More positive on cyclicals

TD's Michael O'Brien encouraged by improved economic backdrop.

Sonita Horvitch 16 May, 2012 | 6:00PM

Michael O'Brien, vice-president and director at TD Asset Management Inc., has been adding to his holdings in commodity-related stocks, encouraged by both healthier economic news from the United States and the cessation of monetary-policy tightening in China.

"Canadian resource stocks have taken a beating and a lot of high-quality cyclical names are attractively priced," says O'Brien, who manages a Canadian large-cap portfolio at TDAM using a GARP style, or growth at a reasonable price.

O'Brien notes that his strategy was more defensive in the second half of 2011. "It was a case of battening down the hatches." He says that he turned more positive about cyclical stocks in the first quarter of this year, given the improved economic backdrop.

In keeping with this approach, O'Brien has been reducing the weighting in the portfolio's more defensive names, for example paring back holdings in pipelines. At the same time, he has been adding to more economically sensitive stocks -- including those related to commodities. He has also been increasing his holdings in Canadian bank stocks.

O'Brien says that he recognizes that "the retail investor's desire for yield is unchanged." As a result, he says, "the ultra-safe dividend payers such as telecommunications-services stocks and pipeline stocks were commanding valuation premiums." By contrast, the Canadian banks, which are also stable dividend payers, but tend to be more cyclical, "had relatively attractive valuations."

On the global economic picture, O'Brien points out that the United States has been producing better job numbers, the troubled housing market is finally bottoming, and auto sales are improving. "There is pent-up demand for housing and autos, south of the border."

 
Michael O'Brien

A note of caution on the United States, he says, is that global financial markets will refocus on the country's structural twin-deficit problems after the November election. "The new administration in Washington will be given a limited grace period to demonstrate its ability and commitment to address these significant challenges," says O'Brien, who has a background in political science.

China, "the poster child for the emerging economies and a major source of demand for key commodities," embarked on a tighter monetary policy in 2011. This phase ended in 2012, says O'Brien and "China's stock market has been quietly rising."

Europe remains problematic, he says, and its troubles will flare up from time to time. "The latest flashpoint was Spain, which with its 25% unemployment rate, is having trouble meeting its fiscal targets."

At TDAM, O'Brien is responsible for a number of institutional and high-net-worth mandates at the firm, focusing on the Canadian equity market. These include TD Canadian Blue Chip Equity  , which has assets of $1.1 billion.

At the end of April, TD Canadian Blue Chip Equity had 36.5% in financials, 26.7% in energy and 15.2% in materials, for a total of 41.9% in the resource sector. The fund is benchmarked against the S&P/TSX 60 Index and has 41 names.

O'Brien's approach to portfolio construction is to target "the most attractive industries and then to invest in those companies with the best growth prospects that trade at a fair price."

In energy, he favours the Canadian oil-sands producers "for their long-life reserves in a politically stable jurisdiction." His call is that the oil price should continue to trade at or above US$100 per barrel.

The fund's three biggest energy holdings are Cenovus Energy Inc. CVE, Suncor Energy Inc. SU and Canadian Natural Resources Ltd. CNQ.

O'Brien has recently added to his holding in Cenovus. He likes this company because "the majority of its future growth is from projects that are SAGD or steam-assisted gravity drainage, an oil-recovery technology." These projects tend to be smaller, he says, and are not subject to the substantial cost overruns of the larger essentially mining projects in Fort McMurray.

"Cenovus has demonstrated that it can bring its SAGD projects on stream on time and on budget." In addition, he says, Cenovus has refining assets. This allows it "to capture the value of a barrel of oil along the production chain and makes it less vulnerable to the differential in the Canadian oil price versus the U.S. and European price."

Cdn Natural Resources Ltd. Cenovus Energy Inc. Suncor Energy Inc.
May.15 close $29.44 $31.77 $27.67
52-week high/low $42.72-$27.25 $39.64-$28.85 $41.80-$23.97
Market cap $32.4 billion $24.0 billion $43.1 billion
Total % return 1Y* -24.4 -0.9  -27.1
Total % return 3Y* 1.6 NA -5.0
Total % return 5Y* -2.3 NA -8.4
*As of May.15,2012
Source: Morningstar

Suncor is a fully integrated energy company with both refining assets and retail outlets (downstream assets). Its oil-sands projects tend to be mainly mining in scope and more prone to cost overruns, says O'Brien.

The company does have SAGD projects in the Fort McMurray area located on leases known as Firebag, says O'Brien. Its mining operations include both the Millennium and North Steepbank sites.

Suncor has a number of growth projects under way, says O'Brien, including its 40.8% interest in Suncor-operated Fort Hills Oil Sands Project with two partners: French multinational Total S.A and Teck Resources Ltd. TCK.B.

Other projects include Suncor's 36.8% interest in the Total-operated Joslyn oil-sands mining project. In addition, the company has a joint venture with Total to build Suncor's Voyageur up-grader.

O'Brien reports that he has trimmed his holding in Canadian Natural Resources Ltd. "Unlike Cenovus and Suncor, CNQ does not have downstream assets to enable it to capture the value of a barrel of oil along the production chain."

Although the major Canadian gold stocks have been disappointing performers for some time, O'Brien considers that they still warrant a place in a Canadian blue-chip portfolio. "They are currently unloved and cheap relative to their historic premium valuations," he says.

Importantly, he says, these stocks provide "some portfolio insurance," given the economic uncertainties in key developed countries and their accommodative monetary policies, which could result in the resurgence of inflationary pressures over time. "This would allow gold to shine."

The two biggest gold holdings in TD Canadian Blue Chip Equity are Goldcorp Inc. G and Barrick Gold Corp. ABX. Of the two stocks, O'Brien favours Goldcorp. "Its mines are newer and it has a superior growth profile to that of Barrick. Goldcorp is starting from a smaller base."

O'Brien notes that Barrick (60%) and Goldcorp (40%) have a joint-venture project, Pueblo Viejo Gold Mine in the Dominican Republic, which is one of the largest undeveloped gold mines in the world. "This mine should be operational this year."

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Sonita Horvitch

Sonita Horvitch