Encounter

Pipelines provide more stable exposure to the energy sector, Michele Robitaille says.
By Sonita Horvitch | 21/06/17

Michele Robitaille, managing director and equity-income specialist at Guardian Capital L.P., says concerns surrounding two key sectors of the Canadian equity market are putting a brake on its performance. "Looking more closely at the issues, these concerns could well be overblown," she says.

About the Author
Sonita Horvitch is a Morningstar columnist who specializes in reporting on money managers and their strategies. A veteran financial journalist, she was formerly with the National Post and its predecessor, the Financial Post. At the Post she was best known as the author of the popular Buy & Sell column, which she wrote from its inception in 1994 to December 2008. She holds a master's degree in business economics from the University of the Witwatersrand in Johannesburg, South Africa.

The Canadian equity market has "stagnated" in the first five months of 2017, says Robitaille. The S&P/TSX Composite Index had a total return of 1.50% and a price return of 0.41% over this period. Dividend stocks, as measured by the S&P/TSX Composite High Dividend Index, were modestly weaker. This index produced a total return of 1.35% for the first five months of 2017 and a price return of minus 0.42%.

Overhanging the Canadian equity market, says Robitaille, is the weakness in the price of oil, which is affecting the heavily weighted energy sector. Also, the overheating in the Canadian housing market and the possibility of a correction is affecting investor sentiment regarding the Canadian banks, which make up another large portion of the S&P/TSX Composite Index.

While the oil price is currently weaker than many anticipated, "the fundamentals for the commodity should improve in the second half of 2017," Robitaille says. There has, she adds, been too much focus on the build-up of inventory so far this year in the United States.

"Naysayers are not recognizing that some of this build-up is due to an early and extended refinery-maintenance season." U.S. crude-oil production, including that of shale oil, has been rising, Robitaille says, but the trajectory is unlikely to be sustainable. With the commodity price at around US$45 a barrel, "it is difficult, from a financial perspective, for many companies to continue to ramp up production," she says. "The low-hanging fruit, in many cases, has been plucked."

Looking beyond the United States, oil inventory in the OECD countries (the Organization for Economic Co-operation and Development) is coming down, says Robitaille. "This all points to a global demand/supply equation that will return to equilibrium and be supportive of oil prices."

Of the financials, Robitaille says that bank stocks had a good run-up in the first three months of 2017, with investors focusing on rising interest rates, which are generally good for banks. But thereafter, she says, the attention turned to concerns about overheating in the Canadian housing market and "the high-profile governance and subsequent liquidity challenges" at the alternative mortgage lender Home Capital Group Inc. (HCG).

Michele Robitaille
Michele Robitaille

Robitaille says the spillover to the banks from Home Capital's woes is "limited and manageable." She points out that Canadian bank stocks carry dividend yields in the 4% to 4.5% range and their trailing price/earnings multiple, at 11 times, is in the middle of the long-term average P/E range. "Furthermore, the banks have been generating excellent earnings growth since the beginning of the year."

At Guardian Capital, the equity-income team's wide-ranging mandates include BMO Monthly High Income ll, which currently holds 36 names. Major sector weights include financials, real estate mostly in the form of real estate investment trusts, and energy, where the focus is primarily on energy-infrastructure companies.

The Guardian equity-income team targets businesses that have sustainable competitive advantages and can generate high levels of free cash flow to support stable and growing dividends or distributions over time. Quality of management at all levels of the company is a big determining factor.

In the financial-services sector, Robitaille reports that the equity-income team has been adding to holdings in bank stocks since the beginning of 2017.

For example, in April and May, the team added to the portfolio's weight in  Canadian Imperial Bank of Commerce (CM). "The stock has been trading at a significant discount to the group, due to concerns about its largely Canadian focus and the above-average growth in its mortgage portfolio," she says. "We consider that those risks are already reflected in the current valuation multiples." Also, she adds, CIBC has now produced 10 quarters of solid earnings per share with no missteps.

