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Regional outlook – CANADA • Stuart Kedwell, CFA
asset growth and the housing market,
coupled with lower net-interest
margins, remain key areas of investor
focus.
We continue to believe that a housing
slowdown is manageable for the banks,
although the loud debate will act as a
brake on near-term valuations. As each
bank prepares to meet Basel III capital
thresholds in the next 12 months, the
focus will eventually return to their
considerable capital generation – even
in a slow-growth environment. Returns
on equity have proven resilient and
the spread of these returns relative to
those available from a 10-year bond
remains attractive. Current dividend
yields coupled with modest dividend
growth should combine to provide
satisfactory total returns.
Insurers’ earnings have been weighed
down by the growing consensus that
interest rates will remain low for a long
time. While the impact of low rates on
earnings power could persist for several
years, we believe insurance companies
have enough capital and earnings
capacity to weather this storm. From
a portfolio standpoint, insurance
companies provide some protection,
since any rise in interest rates would
negatively affect utility companies
and real estate firms, and because we
believe it’s doubtful that the insurers
will need to raise additional equity.
Valuation multiples in the Materials
sector are unlikely to expand because
of slowing growth in China. Yet at
current commodity prices, the sector’s
free cash flow is significant. We think
the use of this cash in the next few
years will be a key factor in the sector’s
performance. As an example, we note
that Potash Corp.’s healthy level of
capital spending will start to tail off,
leaving the company with strong freecash-flow
generation even in a weaker
commodity environment.
Gold stocks lagged bullion again during
the quarter as a number of companies
continue to struggle due to high capital
costs and operational issues. While
the spread between traditional goldcompany
valuations and bullion is at
historically wide levels, some share
prices are starting to look attractive on
a free-cash-flow basis.
Stocks of companies in the Energy
sector continue to trade below levels
one would expect given expectations
for commodity prices. There are a
number of reasons for this trend.
Regional price differences have been
elevated this year, and rising operating
and capital costs continue to be a
concern. As in the Materials sector,
investors are highly focused on capital
discipline. Stock valuations suggest
that many energy companies will find it
more attractive to buy back shares than
embark on new projects.
On the natural gas front, new drilling is
finally beginning to slow in response
to a very warm winter and weakness
in prices for natural gas liquids. With
an abundance of natural gas in North
America and extremely low prices for
gas relative to the amount of energy
produced versus oil, the market is
waiting for a concrete and sustainable
demand response to help prices.
A positive near-term surprise has
been the increasing use of natural
gas instead of coal for electricity
generation, which has helped ease
concerns about a lack of storage
this summer. We expect gas to trade
between $3.50 (the cash cost of
production) and $4.50 (the marginal
cost with a return on capital).
Research In Motion has been a volatile
stock as investors debate the value
of an uncertain stand-alone business
against a large patent portfolio and $4
per share of cash representing about
40% of its market value.
Canada’s Industrials sector offers
a number of opportunities where
current share prices appear to offer
good returns in a slow but steady
growth economy. Should earnings
at companies like Canadian Pacific
and Finning progress in a reasonable
manner in the years ahead, and the
multiple paid on those earnings fall
within historical bands, the share-price
appreciation potential for both would
be attractive.
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