Market Review Quarter 1, 2015
Equity Markets % Change (in Cdn$)
S&P/TSX Composite 1.9%
S&P 500 9.8%
MSCI/Far East -1.6%
TSX Energy -1.6%
TSX Financials -3.0%
Interest Rates March 2015 December 2014
Cdn 91 day T-Bills 0.53% 0.91%
U.S. 91 day T-Bills 0.02% 0.04%
Cdn 10 year Bond 1.37% 1.79%
U.S. 10 year Bond 1.92% 2.17%
Commodities (in U.S.$) March 2015 December 2014
Oil 47.64 53.71
Natural Gas 2.64 2.91
Gold 1183.30 1183.20
Portfolio Management Strategy
What Worked What Didn’t
– U.S. Dollar – Canadian Dollar
– European Stocks – Canadian Telecom Stocks
– Bonds – Preferred Shares
Be Wary Of Sure Things – NL
Canadian equity investors had an interesting first three months of 2015. Despite the fact that prices for oil, natural gas, and most metals declined precipitously during the quarter, the TSX Composite Index still squeaked out a gain. Currency had much to do with that. Yes, Canadian energy stocks went down but thanks largely to the Bank of Canada’s surprise rate cut in January, the Canadian dollar plunged. This had the effect of somewhat muting the effect of the drop in commodity prices for Canadian producers as commodities are generally priced in U.S. dollars. Meanwhile, most Canadian commodity companies have their production here in Canada and most of their costs therefore in Canadian dollars. Also helping buoy Canadian energy stocks was the takeover of Talisman Energy by Repsol of Spain. Repsol paid, in my opinion, an unnecessarily large premium in order to snare Talisman and many investors instantly added takeover premiums into the prices of many Canadian energy stocks. Those premiums still exist. Hope springs eternal.
The bigger bonus for Canadian investors was the currency effect on their U.S. equity investments. While stock prices were quite volatile during the quarter, the S&P 500 index ended the quarter virtually flat. However, in Canadian dollars it was up close to double digits. Similarly, European stocks were big winners in local currencies and in Canadian dollars as the Euro declined pretty much in line with the Canadian dollar (okay, maybe a bit more but not enough to matter).
More interesting during the quarter were Canadian fixed income markets. As interest rates declined, bond prices advanced. At the same time, however, preferred shares generally had a bad quarter. How can that be? Don’t they also track interest rates? Yes, and that was the problem.
There are broadly three types of preferred shares. First, there are perpetual preferred shares. They pay a fixed dividend and exist in perpetuity (hence the term ‘perpetual’) unless the issuing company chooses to redeem them at their option. These are the traditional preferred shares. Second, there are rate-reset preferred shares. They pay a fixed dividend and the issuing company has the option to reset the dividend every five years according to a formula or they can redeem them at their option. Thirdly, there are floating rate preferred shares (floaters) and their dividend fluctuates with short-term interest rates.
Rate-reset preferreds, and to some extent floaters, were all the rage for the past few years as investors wanted protection from rising interest rates and these securities fit the bill. Rates go up and investors either receive a higher dividend in five years or the company redeems the shares and investors are free to invest in other interest-sensitive securities at the new higher interest rates. Or so the sales pitch went. Rate-resets became so popular that some people chastised us for owning perpetual preferreds in our portfolios as ‘didn’t we know their share prices are going to be killed when interest rates go up?’ They were a sure thing.
Except, they weren’t. Interest rates didn’t go up. They went down and so did the share price of all floaters and any rate-reset preferreds that have their dividends resetting in the next two years. The sales pitch left that possibility out because how couldn’t interest rates go up? Well, not only did they not go up but nobody has a clue as to when they actually might start to increase.
What happened to perpetual preferreds? The ones everyone hated for the past few years. Their share prices either stayed the same or some even went up because their fixed dividends looked even more attractive as interest rates declined. Sure they still carry the risk of declining should interest rates increase but in the meantime, they remain excellent fixed income investments (especially in taxable accounts where they get taxed the same as common dividends). Compare that with bond yields which are currently so low that they yield close to nothing after tax in taxable accounts.
