Pessimism about energy has contributed significantly to the Canadian market's lacklustre performance so far this year, says Peter Frost.
By Sonita Horvitch | 23/08/17

Peter Frost, senior vice-president and portfolio manager at AGF Investments Inc., says that the negative sentiment surrounding the energy sector is a big overhang for the Canadian equity market.

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.

Some energy names have experienced steep declines in their stock prices since the beginning of 2017, "The junior energy producers, in particular, have been decimated." As an indication of the degree of pessimism about the Canadian energy sector, even some of the brand name big-cap Canadian pipeline companies have seen a drop in their stock prices, says Frost. "Pipelines have traditionally been viewed as being fairly defensive."

What is puzzling, he says, is that the current crude oil price, at slightly below US$50 a barrel, is far higher than it was in early 2016, during the last bout of severe weakness in the energy sector. In January 2016, the oil price dipped below US$28, which represented a 12-year low in this commodity price. "Over the course of 2016, the oil price recovered to end the year at above US$50 a barrel, and the energy sector rebounded strongly."

The current pessimism about energy has been a significant contributor to the lacklustre performance of the Canadian stock market so far in 2017, says Frost.

The benchmark S&P/TSX Composite Index produced a total return of 0.7% in the first seven months of this year, in sharp contrast to its robust showing of 21.1% in 2016. At the end of July, energy accounted for a 20.4% of the Composite, "thus its fall from grace has weighed heavily on the index."

The overall performance of the Canadian equity market so far this year, he says, is at odds with the strength of the underlying economy. "This has surprised on the upside, as Western Canada has done better than expected and there has been solid job growth across the country."

Peter Frost
Peter Frost

Given this strength, the Bank of Canada raised its target for the overnight rate by 25 basis points (one basis point is equivalent to 0.01%) in July to 0.75%. The financial markets expect the Bank will increase the overnight rate by a further 25 basis points in October, says Frost, and Canadian interest rates across the yield curve have been rising.

Frost is a member of AGF's Asset Allocation Committee, which analyzes the macroeconomic environment and capital markets, in order to determine the firm's asset allocation strategies. Of late, he says, he has been reducing the equity component and raising cash in the two Canadian balanced funds that he manages -- AGF Monthly High Income and AGF Traditional Income. Currently, these two funds have 61% in equities, 34% in bonds and 5% in cash.

AGF Monthly High Income emphasizes stocks with a high dividend yield and AGF Traditional Income focuses on stocks of companies with above-average dividend growth. Both funds have foreign content.

Frost says he has not been adding to his holdings in the energy sector for some time. AGF Monthly High Income has two Canadian energy producers among its top-10 holdings. They are Vermilion Energy Inc. (VET) and Bonterra Energy Corp. (BNE).

Vermilion, says Frost, is benefiting from its natural gas properties in Europe. "The price of natural gas is higher in Europe than it is in North America." Overall, he says, Vermilion is growing its production in the mid-to-upper single-digit range. Bonterra is a low-cost light oil producer and is growing its production in the mid-single-digit range, says Frost. There are concerns, he says, that the company has too much debt on its balance sheet. "But Bonterra plans to reduce its debt through the cash flow it is generating this year."

In AGF Traditional Income, a long-standing Canadian energy services holding is Pason Systems Inc. (PSI). "I have held the stock in a portfolio that I was responsible for almost two decades and continue to like it." The company, he says, is a global provider of instrumentation and data management services for drilling rigs. Pason, Frost says, has maintained and grown its dividend over the past decade. The company's second-quarter 2017 revenue was up substantially from the same quarter in 2016, yet the stock is still close to its 2016 low. "This is indicative of the extreme weakness in the energy sector."

Bonterra Energy Corp.Pason Systems Inc.Vermilion Energy Inc.
Aug. 18 close$14.99$17.97$39.38
52-week high/low$29.76-$14.53$22.36-$14.79$58.98-$38.33
Market cap$499.7 million$1.5 billion$4.7 billion
Total % return 1Y*-40.7-1.3-15.9
Total % return 3Y*-31.6-15.0-12.0
Total % return 5Y*-
*As of Aug. 18.
Source: Morningstar

Turning to the materials sector, a stock that is held in both funds is Methanex Corp. (MX). "I have liked this stock for decades," says Frost. Canada-based, the company is a global producer and supplier of methanol, "which has many industrial applications." The company, says Frost, is benefitting from the low price of natural gas, the feedstock used in the production of methanol. A strong free cash flow generator, Methanex is "an excellent dividend grower, and it has also undertaken to make substantial share buybacks."

Rising bond yields are positive for the financial services sector, says Frost, "but they are better for the insurers than the banks." Frost has increased his holding in major Canadian insurer  Manulife Financial Corp (MFC), which is a significant holding in both balanced funds. "I like the company for its exposure to Asia." The Street is speculating, he says, that Manulife could divest itself of its Boston-based division, John Hancock Financial Services Inc. "It is uncertain whether or how Manulife will proceed with this," he says. "If it goes ahead, the question is will Manulife sell John Hancock outright or will the Canadian insurer spin out its U.S. division into a separate company?"

In keeping with Frost's enthusiasm for insurers, he recently initiated a position in another major Canadian insurer,  Sun Life Financial Inc. (SLF). "The company's investment management subsidiary, MFS, is starting to see a solid improvement in its net sales."

Frost has not been adding to his bank holdings. "The stocks of the major Canadian banks have been essentially flat since the beginning of the year to recent close." This is despite the fact that rising interest rates are generally good for banks, he says. "They allow the banks to widen their net interest margins -- the difference between the rate that they pay on deposits and the rate at which they lend money out." The main concern among investors, he says, is the banks' exposure to the Canadian residential real estate market, "given the rising interest rate environment and the moves by certain provinces to dampen market activity."

In the real estate sector, rising Canadian interest rates will negatively impact Canadian Real Estate Investment Trusts, says Frost. Of the fundamentals, this can increase the cost to the REITs of financing their existing real estate portfolios and be a headwind in the development of new properties, he says. Then, as an investment, REITs are seen as fixed-income proxies, and as such, are interest-sensitive. "I do not own any REITs in the portfolios I manage at this time."

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