The risks of a peaking in North American equity markets and a strategy to protect and prosper

Transcription

1 1 December 15, 2015 INVESTMENT STRATEGY NOTES Nick Majendie, CA Director, Wealth Management ScotiaWealth Senior Portfolio Manager, with responsibility for advising the Anchor The risks of a peaking in North American equity markets and a strategy to protect and prosper Stock market outlook Some of the warning flags that we see currently in the U.S. market are as follows: 1) The U.S. stock market s breadth is narrowing to a rapidly diminishing number of stocks. This is a warning sign in terms of what often happens in the late stages of a bull market. The market has narrowed to essentially four key stocks namely Facebook, Amazon, Netflix, and Google. They ve been rising strongly all year while the broad stock market has effectively gone sideways. At the beginning of this year, their combined market cap was $740 billion. Their combined market cap currently amounts to about $1.150 trillion - for an increase of 55% or $410 billion while their combined earnings for the first three quarters of the year were up by only 13%. The combined P/E of the four stocks has risen from a 42 times reported earnings to a 58 times earnings. This has echoes of the spring of At that time, the four leading stocks in terms of performance were Microsoft, Dell, Cisco and Intel. The combined market cap of these four stocks had risen by an incredible $800 billion in the approximate 12 months before the 2000 peak. By the fall of 2002, the combined market cap of these four stocks had fallen to $450 billion for a decline in value of about $1 trillion. The valuation of the four stocks in the spring of 2000 was more extreme than that of Facebook, Netflix, Amazon and Google today but nevertheless Facebook sells at a P/E ratio of 107, Netflix at a 320 P/E, Amazon at 968, and Google at 31. The point is that, if the rest of the market comes under pressure for whatever reason (fears of rising interest rates, a slowing global economy etc.), there is considerable downside risk in these four stocks due to multiple compression from elevated levels. 2) Junk bond yields under pressure In the last cycle, U.S. junk bond prices peaked at the end of May Over the next 14 months, the prices of the junk bond index fell by 14%. Rising yields in this segment of the bond market were a precursor of subsequent wider problems in the corporate sector and the economy in general. In this cycle, since their peak in June 2014 to the beginning of December, the junk bond index has fallen 14.5% as of Friday December 11th. A good proportion of these junk bonds are in the energy sector and, should oil prices stay depressed through most of 2016, there will be increased downwards pressure on the prices of junk bonds in this sector. Junk bonds are very sensitive to what is happening in the economy and they often provide warning signs ahead of other assets. Last week, investors pulled $3.5 billion out of junk-bond funds, according to Lipper -- the most since August ) U.S. companies are paying shareholders more than 100% of profits through dividend payments and stock buybacks. In 2014, U.S. companies spent 95% of their operating profits on dividends and buybacks and in Q1 this year, it was 104%. In the last cycle, the payout to shareholders exceeded 100% of operating earnings in Q and the payout peaked two quarters later at 157% of profits, which was just before the financial crisis hit.