Stocks of the Canadian insurers have had a good run, says Robitaille, and "we have taken some profits here," notably in  Manulife Financial Corp. (MFC). "We continue to like the stock. It is a top-10 holding in the portfolio."

Real estate investment trusts should form "a core part" of any yield portfolio, says Robitaille. These units currently have distribution yields in the 4.5% to 5% range, she says. The earnings growth of the REITs is "modest" in the 2% to 3% per annum range, and their valuation is "reasonable."

An office REIT in the portfolio that the team recently added to is H&R REIT (HR.UN). It has some exposure to western Canada. In Calgary, a major holding is The Bow Building, an office skyscraper. But, says Robitaille, The Bow has long-term tenants such as  EnCana Corp. (ECA) and  Cenovus Energy Inc. (CVE). "In all, this REIT has solid office exposure in major cities in Canada and the United States," she says. "It also has diversification through its holdings in both retail and, to a lesser extent, multi-family residential properties."

At the end of 2016 and into January, Guardian equity income team added to the portfolio's holding in the shopping-centre giant RioCan REIT (REI.UN). "Canadian retail REITs are under less pressure than their U.S. counterparts," says Robitaille. "The Canadian retail environment is less competitive. There is less retail square footage per capita in Canada than there is in the United States." Also, while the adoption of e-commerce in Canada is high, it is still lower than is the case south of the border, she says.

An apartment REIT where Robitaille and her colleagues have taken some profits is Boardwalk REIT (BEI.UN). Its apartment portfolio focuses predominantly on Alberta. The unit price has had a strong move, yet this REIT is facing challenges, she says. For example, its apartment buildings in Calgary "are still working through stiff competition from the growing supply of condominiums in this market."

In the energy sector, the portfolio's emphasis is on pipeline and midstream companies (companies that process, store, market and transport energy). "These energy-infrastructure companies have relatively stable earnings reflecting long-term contracts and they also have limited commodity exposure."

Robitaille reports that the equity-income team has been adding to the portfolio's holding in  Enbridge Inc. (ENB), since the stock offered "good value." The company completed the acquisition of Houston-based Spectra Energy Corp., in February of this year. There are concerns, she says, that Enbridge's structure has become too complicated and thus more challenging to analyze.

Enbridge, she notes, has a number of separate subsidiaries and affiliates that include Enbridge Income Fund Holdings Inc. (ENF), which holds energy infrastructure assets. "Spectra's structure also includes similar underlying vehicles, adding to the complication." Another negative, she says, is that the company's Line 3 replacement program has been pushed further out. "There is thus no near-term catalyst for the stock," she says. "But the valuation discount on Enbridge relative to rival TransCanada is excessive, considering that Enbridge has historically traded at a premium to TransCanada."

 TransCanada Corp. (TRP), another significant holding in the fund, has had a stronger performance for the year to date than Enbridge, Robitaille notes. "There are more factors currently in TransCanada's favour." This March, for example, its controversial Keystone XL pipeline project received the go-ahead from U.S. President Donald Trump. In early July 2016, TransCanada completed its U.S. acquisition of Columbia Pipeline Group Inc.

Enbridge Inc.TransCanada Corp.
June 19 close$51.09$63.62
52-week high/low$59.19-$49.61$65.24-$55.15
Market cap$82.1 billion$54.6 billion
Total % return 1Y*1.218.6
Total % return 3Y*3.911.3
Total % return 5Y*8.211.4
*As of June 19, 2017
Source: Morningstar

Robitaille says there are "considerable growth opportunities resulting from TransCanada's purchase of Columbia Pipeline." For example, she says, Columbia Pipeline's assets include pipelines and storage capacity in the large and prolific Marcellus Formation and in the Utica shale area. "A lot of the good news has already been priced into TransCanada's stock," she says, "but we still like it."

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