In part two of our manager roundtable on Canadian equities, the discussion turns to opportunities in the struggling resources sectors.
Morningstar columnist Sonita Horvitch, whose three-part series began on Wednesday and concludes on Friday, convened a panel of three value managers. They are:
Daniel Bubis, president and chief investment officer and founder of Winnipeg-based Tetrem Capital Management Ltd., which manages money for institutional and high-net-worth clients. Bubis manages a range of mutual funds for CI Investments Inc., including CI Canadian Investment and CI Canadian Investment Corporate Class funds.
Mark Thomson, managing director and head of research at Beutel, Goodman & Co. Ltd. Thomson and his team manage a range of mandates including Beutel Goodman Canadian Equity, Beutel Goodman Canadian Dividend and Beutel Goodman Balanced funds.
Q: Let’s take a closer look at the Canadian materials sector.
Thomson: I’m negative on gold stocks, which are a big slice of this sector. The large-cap gold stocks that we primarily invest in are discounting a bullion price at US$2,200 per ounce. There’s a lot of optimism built into these stocks. Bullion has been an exceptional performer in the last few years and gold stocks have underperformed.
Bubis: I’m cautious on them. It’s hard for the companies to create shareholder value, as they are facing ongoing cost escalation. If you’re optimistic about the global economy, it’s hard to be too optimistic about the bullion price. Gold has been a hiding spot for investors. Also, at some point, interest rates are going to go up, which is negative for gold. But, it’s difficult to forecast the bullion-price trajectory.
Hardacre: Our gold-stock weight is minimal. We own only Kinross Gold Corp. K , which has had a tough time. I’m spending more time looking at the gold group again. It has underperformed the Canadian equity market significantly. Gold stocks represent 9% of the composite index, or roughly half of the materials weighting.
Q: What about the Canadian fertilizer stocks?
Bubis: These stocks are sensitive to an agricultural cycle, which tends to be longer than the economic cycle. Looking at Potash Corp. of Saskatchewan Inc., which I own, its valuation is low. There has been pressure on the commodity price, but the low price has dimmed the prospects of new projects. Some of Potash Corp’s expansion projects, which created additional supply, were painful for the share price in the short term. But it was smart strategically. It scared off some competitors. All that capital expenditure is rolling off and the company can be a great free-cash-flow generator, even at the lower potash prices. It could take over Israel Chemicals Ltd. It would be a strategic move to sustain the price. We also own Agrium Inc.
Feb. 1 close
52-week high / low
$116.38 / $77.50
$47.94 / $37.02
Total % return 1Yr*
Total % return 3Yr*
Total % return 5Yr*
*As of Feb. 1, 2012
Thomson: We have big weightings in both stocks. We sold down our holding in Agrium. The stock has more than doubled. Potash has been a poor capital allocator historically. Both Agrium and Potash have started to increase their dividend-payout ratios. Even now, Potash’s dividend-payout ratio is low. The two companies are getting a lot smarter about returning capital to shareholders. We have some concerns about Agrium’s tender offer to repurchase its shares last year. The price it paid was high.
Bubis: I also have concerns about this tender offer.
Hardacre: You’re talking about the role of New York-based Jana Partners LLC, a hedge fund, which has been advocating changes at Agrium. The interesting thing about this is that Agrium’s stock has done well. Shareholder activism is a lot easier when the stock has underperformed.
Bubis: Jana is focusing on ways to optimize the retail side of Agrium’s business. Agrium has had this activist investor involved since last summer. This has helped the stock.
Thomson: Agrium’s stock performed well prior to that. Potash has underperformed and has good prospects.
Hardacre: We don’t own either of them. Potash has become more interesting to us. The question is: Will the mechanism for determining the commodity price hold together? In the Canadian materials sector, we own Teck Resources Ltd. We bought it a couple of years ago.
Bubis: It’s in the top 10 holdings in CI Canadian Investment Fund.
Thomson: We own it.
Hardacre: It produces metallurgical coal and some copper. The stock was flat during 2012.
Bubis: But this is offset by a dividend, which was increased during the year. There’s better capital discipline, which is a theme across a number of resource companies, returning more capital to shareholders. It’s positive for Canada.
Hardacre: Investors have put pressure on companies to return capital to shareholders, rather than misallocate capital.
Bubis: This trend benefits the larger natural-resource companies, the incumbents, that already have resources, rather than some of the juniors that need to grow. The gold companies are caught between a rock and a hard place in this trend. They have finite resources that are shrinking and it’s more expensive to extract the ore. They can return capital to shareholders only for so long, before running out of resources to mine.
Thomson: On the base metals, we’re in the midst of a global confiscation cycle. It’s difficult to find companies that don’t have jurisdictional risk. Teck and Inmet Mining Corp. are probably the only two examples on the large-cap side. Inmet is a takeover target.
Bubis: This jurisdictional risk is another negative for a lot of the gold companies.
Hardacre: This all indicates how tough the mining business is.
Q: Time to talk about the Canadian energy sector in more detail.
Thomson: We’re interested only in low-cost producers. Examples are Canadian Natural Resources Ltd., Cenovus Energy Inc. and Crescent Point Energy Corp. We don’t own Crescent Point. It’s too expensive. We’re most positive on CNQ. It’s a good capital allocator.
Bubis: I own Canadian Natural Resources. It’s a major holding.
Hardacre: I also own Canadian Natural Resources. It’s a relatively recent position for us. The stock has been hit for a few reasons, including the commodity-price differential. Heavy oil coming out of Western Canada is discounted significantly because of lack of pipeline and upgrading capacity. Its Horizon oil-sands operation has had its hiccups. Management has a more realistic target for this project. Canadian Natural Resources is well managed and its management owns a lot of stock on a dollar basis.
Thomson: The heavy-oil price differential is hitting the company. This will get sorted out over time. There is huge opportunity there. It’s a 4.4% weight in our Canadian equity fund. We have built this position in the last six to eight months.
Hardacre: Suncor Energy Inc. is in our top 10 holdings. We like the asset base. The new management team has a good attitude when it comes to returning capital to shareholders. The company should generate substantial amounts of free cash flow over the next couple years at these commodity prices. The stock has underperformed and is inexpensive.
Bubis: I have a big weighting in Suncor. I am surprised how badly the stock has underperformed, given how well the company is doing in terms of cash-flow generation, share buybacks, growth opportunities and dividend increases. Suncor is minting cash from its refining operations.
Hardacre: Suncor is doing everything right. The market is not responding. This is not the only situation. The equity market is ignoring these companies and therein is the opportunity.
Bubis: Plays such as the Bakken shale-oil play that straddles the U.S. border with Canada and runs through North Dakota, Montana, Saskatchewan and Manitoba, have taken capital from the oil-sands. Investors have been focusing on these plays, which are lower-cost than the oil-sands. That has been the big rush over the last few years. The pendulum has probably swung too far.
The final part of the roundtable will appear on Friday.