet in Home Capital itself will return the market to focus on fundamentals. As an aside, the Canadian banks are one of the only broad investment classes to outperform Berkshire Hathaway over its lifetime (data courtesy of Matt Barasch at RBC). 

On oil, we see the same kind of relentless pessimism in the face of reasonable fundamentals. U.S. oil inventories have remained stubbornly high. However, they started drawing about a month earlier than normal this year and Saudi Arabia has informed customers that they are raising prices and cutting exports as the summer months approach. These positive data points have been swamped by extreme bearish sentiment, which has pushed us back to the low end of the recent trading range. This is part of the normal recovery process that began last year. We are still in the early stages, however select Canadian oil equities are priced at or below levels from Q1 last year when oil bottomed at $26. This seems overdone to us. 

On NAFTA, we see little evidence of anything happening at the core of the agreement and that the headlines mostly reflect posturing at this point and little substance. Any reforms that are enacted are likely to penalize Mexico more than Canada. However, both the Mexican peso and stock market have significantly outperformed their Canadian counterparts year to date. 

Central to the market’s thinking at the beginning of the year was how probable tax cuts to be enacted in the U.S. and fiscal spending were likely to be inflationary. As the prospects for tax reform have waned, so has the market’s enthusiasm toward higher interest rates and inflation proxies, including commodities. The prevailing trade has swung back towards a barbell consisting of defensives (utilities/telecom/staples) and non-resource growth (technology/health care/discretionary). At the beginning of the year we thought the U.S. dollar would roll over (correct), longer-term interest rates would rise in combination with the short end (wrong so far) and inflation proxies would continue to outperform at the expense of defensives and non-resource cyclicals (again wrong so far). The year is only half over, though, and we remain watchful for a repeat of what happened in the back half of 2016 that few saw coming. We also remain wary of U.S. equity valuations, specifically in the technology space where things are starting to look a little 1999ish to us. With the U.S. dollar down more than eight per cent on a trade-weighted basis since December, international capital has a reason to look elsewhere.

TOP PICKS

ENBRIDGE (ENB.TO) – Most recent purchase $50.50
Enbridge has not performed well so far in 2017 despite two dividend increases totaling 15 per cent and the closing of a major acquisition (Spectra). Enbridge has been one of the best dividend compounding vehicles known to man and they are about to embark on the most ambitions capital program in their history. Enbridge has guided to 10-12 pe cent dividend growth through 2024. Let’s assume they hit only the low end for five years. That would put you at a dividend yield of approximately 7.8 per cent in 2022, assuming the stock goes nowhere. 

VERMILION ENERGY (VET.TO) – Most recent purchase $42
Vermillion Energy has traded down with oil prices and Canadian-based producers despite having little to do with either. Only one-third of Vermillion’s cash flow comes from Canada and less than 25 per cent of the cash flow is linked to North American oil prices. Vermillion has been a disciplined allocator of capital and has maintained a consistent dividend through both the conversion to a corporation and the current commodity downturn. Disciplined management of the balance sheet combined with a diverse production base allow investors to collect a current yield of over six per cent while they wait for share price upside during an oil price recovery. Very low probability of a dividend cut from Vermillion; oil prices would have to retreat below $40 for an extended period (more than a year), and the shares hit the $57 level following the initial OPEC cut news last fall.

TD BANK (TD.TO) – Most recent purchase $65
TD Bank shares are off nearly 7.5 per cent from March levels, largely on the back of the Home Capital situation, and that fear seems to be dissipating. TD has lower exposure to the Canadian housing market than most of their peers owing to their increased presence in the U.S. where they now have more branches. We believe the conditions exist for rates to go higher, especially in the U.S., which would be a tailwind for TD, and the valuation looks reasonable to us in a market where Canadian banks trade at a 30 per cent valuation discount to Canadian grocers with a far better business and more than twice the dividend yield. We understand that the Canadian banks are expensive relative to their U.S. counterparts, but it’s simply not the same business. Canadian banks have delivered double the annualized return of the U.S. banks over the past 35 years with only two-thirds the volatility. We think TD is No. 1 or No. 2 in the group and it is trading cheaper than its historical range, at only a slightly lower dividend yield than Scotia, BMO and Royal Bank.
 

PAST PICKS: JULY 25, 2016

FREEHOLD ROYALTIES (FRU.TO)
Freehold has had a nice year but still trades at a significant discount to its main peer (Prairie Sky) so we believe there is more upside, even taking oil prices out of the equation. We were pleased to see Freehold increase their dividend 25 per cent this year, on route to hopefully restoring the payout they had prior to the oil price downturn. With a 4.7 per cent yield at current levels, this is another investment in the downtrodden oil-and-gas sector where investors can collect a significant dividend return while they wait for the commodity. The probability of a dividend cut is very low if oil prices do not drop below $40 for an extended period (more than a year).

• Then: $11.43
• Now: $12.83
• Return: +12.24%
• TR: +16.39%

ALTAGAS (ALA.TO)
Easily the most confusing stock in our portfolio. Traded up with oil in 2014 despite having almost zero oil exposure and traded down with oil in 2015 with even less oil exposure. More than two-thirds of their cash flow comes from regulated distribution utilities and renewable/conventional power generation. The recent proposed acquisition of WGL holdings is progressing and will only increase those percentages. We are surprised that AltaGas has not recovered alongside either its midstream or utility peers. With a seven per cent dividend yield, ongoing dividend growth in the mid-single digits and continued project awards, we think investors are well served to own this name. The pushback we get is that the story is too spread out and lacks a catalyst. That’s fine; we’ll collect our seven per cent yield (with growth) and wait for the market to do their homework.

• Then: $32.83
• Now: $29.50
• Return: -10.14%
• TR: -4.62%

MANULIFE FINANCIAL (MFC.TO)
Obviously our timing on Manulife was good as long-term interest rates had cratered following the Brexit vote and staged a solid rally, taking MFC shares with them. While we do believe rates are unsustainably low, it is not our key reason for owning the stock. Life insurance companies are poised to benefit from demographics as people look to annuitize their wealth in retirement. We like the wealth management aspect of both Manulife and Sunlife as well as the emerging Asia exposure, particularly in Manulife. Manulife just announced a CEO transition; their previous head of Asia will be taking the helm of the company in October, which we view as positive. The shares have held in well despite a drop in rates, which we feel is justified because there is more to the story. With a 3.5 per cent dividend yield and solid dividend growth, we are happy to continue owning the company.

• Then: $18.15
• Now: $23.71
• Return: +30.63%
• TR: +35.38%

TOTAL RETURN AVERAGE: +15.71%