Ryan Bushell, vice president and portfolio manager at Leon Frazer & Associates
FOCUS: Large cap Canadian dividend stocks
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MARKET OUTLOOK

Equities came back to life in September to close out a strong third quarter. Meanwhile some significant winds of change freshened as summer reluctantly gave way to fall. The S&P/TSX Composite Total Return Index returned 3.7 per cent in Q3 and is now up 4.4 per cent year-to-date, while the S&P 500 Total Return Index returned 0.5 per cent in Q3 and is now up 5.9 per cent year-to-date in Canadian dollars. Higher interest rates, oil prices and surprisingly strong economic growth were the drivers of a strong quarter in Canada.

Canadian banks and energy shares represent over 40 per cent of the index weighting on the TSX and were the top performers during the quarter. On banks: the abrupt change in positioning in Canadian interest rates was spurred forward by a robust 4.5 per cent annualized GDP growth rate in Q2. The Bank of Canada sprang into action with two surprise interest rate increases over the summer which sparked a 12 per cent rally in the Canadian dollar from the lows in mid-May. Increasing interest rates can be a concern for the Canadian banks to the extent that they cause credit losses arising from people defaulting on loans and mortgages. However, they can also be a tremendous positive as it increases the spread between borrowing and lending rates. The best case scenario for the banks going forward is a continued strong economy with gradually rising interest rates, which is exactly what we are seeing at present. 

On oil prices: the fundamentals continued to improve over the summer as production additions in the United States remained muted while demand was exceedingly strong. This led to the largest seasonal drawdown on record of U.S. crude oil inventories and a 23.8 per cent rally in crude oil prices from the lows in mid-June. While we are not wildly optimistic on either the Canadian economy or oil prices over the near to medium term, we think the conditions for both remain solid, justifying a catchup in the Canadian banks, energy producers and pipelines, which have not performed in-line with fundamentals so far this year.

The strength in the Canadian economy is perhaps the biggest surprise to North American financial markets so far this year. The sharp reversal in central bank policy caught many investors who were overweight U.S. dollar-denominated assets and fixed income off-guard, and it appears markets may now have overshot fundamentals to the upside as it relates to anticipated Canadian dollar strength at least. As stated earlier, the Canadian dollar appreciated more than 10 per cent versus the U.S. dollar over the past four months, while Government of Canada 30-year bonds dropped more than 6 per cent. We are most concerned with inflation given our long-term goal of sustainably protecting and growing wealth for our clients.

While inflation has been benign since the financial crisis, we again see signs of it bubbling beneath the surface. Three of Canada’s most populous provinces are moving to a $15 minimum wage in the next handful of years at a time where unemployment is low. U.S. unemployment is historically low and job openings are at all-time highs. Skilled workers are leaving the workforce at an accelerated rate in both countries, as the baby boomer demographic continues to age. And there remains an unprecedented amount of stimulus in the financial system following years of artificially low interest rates. 

Our portfolio construction emphasizes income production and inflation protection by owning quality dividend-paying companies primarily in industries that grow in-line with the general economy complimented by resource producers and U.S. equities (where appropriate) to combat inflation. This discipline has led to some underperformance relative to equity indexes off and on over the past few years, as so-called “secular growth” (technology/consumer) stocks led in an environment with benign inflation and low interest rates. We feel things are starting to shift back to a more normalized environment where the real economic engines (financials, resources, and industrials) take the lead. A similar pattern occurred at the turn of the century; let’s hope the damage done to technology investors is less severe this time around.

Regardless of what comes next, we remain confident in our portfolio positioning. Dividend growth in 2017 has been very strong with over 70 per cent of our holdings, increasing dividends firm-wide and zero dividend cuts.  Aggregate income growth has been greater than 5.5 per cent in all portfolios year-to-date and has recovered nicely from the drop in 2015/2016. Portfolio changes and dividend growth have allowed overall portfolio dividend yields to remain attractively above the 3.5 per cent level, which continues to warrant a fully invested stance. Although capital (share price) performance has been disappointing so far in 2017, we are optimistic on Q4 following strong outperformance in Q3. When the next downturn comes we will be ready and have the utmost confidence in the businesses we own. In the meantime we hope to benefit from the rotation of sector leadership discussed earlier. Discipline and patience remain in short supply; those who exercise these qualities will see long-term benefit.

