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Pipelines "still reasonably valued"

Significant growth ahead, says 1832's Jason Gibbs.

Sonita Horvitch 16 July, 2014 | 6:00PM
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 Jason Gibbs, vice-president and portfolio manager at 1832 Asset Management L.P., says that the Canadian equity market is in the seventh-inning stretch.

Investors are far from euphoric, he notes, and although certain stocks and sectors are getting expensive, there are still opportunities. "Classic dividend-paying stocks, such as pipelines, where the companies are growing their cash flow and dividends, are still reasonably valued," says Gibbs, whose specialty is equity income.

Furthermore, he says, the interest-rate environment for dividend-paying stocks should remain positive. "Rates are likely to remain lower for longer," he says. On concerns about possible wage inflation, Gibbs counters that labour does not have much pricing power, at present, "in the face of much improved technology."

The Canadian equity market put on a strong spurt in the first half of this year, Gibbs notes. The S&P/TSX Composite Index produced a total return of 13%. The rebound in the heavily weighted Canadian energy sector, with a total return of 21%, has been one of the key drivers of this performance.

The fundamentals for this sector are more encouraging, Gibbs says. "Commodity prices are firmer and the gap between Canadian oil prices and those realized in the United States and internationally has narrowed." Also, he says, pipelines are being built or repurposed to help move product.

A further impetus for the Canadian equity market so far this year, says Gibbs, has been the recovery in the materials sector, another substantial weighting in the Composite index. These stocks produced a total return of 17% in the first six months of 2014.

Both energy and materials were out of favour coming into 2014, says Gibbs. Since then, these stocks have attracted both foreign and Canadian money, he says. "There is still a lot of money sitting on the sidelines in both Canada and the United States." Investors remain cautious, he says, and "this is one of the reasons why I consider that the market has further to run."

At 1832 Asset Management L.P., Gibbs is a senior member of the firm's equity-income team, which has a wide range of mandates including Scotia Canadian DividendScotia Diversified Monthly Income and Scotia Income Advantage.

In stock selection, the equity-income team focuses on companies that are "best in class" -- businesses that are strong cash-flow generators and have solid balance sheets. "The target must have a dominant market position in an industry where there are high barriers to entry," says Gibbs.

At the end of May, Scotia Canadian Dividend (assets $6.6 billion) had foreign content of 25% (its mandate allows for a maximum of 30%), with the bulk of this in U.S. companies. The fund is benchmarked against the S&P/TSX Composite Index and currently has 55 names. Its two largest sector weights continue to be financial services at 33% (including 9% of the fund in real estate) and 21% in energy, of which 9% of the fund is in energy infrastructure stocks.

In financial services, the fund has 12% in the major Canadian chartered banks. Ongoing significant weightings are Toronto-Dominion Bank TD, Bank of Nova Scotia BNS and Royal Bank of Canada RY, the top three holdings in the fund. Gibbs reports that he has not been adding to these stocks for a while. "Trading at 12 times estimated forward earnings per share, they represent fair value and are more of a hold."

 
Jason Gibbs

But he notes that he has added a major U.S. financial-services company to the portfolio, Wells Fargo & Co. WFC. "This bank, which has a commanding retail-banking presence in the United States, survived the financial crisis and used its strength to acquire rival Wachovia Corp. in the fall of 2008," says Gibbs.

This stock trades at a similar multiple to that of the three Canadian banks in the portfolio, "yet it has superior earnings and dividend-growth prospects given that the U.S. economy is still coming off the bottom."

A Canadian non-bank financial that he has been adding to is Power Corp. of Canada POW, a diversified holding company, which controls Power Financial Corp PWF, which in turn controls Great-West Lifeco Inc. GWO and IGM Financial Inc. IGM. "The holding-company discount on Power Corp.'s stock relative to the company's net asset value had become excessive," says Gibbs. "It is a challenge in the Canadian equity market to find a blue-chip stock trading at such a cheap valuation."

In the energy sector, Scotia Canadian Dividend's two largest energy producer weightings are Suncor Energy Inc. SU and Canadian Natural Resources Ltd. CNQ. The common theme in the case of these companies, says Gibbs, is that their management "has become more focused on growing the companies' free cash flow and increasing dividends, while demonstrating greater capital-expenditure discipline."

Suncor is trading at six times and CNQ at five times their respective estimated forward cash flow per share, says Gibbs. "They are fairly valued and I have not been adding to them."

But he has been adding to his holding in the pipeline company Enbridge Inc. ENB. "The Canadian pipeline companies are in a significant growth phase." Enbridge, says Gibbs, is expanding its infrastructure and generating good returns on its capital expenditure. "It is also growing its dividends at 10% plus per annum."

In addition, Enbridge has the opportunity to take full advantage of its U.S. subsidiary, Enbridge Energy Partners L.P. EEP, "which is in the nature of an income trust." Gibbs considers that the stock is cheap, based on Enbridge's free-cash-flow yield and growth in the companies' free cash flow per share.

He continues to like TransCanada Corp. TRP, "which is one of the cheapest pipeline stocks in Canada." Investors, he says, are focused on problems with its Keystone XL pipeline project and are ignoring other significant projects, which are likely to face fewer challenges and contribute to the company's "solid long-term growth prospects."

Canadian Natural
Resources Ltd.
Enbridge Inc. Suncor
Energy Inc.
TransCanada Corp.
July 14 close $48.53 $50.96 $44.99 $53.04
52-week high/low $49.57-$30.45 $53.73-$41.74 $47.18-$32.04 $53.12-$43.94
Market cap $51.4 billion $42.5 billion $64.2 billion $37.6 billion
Total % return 1Y* 48.9 13.8 41.3 16.5
Total % return 3Y* 8.5 20.7 7.7 13.4
Total % return 5Y* 11.2 23.4 8.7 15.0
*As of July 14, 2014.
Source: Morningstar

As part of his rigorous sell discipline, Gibbs eliminated his holding in the global pharmaceutical giant Pfizer Inc. PFE when the company announced a takeover bid for an English company, "which, if it went ahead, would have produced no discernible benefit to Pfizer shareholders."

The portfolio continues to have a modest holding in Johnson & Johnson JNJ. "The company has well-established global brands and the stock is reasonably valued," says Gibbs. "It also fits my strategy of using foreign content to invest in stocks that you cannot get exposure to in Canada and further diversify the portfolio."

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Sonita Horvitch

Sonita Horvitch  

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