Managers drill down into energy-stock valuations

Michael O’ Brien, managing director and head of the core Canadian equity team at TD Asset Management Inc. His mandates include that of lead manager of TD Canadian Equity, TD Canadian Blue Chip Equity and TD Balanced Income.

Mark Thomson, chairman of the board and managing director, equities, at Beutel, Goodman & Co. Ltd. Thomson and his team are responsible for a range of mandates including Beutel Goodman Canadian Equity, Beutel Goodman Canadian Dividend and Beutel Goodman Balanced.

Ian Hardacre, vice-president and head of Canadian equities at Trimark Investments, a division of Toronto-based Invesco Canada Ltd. His mandates include the flagship Trimark Canadian.

Daniel Bubis, president and CEO of Winnipeg-based Tetrem Capital Management Ltd. Bubis and his team manage a range of mutual funds for CI Investments Inc., including CI Canadian Investment and CI Canadian Investment Corporate Class.

This three-part series began on Monday and concludes on Friday.

Q: Canadian equities appear to be out of favour both with domestic and foreign investors. What will change this?

Bubis: The Canadian dollar has weakened, with the Bank of Canada’s move to lower its policy rate twice this year reinforcing this. From a foreign investor’s perspective, this is not attractive. You don’t necessarily need to see a rally in the Canadian dollar, but more stability. In addition, you’re going to need to see some strength in commodities, at least on the energy side.

Hardacre: If you’re looking two to three years out, our view is that there is good upside in Canada. There are three heavily weighted sectors in the S&P/TSX Composite Index: financials (37%), energy (18.5%) and materials (9%). If you believe energy prices are going to go higher, which we do, there is good upside. Higher energy prices will help the banks and the Canadian dollar. Looking out two to three years, we’re bullish on the Canadian equity market. Within the Canadian equity market, money has moved from the resources into other areas, such as consumer staples. We consider the valuations on these stocks to be high.

Bubis: Anything that wasn’t economically sensitive or tied to oil got a boost this year. We do not own it, but, as an anecdote, Restaurant Brands International Inc. (QSR), the parent for Tim Hortons, is trading at an enterprise value to EBITDA (earnings before interest, tax, depreciation and amortization) of 17 times next year’s estimates. I have trouble paying that as a price/earnings multiple, let alone an EV/EBITDA multiple. One of the reasons why the consumer-staples stocks are so expensive in Canada is the scarcity premium.

Hardacre: The question is: are the defensive, defensive?

Thomson: They are defensive businesses, not defensive prices.

O’Brien: It’s a question of whether you’re looking at earnings risk or valuation risk. Where you focus on depends on your outlook for the global economy. Longer-term, the balance of risk shifts in favour of some of these more cyclical, beaten-down names recovering.

Q: On the theme of Canadian economically sensitive stocks, the industrial stocks were weak over the 12 months to September end.

Hardacre: The challenges at Bombardier Inc. (BBD.B) have not helped this sector.

Bubis: Some of the companies in the industrial sector have been impacted by the weakness in the energy sector. Looking at the Composite as a whole, the troubles at Valeant Pharmaceuticals International Inc. (VRX) have done some damage.

O’Brien: Of Valeant, the role of specialty pharmaceutical company Philidor RX Services LLC has come as a surprise to many. In all the work we did on Valeant, we had a number of concerns and questions around the business.

Hardacre: I don’t own Valeant.

Thomson: We’re always skeptical about companies where the notes to the financial statements are longer than the financial statements themselves. Also, the company has a pretty onerous debt load.

Bubis: We bought a bit of Valeant in 2014. We owned it for a short period of time. We were building the position and monitoring it and ultimately sold it for a small gain.

Q: We have talked about the importance of the energy sector to the Canadian economy and to the TSX. What is the outlook? Which stocks do you own among the producers?

O’Brien: It’s not a question of whether oil will go up from this roughly US$45 per barrel level, but when. There are a lot of energy producers in Canada that are significantly undervalued. You have to focus on the better-capitalized companies that can weather this. In TD Canadian Equity we own Suncor Energy Inc. (SU), our biggest energy holding. Cenovus Energy Inc. (CVE) is also in the top-10 and Canadian Natural Resources Ltd. (CNQ) is a significant weight.

Hardacre: We have seen a lot of share issues by Canadian energy companies. There is the beginning of consolidation in the energy industry. Suncor is making a bid for Canadian Oil Sands Ltd. (COS). You want to own the companies with strong balance sheets. Mid-caps could have outsized returns, when things turn around. We own some in Trimark Canadian, for example Crew Energy Inc. (CR). It is a Montney resource play (in Alberta and B.C.). On the large-cap side, Canadian Natural Resources is a name we like a lot. We sold our holding in Suncor early in the year. The energy-service side has more risk to it. The fracking companies’ stocks are down 80% to 90%. They have a lot of debt.

Thomson: The longevity of the current pricing is uncertain. Not only do you want to own companies with good balance sheets, but also low-cost producers. The stocks are probably discounting oil at US$65-plus per barrel and we don’t think that the opportunity is that great here, unless oil goes up to US$80, which is a possibility. The stocks of some of the companies like Suncor and Imperial Oil Ltd. (IMO), which have refining exposure, have not been hit nearly as hard as their peers. Their discount to the companies’ net asset value is insufficient, even with oil at US$80 to US$85 a barrel, to generate more than 20% or 25% return. We require a minimum 50% return over three years. Cenovus and Canadian Natural Resources are large weights in Beutel Goodman Canadian Equity. They’re low-cost producers and the stocks, which have been hit more heavily, do offer a 50%-plus return. But that’s conditional on oil at US$80 a barrel.

Bubis: Suncor, a holding in CI Canadian Investment, is an example of a company that is maneuvering through the downturn and will emerge stronger versus its competitors. We reduced our holding in it this year, but it’s still a significant weight, as is CNQ, which is cheaper than Suncor. We bought some intermediate producers, for example, Vermilion Energy Inc. (VET), earlier this year. It’s not the cheapest stock, but it’s a strong company with good growth opportunities.

What makes you bullish on energy is the amount of capital expenditure going into the sector that is being crushed. So many projects are being shelved including Royal Dutch Shell PLC’s oil-sands project in Alberta and its drilling project in the Arctic. It’s happening globally. There is a mean-reversion opportunity in the energy sector in Canada.

Q: What about the Canadian materials sector?

Thomson: The bulk of companies in this sector are gold companies and they have a tendency to destroy value over time. They trade at high valuations because investors don’t use normal discount rates to determine the companies’ net asset values. A great company among gold producers is Franco-Nevada Corp. (FNV), but it’s priced higher than a great business. The agricultural producers in the materials sector are good businesses. It’s a question of valuation. A company like Agrium Inc. (AGU) is actually interesting, at this stage. We own the stock.

Hardacre: I own two gold stocks in Trimark Canadian. They are Kinross Gold Corp. (K) and Yamana Gold Inc. (YRI). The valuations are grossly depressed. Gold is really out of favour. The price-to-cash flow on the stocks is quite low. We sold our holding in Potash Corp. of Saskatchewan (POT) early in the year.

O’Brien: We have some gold holdings. Our biggest position is in Franco. I agree with Mark that it’s not cheap. The company has had a good year this year. It has the cash flow and opportunities will arise, as other gold companies do not have cash. We also own Silver Wheaton Corp. (SLW) and Goldcorp Inc. (G).

Bubis: We don’t own any metal-mining stocks. We like the outlook for energy better. We do own Agrium. It’s a great free-cash-flow generator.

Part two of a three-part Canadian equity roundtable.

The three-part series continues on Friday.