In accounts where we hold fixed income investments, our bond weighting remains at historically low levels. As far as preferred shares go, we hold a mix of both perpetuals and rate-resets as we like the certainty of the dividends perpetuals offer and we want to have some protection against rising interest rates, should they someday once again go in that direction.
Return On My Money – RD
Everyone understands what a return of your money is. However, a return on your money needs some clarification.
How exactly do our clients make a return on the money they entrust to us? When examining the rate of return on stocks there are 2 basic components in assessing the overall rate of return of a stock: 1) whether a stock price increases compared to the price it was purchased at, and 2) the dividend yield a stock pays, if any. Dividends, which are generally paid from company’s earnings, often comprise a notable percentage of a stock’s overall investment return. However, this article will concentrate on comparing the price of the stock to the earnings of the company and how the ratio of the price (P) of the stock to company earnings (E) can influence a stock price. The price of the stock compared to the earnings of the company is referred to as the ‘price to earnings’ multiple or ‘P/E’. The earnings per share of a company is derived from taking the company’s total profit after paying taxes and dividing that number by the number of shares it has issued.
Clearly, a higher stock price today than when it was originally purchased is what we strive for but how we get to that point can take different routes. There are many reasons why a stock might increase in value.
The price of a stock can go higher (or lower) in the absence of any underlying positive performance of the company. As an example, sometimes investors will pay more for a stock because low interest rates make it difficult to find anything else to invest in with a reasonable expectation of making a decent return. However, more likely the reason investors will pay more for a stock is that there is something going on within the company that makes the stock more attractive to investors based on some particular items of interest. A common item is the expectation of revenue growth and / or lower costs resulting in higher company earnings (profits). Higher earnings often result in the stock price going up. This is particularly the case if investors were not already expecting the company to have increased earnings when the earnings are announced. This is just to say that investors are willing to pay a higher stock price because they feel the company’s earnings will be increasing fast enough to justify paying more. So a higher P/E multiple is an important component of the share price valuation (ie when a stock is a good buy) and total investment return. Investors can still make money without a higher P/E multiple but the upside needs to come from earnings growth alone. As an example, if I buy a stock for $40 that has $2.00 a share in earnings I am paying a 20X P/E multiple for it. Should the earnings grow to $2.50 a share in earnings but the P/E multiple remain the same at a 20X P/E than I would have a $50 stock price. Both price (P) and earnings (E) increased by the same percentage thus leaving the overall P/E multiple unchanged. This is a nice return that came entirely from earnings growth and nothing from a higher P/E multiple.
Typically, many industries, in the absence of rapid technological change will, over time, have a stock price that sits within a ‘normal’ trading range of what investors will pay as a multiple of its earnings. We get interested when valuations for industries fall to the low end or below a ‘normal’ long term range. Health Care is highly valued right now but this wasn’t the case several years ago.
During the fourth quarter of 2009 the health care group’s valuation was depressed due to the specter of U.S. led health care reform. We bought Bristol Myers Squibb (BMY) at a historically inexpensive P/E multiple of 12X. That is to say we paid a stock price that was 12 times higher than its earnings for one year. BMY now trades at a P/E of 33X. That’s what you call a P/E expansion. At a 12X multiple investors felt that future earnings were never going to measure up to anything good and at a 33X P/E investors feel highly confident good things will happen in the future.
During the second quarter of 2010 we added Baxter International at a 10X forward earnings multiple and now it trades at 15X. Covidien was bought during the 3rd quarter of 2010 at a 10.5X P/E and now trades at over 23X after its acquisition by Medtronic. We purchased more Pfizer for our investors in the first quarter of 2011 when it was trading at 9X forward earnings and it now trades at 14.5X forward earnings. Rounding out our health care picks was the purchase of Wright Medical in the 4th quarter of 2011. This was a turnaround situation where earnings metrics didn’t apply because prior executives mismanaged the company to the point where it had no earnings but a new, highly respected CEO had just joined the firm. We bought the stock at $14.75 and doubled our money.