TOP PICKS

ALTAGAS (ALA.TO) - most recent purchase at $28 on October 3rd.
AltaGas is a stock I have recommended many times on the show including last time. They are currently in the process of completing a transformational acquisition of a utility provider in the Washington D.C. area.  Following a recent meeting with management in our offices last month, we are more comfortable with how the transaction is progressing. The market does not like the complexity of the company as it operates in many different jurisdictions and segments, and perceives there to be a funding gap to close the acquisition. The company reiterated that the regulators who need to approve the transaction would find it presumptuous for them to be selling assets ahead of the regulatory approval so they are taking a measured approach. Regardless of what happens the stock yields over 7.25 per cent at current levels, and that is BEFORE a likely dividend increase in Q4. You are paid handsomely to wait while you see how this plays out. This company has a stellar reputation as both an operator and acquirer. 

CENOVUS ENERGY (CVE.TO) - most recent purchase at $9.55 on July 24th.
Cenovus Energy has traded down following the announcement of the acquisition of ConocoPhillips interests in the Christina Lake and Foster Creek oilsands projects and Deep Basin natural gas assets. Again, the market perceived a funding gap for Cenovus to complete the transaction, especially given that oil prices corrected sharply following the announcement. We believed strongly that they would be able to sell the conventional properties they identified because they have positive cash flow, even at current US$45 to US$55 oil prices, and indeed they have now sold two of the four properties at above what most analysts anticipated. This is similar to how Encana repositioned their company a few years ago. Assuming they can complete the remaining dispositions in Q4, the company’s debt/cash flow falls dramatically in 2018 at strip oil prices, while the company has repositioned itself to be a tighter entity with basically only a top decile oilsands asset and a high-quality/under-utilized natural gas play. The stock has run significantly (around 33 per cent) from our recent purchase to average down client cost bases, but watch if it dips back toward the $11 level.

BANK OF NOVA SCOTIA (BNS.TO) - most recent purchase at $79 on October 3rd.
The last time I was on in June I recommended TD bank at $65, as I believed that the concerns on Canadian housing following the Home Capital share price collapse were overdone and the shares have sharply rallied 13 per cent including dividends. Now, not only is housing remaining stable, but interest rates and the economy have picked up. This is an ideal scenario for banks, and Canadian banks continue to trade at a significant discount to their U.S. peers, despite having higher return on equity, lower competition and higher dividend yields. We think the Canadian banks play catchup in the next few months and beyond.

PAST PICKS: NOVEMBER 10, 2016

ALTAGAS (ALA.TO)
The performance has been surprising to us, however we are always happy to keep buying a quality company consistently growing their dividend that yields over 7 per cent sustainably, especially when cash yields around 1 per cent.

• Then: $32.09
• Now: $28.57
• Rturn: -10.96%
• Total return: -5.20%

AGRIUM (AGU.TO)
We continue to like the Nutrien merger for the long-term. Resource producers with sustainable yields are hard to find but this Canadian juggernaut will be around for years to come. his is a long-term hold in our portfolios going forward.

• Then: $131.94
• Now: $133.63
• Return: 1.28%
• Total return: 4.93%

VERMILION ENERGY (VET.TO)
We are surprised this company hasn’t done better given their exposure to Brent oil prices (which are up around 18 per cent since last September and European natural gas). Similar to Agrium (Nutrien) above, we desire long-term exposure to resource producers with sustainable dividends. Vermilion has been an excellent steward of capital in this regard for many years and we have confidence in their ability to carry that discipline forward.

• Then: $53.31
• Now: $43.93
• Return: -17.59%
• Total return: -13.39%

TOTAL RETURN AVERAGE: -4.55%
 

WEBSITE: www.leonfrazer.com