2 2 4) The level of U.S. margin debt Margin debt peaks during the final run to the cycle high in stocks with each bull market. The recent peak in margin debt was $51 billion in April this year after being flat in all of last year around $45 billion on average. Because this data comes to us with a short-term lag, it is only observable with a degree of hindsight. In July, the S&P traded to its current peak at 2,135, while margin debt balances fell just shy of $18 billion. On a very short-term basis at least, a divergence was therefore established in July. In the bull market, the peak in margin debt was in March 2000 exactly coincident with the peak in the S and P 500. In the last cycle, the peak in margin debt was in June 2007 but the market itself did not peak until the fall in the case of the S&P 500 and the summer of 2008 in the case of the TSX. The latest U.S. margin debt number is for October and was reported at $7 billion not significantly lower than the April peak. The timing of the April peak in margin debt would suggest at least that we are the final leg of this bull cycle. In conclusion, none of these warning signals mean definitively that we are at the end of the North American equity bull market that started in March Volatility in equities has picked up sharply and undoubtedly owes much of that to the upcoming Fed meeting which will result most likely in the Fed hiking rates by 25 basis points. Historically, volatility has died down after the first Federal rate hike and equity markets have done well in the following six months. Certainly, this cycle is different having gone the best part of a decade without a Federal rate hike and so it is hard to know whether the historical positive performance in North American markets after that first rate hike will prevail in the current cycle. Our strategy for how to protect and prosper in the next few years. Introduction Over the last three months, we have interviewed the senior management of most of the 70 companies in our equity universe in Calgary, Montreal, Toronto and Vancouver. Despite all the negativity and concern about Canada s currency, its economy, the trend in the price of oil and commodities generally, we have been struck by the degree to which Canada has globally competitive companies in areas which we think will be booming over the next five to ten years. Where do we see these burgeoning areas and what do they mean for an investor? In one word, the boom will be in infrastructure. Specifically, there are three different infrastructure themes, which we would name as follows: general infrastructure (toll roads, ports, rails, terminals etc.), clean power (renewables such as hydro, wind and solar as well as natural gas, the cleanest fossil fuel) and telecom infrastructure whereby the Internet will become the phone of tomorrow. When we talk of infrastructure, we recognize that the promise to run budget deficits to finance infrastructure spend in Canada helped the Liberal party gain a majority in the Canadian election in October. However, our Federal Government is the exception that proves the rule. The vast majority of governments around the world are over indebted and do not have the resources to fund infrastructure investments. It is the same story with much of the private sector in Europe particularly, but also in South America, Australia and to some degree the United States. A number of companies we interviewed have strong balance sheets and a relatively low cost of capital which allows them to consider deploying capital with excellent returns in opportunities that they are seeing in abundance. For example, in our interview with Brookfield Infrastructure, they mentioned they are seeing extraordinary opportunities in Brazil currently. Brookfield has been operating in Brazil for many decades and although the country is in recession, it is extraordinarily rich in resources and is a democracy (they view the Petrobas investigation and the President impeachment process as a very positive affirmation of a democracy in action). In addition, the devaluation that has taken place will make the country competitive again. Were it not for all these short term negatives, the company could never have dreamed of being able to participate, for example, in the Rio Di Janeiro metro system or the Sao Paulo airport, which they regard as once in a lifetime opportunities as well as many others that they are examining.

3 3 Similarly, both Brookfield Renewable Energy and Enbridge are seeing a lot of opportunity for their expertise in wind and for investment of their capital in the sector in both Europe and the United States. We noted in our last Anchor Note that Alberta s new climate change plan was to replace two thirds of its coal electricity generation by renewable energy, primarily wind power. Currently, 9% of power comes from renewables. Despite the abundance of natural gas in Alberta, its role is to be restricted to base load reliability. It is estimated that at least $15 billion will have to be invested in new power generation. That same Anchor Note also outlined how TransCanada is currently operating wind, hydro and nuclear plants as part of its 111,800 MW of power generation, and would likely benefit from the need for several new gas-fired plants over the next number of years. As an example, we mentioned how TRP s management told us that an average gas fired plant would likely require in the area of a $1 billion investment with attractive rates of return for a company like TRP with a low cost of capital. Several of these will be required over the next number of years and TRP should be capable of getting its fair share of that incremental investment. In terms of infrastructure build in the telecommunications sector, Rogers, BCE and Telus will all be investing in the infrastructure necessary to provide ever increasing Internet speeds over the next five to ten years. Rogers will be installing its next-generation broadband technology, DOCSIS 3.1, while BCE and Telus have embarked on a major program to provide Fibre to the Home (FTTH). The former is an incremental approach and requires much less capital investment than FTTH. The latter is much more capital intensive. For example, Telus has announced a $1 billion program for Edmonton FTTH installation and another $1 billion to cover Vancouver. Since 2000, incidentally, its Capex has amounted to $28 billion. BCE has an even more sizeable program whereby it will install fiber to potentially connect up to 11 million homes in its footprint. It hopes thereby to achieve 50% penetration over the next 10 years versus the one third penetration it currently has in its markets. They describe this as a $3 billion incremental revenue opportunity. Our strategy 1) Our findings From these interviews, we were able to identify 13 companies from our universe that we believe will be able to benefit materially from the aforementioned three infrastructure themes. These corporations have acceptable to outstanding balance sheets. They also have strong cash flow and dividend growth prospects. Furthermore, on a blended basis, over two thirds of their cash flow over the next five and even ten years will be covered by regulation or long term contracts, thus materially increasing the predictability of the future cash flow and dividend growth over the longer term. In fact, over 60% of those companies have been able to publish three to five year dividend growth targets and in a couple of cases, their ten year dividend growth potential. None of the 13 companies are commodity producers or in the financial and consumer sectors. With appropriate weighting of each of these holdings, the blended current dividend yield is estimated over 5%. We estimate that the blended growth rate of dividends of these stocks will be between 7.5% and 8% over the next five years, which would imply a blended yield on today s cost of about 7.5% five years from now. We have discussed possible dividend growth rates post 2020 with company managements and while we obviously have less confidence in the predictability of dividend growth that far out, a growth rate of 6%-7% in the second five year period does not sound overly optimistic to the executives we talked to. Were a dividend growth rate of 6.5% to prevail in the second five years for the 13 stocks, the implied dividend yield on today s cost 10 years from now would be over 10%. However, in terms of Total Shareholder Return, the average dividend yield for the first five years would be over 6% and, if the capital value of the stocks grew at the same rate as the growth in dividends, the overall return (dividends plus capital gains) would be handily double digit.

