Sector Watch: Optimism, with a dash of caution

Still, Hall admits, there is uncertainty about Europe’s fiscal mess and whether China will achieve a soft landing as its economy adjusts to slower global growth. “We would expect to see continued volatility — both to the upside and downside,” says Hall, adding that Europe’s fiscal woes appear to be lessening but longer-term issues need to be ironed out. “Things appear to be improving in Italy, for instance, where the cost of debt is falling. But they need to implement a lot of these austerity measures. Longer term, there is still some uncertainty. So, markets will continue to react, on the positive and negative, to news coming out of the region.”

Although Canada’s economy will be affected in 2012 by a global slowdown and deleveraging by domestic consumers, Hall believes there is one positive to consider: equities valuations are very attractive: “When you look at dividend yields relative to Government of Canada bonds, everything looks pretty cheap.”

Moreover, profits for Canadian companies have been strong, he says, “and generally beating expectations quarter after quarter. That has resulted in record levels of cash on balance sheets. Given this low-rate environment, companies have lengthened their debt maturities and locked in some attractive interest rates. This will continue to translate into increases in dividends.”

Bottom-up stock-pickers who follow a “growth at reasonable price” style, Hall and Robitaille have become less defensive. They have reduced the weighting of real estate investment trusts in the BMO fund to about 21% of assets under management from 25% and pushed the banks’ weighting to 12.5% of AUM from 9.5%. There is also about 31% in energy companies (split among oil and gas producers, pipelines and infrastructure names) and smaller weightings in sectors such as telecommunications.

One of the top holdings in the 42-name portfolio is AltaGas Ltd., a Calgary-based former income trust that offers power generation and natural gas processing. “[Alta-Gas has] an attractive dividend yield [of] 4.6%. [It] will provide good growth in dividends, driven by a visible pipeline of development projects and potential acquisitions,” says Hall, noting that the firm is in the process of building the Forrest Kerr hydro-electric project in northwestern British Columbia on a 60-year purchase agreement with B.C. Hydro.

AltaGas stock is trading at about $29.77 a share. Hall has no stated price target.

 

jennifer mCclelland, vice president with Toronto-based RBC Global Asset Management Inc. and co-manager of RBC Canadian Equity Income Fund, says she is cautiously constructive: “The economic data coming out of the U.S. has been a little more encouraging. There are signs that the housing market, for instance, is flatlining. Everything is tentative; the environment is volatile. But there is room to increase the cyclical exposure — in a safe way — and monitor the situation very closely. We have a more optimistic bias than six months ago.”

Like Hall, McClelland notes that equities are attractive, especially compared with the bond market. “Stocks are trading at pretty reasonable price/earnings multiples. And they are attractive, given the opportunity for a pickup in earnings growth,” she says. “In general, companies have kept their balance sheets in really good shape. A lot of them are holding cash and being more cautious, given what they went through in 2009. They have the opportunity to spend the cash in a constructive manner over time — that’s a positive. So, the earnings growth opportunity is compelling. We’re pretty constructive on valuations in the market. But you have to be selective.”

A bottom-up stock-picker who shares fund-management duties with RBC GAM vice president Brahm Spilfogel, McClelland aims to get broad exposure to the market and does not manage to a benchmark.

Currently, about 31% of the RBC fund’s AUM is in energy stocks, 29% in financials (which includes REITs), 14% in industrials, 8% in materials, plus smaller holdings in sectors such as consumer staples. There is no minimum yield for each holding, although the fund’s target overall running yield is 3.25%, or 1.25 times the S&P/TSX composite index’s return yield of 2.6%.

One of the top holdings in the 100-name fund is Newalta Corp. A former income trust, Newalta treats industrial waste and is also active in the oilpatch, for which it provides waste processing and recycling. “[Newalta has] grown a very strong business in Canada and [is] starting to do the same thing in the U.S.,” says McClelland. “It’s not well followed because the company is a kind of hybrid, but it has a reasonable valuation and an interesting growth profile. The company is involved in ‘greening’ a lot of energy projects.”

Newalta stock is trading at about $14.20 a share, or about six times enterprise value to earnings before interest, taxes, depreciation and amortization, and has a 2.5% dividend yield. McClelland has no stated price target.

Another favourite name is Russell Metals Inc., a service provider to the steel industry. “[Russell is] positioned to benefit from a pickup in industrial activity,” McClelland says. “[It] also provides the oilpatch with tubular steel, so this is a play on the economic pickup and production on the oil side in Canada.”

Russell’s stock is trading at about $26 a share.

jackee pratt, vice pres-
ident with Toronto-based Matrix Funds Management Inc. and manager of Matrix Monthly Pay Fund, is also bullish and notes that markets have been up by more than 13% since early October, when they bottomed.

Looking out 12 to 18 months, Pratt anticipates the benchmark S&P/TSX composite index could hit 14500 (vs 12500 at time of writing). “When I put a target on the TSX,” Pratt says, “I look at earnings 12 to 18 months out. The index has tended to gravitate to a multiple of 15 times earnings on next year’s earnings — that’s been the average. I believe the U.S. economy did not go into recession last year. In fact, it’s undergoing an inventory rebuild phase, which will be good for industry, manufacturing and earnings — and, therefore, North American stock prices.”

Although only half the companies in the S&P 500 composite index have reported 2011 fourth-quarter earnings, more than 60% of the reports have been positive surprises, notes Pratt: “It is early days. But at least more are reporting positive surprises than negative ones.”

Canada stands to gain from a growing U.S. economy, says Pratt, but will also benefit from expansion in China, even if that country’s growth rate has slipped below the double-digit pace recorded in 2010. Referring to a recent Bloomberg LP survey of economists’ forecasts, Pratt notes that the median real gross domestic product growth forecast for the U.S. is 2.3% in 2012 and 2.4% in 2013. Canada’s real GDP growth is forecast to be 2% this year and 2.3% in 2013. China is forecast to grow by 8.5% in 2012 and 8.2% next year.

“This is where I’m coming from,” Pratt adds. “I’m expecting slow economic growth in the U.S. and Canada.”

A bottom-up investor who utilizes a blend of value and growth investment styles, Pratt is running a 50-name portfolio. Financials, including REITs, account for 31% of the Matrix fund’s AUM, followed by 24% in energy, 11% in industrials, 10% in materials and smaller weightings areas, such as 6% in telecommunications.

One favourite holding is Suncor Energy Inc., the largest integrated oil company in Canada, which has major interests in Alberta’s oilsands. In the fourth quarter of 2011, Suncor produced 576,500 barrels of oil equivalent a day. Suncor is aiming for 580,000 BOE this year and hopes to reduce costs to about $37-$40 per barrel.

Suncor stock is trading at $33.90 a share and yields 1.3%. Pratt believes Suncor’s stock could hit the mid-$40 range within 12 to 18 months.

Another favourite holding is Bank of Nova Scotia. In the fourth quarter, the bank reported a 17% return on equity; yet, it trades at less than two times book value.

“It looks cheap. And it’s one of Canada’s best-managed banks,” says Pratt. “It’s also Canada’s most global bank. Some of the economies it is in, such as in Latin America, are thriving.”  IE