The above examples demonstrate that companies can be bought ‘on sale’ when there is an overriding investment concern that turns out to be faulty. It is also much easier for companies to show better than expected earnings growth when investors aren’t expecting much. In the above mentioned instances, the return on your money came from earnings growth but also from higher P/E multiples. Now, however, the recovery to a more normal valuation range for the health care sector has taken place. The great success we have had in buying health care stocks when they were out of favour is what value investors do. Similarly, when investors pile on and P/E multiples are significantly higher than historical valuations for a particular industry, we reduce our exposure to the area, which is what we have done with the sales of Wright Medical, Baxter and Covidien. I am glad we had the opportunity to buy these stocks when we did but finding value in health care now is considerably more difficult. We will be concentrating our research efforts on other areas of the market until value is again visible in the Healthcare sector.
Cara – less – RD
Cara Operations, the owner of 10 branded restaurant chains including Swiss Chalet and Harveys will soon be issuing about $200M worth of new stock to the public in an Initial Public Offering (IPO). A public company since 1963 it was taken private in 2004 by the Phelan family. At that time, the company made most of its money from providing in-flight airline food until selling that business in 2010. Since then, the company has focussed on the restaurant business. The company is owned by members of Canada’s Phelan family and Toronto based Fairfax Financial, who will each sell some stock but will retain voting control over the company. The shares being issued to the public have less voting rights than the controlling shareholders have. You would think this should matter but in this case it won’t.
I recently attended this company’s investor IPO roadshow. The road show is management’s opportunity to extoll on the great and good things about their company in order to drum up interest in the IPO. IPO’s always have a great story to tell, if it didn’t it wouldn’t be going public. While I have been to many of these over the course of my career this management team painted as attractive a picture as I have heard. The Toronto road show I went to over the noon hour was extremely well attended, so much so that there were no seats left for me in the main speakers room and I was left with a hoard of other Bay Street types to sit in the overflow room until it had overflowed as well. You would think as a consolation prize that lunch would be, well something befitting of a restaurant stock. Nada. No rotisserie chicken, no hamburger that’s a beautiful thing, nothing.
After returning to my office, somewhat hungry, I proclaimed to my partners that this deal would fly off the shelves but that we would not be participating. I also stated that the selling price would get raised and sure enough, a week later, it was. This is an awesome time for Cara to go public (again). Canadian investors are clamouring for anything that is not associated with mining or energy. Even the Canadian banks have lost their lustre due to their resource exposure and a slowing Canadian economy. The S&P TSX index is a concentrated stock market with over a third of the weighting comprised of only 10 names. Having a prudently diversified portfolio of stocks is challenging. Then along comes a restaurant stock, with some very strong brands, a new and proven management team, profit expansion opportunities (think takeout and delivery), and a great balance sheet (post the IPO). Get the picture, this stock is going up. So why are we not participating?
The way an IPO works is after management has travelled around extensively telling their story to all and sundry, interested parties must submit to the dealers (bankers like RBC and Scotia) the amount of shares they would like to purchase. With ‘hot’ deals like this one, investors will typically pad their orders. So if I need 100,000 shares for my clients, I will ask for 200,000 in expectation of having my order cut back by the brokerage firms running the deal. Of course everyone else is thinking and doing the same. My experience with these highly sought after deals is that I am allocated somewhere between 5% and 10% of the number of shares requested and once placed evenly across our clients’ accounts it is too small a position to do any good. Sadly, we then need to go into a frothy market environment to buy enough additional shares that can make a difference in a portfolio. As an example, the Tim Hortons original IPO range was $21 to $23 but was upped to $27 by the day of the IPO. The shares traded as high as $38 on the first day of trading and closed at $33. After the excitement died down the shares eventually dropped back down. History may not repeat itself but it often rhymes. We will wait for the hype to wane to see if a value opportunity might arise later.