4 4 2) How to incorporate the 13 stocks into our Anchor Strategy In the first part of this Note, we noted several warning signs which could indicate that we are in the latter stages of this bull market. However, we have frequently pointed out how we are in uncharted waters in terms of the incredible infusion of liquidity into the financial system by the world s central banks. Thus, the predictability of the market s peak is hazardous at best. The peak could have already taken place or just as easily could be prolonged till the first year of the new President s term, which has historically seen the Administration take unpopular moves to limit inflation through braking the speed of economic growth. Amid this uncertainty, we believe that it is prudent to be very defensive in one s strategy. In this respect, it makes sense to use the Anchor Defensive Income fund in whole or in part to help protect one s capital from undue (i.e. market type loss). This fund has no commodity stocks in it, is currently 39% exposed to equities, has about 8% in preferred shares (hopefully bottoming out in tax loss selling season) and the balance in one to five year laddered investment grade bonds. Already, this portfolio has eight of the 13 stocks already in it and we plan to add the remaining five companies to the equity segment of the fund in the next short while. As mentioned, the equity segment of the fund stands at approximately 39% but should our Deflation Monitor trigger or certain equity markets be down from their peaks by a certain percentage, the equity exposure could be reduced down to approximately 25%. Should that be the case, there would be an overall loss from here but it should limited to a single digit decline even if the Canadian market decline turned out to be as great as it was in the last bear market. That assumes that the stocks declined by the same percentage as the market which is unlikely to be the case. In sum, we believe that this fund would decline significantly less than the TSX. What that means is that there would be more capital to switch into full exposure to the 13 stocks at the start of the following bull market. This would be accomplished by switching into the Anchor High Income fund which is limited to stocks and would then comprise all the 13. To put that into context, even if the TSX decline did indeed turn out to be as great as it was in the last bear market, one would then be switching out of the Anchor Defensive Income fund which could offer 25% exposure to the 13 stocks into 100% exposure to those stocks but the going in yield at that stage would be estimated at over 7% rather than the estimated current level of 5% (as the lower price of the stocks boosted the yield level) and with the aforementioned growth in dividends, the yield on cost five years from now would be in excess of 10% and the average dividend yield over the five years would be close to 9% without taking into account capital gains. Given the predictability of the dividend growth that we have described above, we believe the use of the Anchor Defensive Income fund in the next year or so to help protect capital in the event of a bear market and investing that capital in the Anchor High Income when the yield on the 13 stocks gets to 7% or beyond on price weakness makes good sense. Portfolio Changes The NYMEX gas price hit a 14-year low at the beginning of this week. We spoke at some length with Peyto last week and although the Aeco gas price is not quite as depressed and the Company is 40% hedged for 2016, we believe that investors will question the sustainability of the Company s dividend despite it being the lowest cost gas producer in Alberta. We therefore decided to switch the Peyto holding into TransCanada Corporation, which will be a major beneficiary of two of the three infrastructure themes that we have described above. These transactions were completed in the Anchor Dividend Growth and High Income funds. We previously had raised cash in all three Anchor funds by taking profits in Bank of Montreal, CIBC and Fortis. Additionally, we reduced our TD exposure in the Anchor Defensive Income fund and made a modest addition to our Brookfield Infrastructure holding following our interview with the Company. The profit taking in banks came after a decent recovery in the sector since the summer. However, we fear the recent route in oil and commodity prices will put the Canadian economy in very slow

5 5 growth/possible recession territory. Due to the holiday season, the next edition of our Anchor Notes will appear on January 15. It will carry our Outlook Nick Majendie, CA Director, Wealth Management, Senior Portfolio Manager, ScotiaWealth PLEASE NOTE: IMPORTANT DISCLOSURES AND DISCLAIMERS ARE CONTAINED ON THE FOLLOWING PAGES.

6 6 i The Bank of Nova Scotia is the parent company of Scotia Capital Inc. ( SCI ) and is therefore a related issuer of SCI. Scotia Managed Companies Administration Inc., a wholly-owned subsidiary of SCI, is the manager of the Anchor. ScotiaWealth, a division of SCI is the portfolio advisor to the Anchor. Nicholas L. Majendie, who is employed by ScotiaWealth, provides portfolio advice to the Funds. This information reflects Mr. Majendie s opinions as of the date of these notes. These opinions may change at any time and neither Mr. Majendie, ScotiaWealth nor their affiliates undertake to update the information or opinions. This information and opinion does not constitute investment advice or an offer to trade securities. Anchor hold securities of the following issuers referred to in this note: BCE Inc., Brookfield Infrastructure Partners, Brookfield Renewable Energy Partners, Enbridge Inc., Peyto Exploration & Development, TD Canada Trust, Telus, and TransCanada Corp. Nick Majendie, who provides portfolio management advice to the Anchor, personally holds securities of the following issuers referred to in this note: BCE Inc., Brookfield Infrastructure Partners, Brookfield Renewable Energy Partners, Enbridge Inc., Peyto Exploration & Development, TD Canada Trust, Telus, and TransCanada Corp. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. These Anchor are distributed under a Simplified Prospectus. The Simplified Prospectus, Fund Facts and Annual Information Form are available from ScotiaWealth or on This publication is intended only to convey information. It is not to be construed as an investment guide or as an offer or solicitation of an offer to buy or sell any of the securities mentioned in it. The author is an employee of ScotiaWealth, a division SCI, but the data selection, analysis and views expressed herein are solely those of the author and not those of SCI. The author has taken all usual and reasonable precautions to determine that the information contained in this publication has been obtained from sources believed to be reliable and that the procedures used to summarize and analyze such information are based on approved practices and principles in the investment industry. However, the market forces underlying investment value are subject to sudden and dramatic changes and data availability varies from one moment to the next. Consequently, neither the author nor SCI can make any warranty as to the accuracy or completeness of information, analysis or views contained in this publication or their usefulness or suitability in any particular circumstance. You should not undertake any investment or portfolio assessment or other transaction on the basis of this publication, but should first consult your investment advisor, who can assess all relevant particulars of any proposed investment or transaction. SCI and the author accept no liability of CONT D ON NEXT PAGE

7 7 whatsoever kind for any damages or losses incurred by you as a result of reliance upon or use of this publication in contravention of this notice. The statements in this newsletter may contain statements related to future financial performance of certain securities, indices or the Anchor Managed funds that may constitute forward-looking statements. These statements may be identified by words such as expect, look forward to, anticipate, believe, seek, estimate, project, potential, predict, or words of similar meaning. Such statements are based on the current expectations and certain assumptions of the author, and are, therefore, subject to certain risks and uncertainties. A variety of factors, many of which are beyond the author s control, affect the performance of the securities and capital markets indices and therefore the performance of the Anchor funds and could cause the actual results, performance or achievements of the securities, indices or the Anchor funds to be materially different.