March 2015 - The Quarter that Was

The TSX had an OK start to the year, with a 1.8% return over the quarter. Of course, energy was down another 1.9%. Declining crude prices continued to put pressure on energy stocks, but technically stocks are behaving well having put in what may be their low in December with higher highs and higher lows since then. The US S&P 500 was up just 0.4% in the quarter. But currencies added 9.1% for Canadian investors!!

 

As this is my first blog of 2015, I thought it would be useful to share how I think about Investing and my long-term goals for my portfolio. My long-term goal is to compound capital at a high rate of return while minimizing the risk of permanent loss of capital in any individual security or holding. In other words don’t lose money but outperformed the major market indexes. So far so good!!

 

I expect to continue to hold a 60/40 (60 % equity, 40% cash) allocation in about 40 to 50 investments, and estimate that my typical holding period will be long-term, typically ten or more years.

 

Recently I was approarch by a fellow investor and his advice was to sell equities because of technical indicators he seen on another blog which could cause a market crash. Personally I have no time for technical indicators or reacting to other people investment advice when managing my portfolio. I tried to keep in mind of some famous quotes by Warren Buffett on Investing ;

 

 “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”

 

 “We have long felt that the only value of stock forecasters is to make fortune-tellers look good.”

 

I couldn’t agree more and as a matter of fact “time arbitrage” can be an investor advantage. For example by taking advantage of the opportunity for long-term profit offered when short term investors sell due to disappointing short-term macro or business progress – this has always been a major source of profitability for my portfolio. In my experience, stock prices are often much more volatile than the underlying value of the business they represent.

 

I believe it is self-evident that the value of a business is the present value of the cash that it will generate for distribution to its owners over its lifetime. For the high quality, simple, predictable, low-leverage businesses in which I prefer to invest, their discounted expected lifetime cash flows generally do not change meaningfully due to events in Greece, greater Europe, or technical indicators in the markets.

 

As always for my quarterly blog I like to profile one of my holdings;

 

Portfolio Update - Agrium

 

I began taking a position in Agrium last year when the stock was in the low 80s.

 

Agrium is a well-diversified crop input company. The company’s Retail division operates North America’s largest agricultural retail network and has significant operations in Australia. Agrium Wholesale has significant operations that produce nitrogen fertilizers, along with sizable operations that produce phosphate and potash fertilizers. Agrium’s nitrogen operations are primarily located in Western Canada with access to low cost natural gas and located near higher netback regions – Western Canada and Western US nitrogen prices are typically priced at a premium.

 

EPS estimates have increase with the start of many positive trends for Agrium's operations in 2015. The increase was primarily attributable to lower nat gas input costs and a more favourable CAD/USD exchange rate. While not immune to agricultural headwinds, I continue to argue the longer term outlook for Agrium retail segment remains underappreciated. I base my argument on (i.) further cost reductions (incl. asset rationalization) and working capital improvements, (ii.) global growth in private label initiatives, (iii.) additional improvements in Australian Retail (an emerging theme), (iv.) Viterra results continuing to surprise to the upside.

 

I expect Agrium to focus capital on the following (i.) maintaining its core asset base , (ii.) growth investments with minimal returns of ~12% (in excess of AGU's 8% WACC), (iii.) sustainable dividend growth, (iv.) opportunistic share repurchases.  

Capital Allocation- Show Me the Divy!

 

Agrium free cash flow inflection in 2016 can support much higher dividends: I  forecast  significant  free  cash  flow  starting  in  2016  based  on sustained Retail cash generation, improved nitrogen earnings due to Borger expansion start-up, and continued ramp-up of the Vanscoy potash mine.  Additionally,  I  expect  capital  expenditures  will  decline  from approximately $2B in 2014, to $1B in 2015, and then $600M in 2016. I believe this oncoming free cash flow inflection will allow management to significantly increase its dividend while remaining confident that the company can support its dividend payout even in a downside scenario. I think a $5/share dividend by 2016 is not unreasonable, and even extreme downside scenario would support dividend payments well in excess of $4/share.

 

 

 

 

 

 

 

Fiscal 2014 Update - OPEC Didn't Blink - Will US & Canadian Producers?

On a average to low risk adjusted basis my 60/40 (60 % equity, 40% cash) portfolio grew 12% in the 2014 calendar year. Positioning the portfolio to be underweight the two poorest-performing sectors (Energy and Materials) and overweight some of the best-performing sectors (Consumer Staples, Utilities) and U.S. Equity all worked to my advantage.

 

Canadian equity markets were mired in negative territory given their relatively large exposure to the besieged  Energy sector. In 2014, the S&P Global Energy Sector decline 11% and recent data by RBC Global Energy suggests continued challenging energy market conditions well into 2015.

 

· The oil market is roughly 800,000 Bopd oversupplied.

· The overwhelming issue is continued hyper US production growth.

· There has been steady growth out of Canada as well and this is likely to be a little sticky as oil sands projects have a longer-term horizon.

· OPEC is currently producing roughly 30.5 MMBopd. There may be modest upside to this over time due to potential growth in Iraq and the potential resumption of offline barrels.

· For the last 16 years, OPEC has defended price as opposed to market share. This changed on November 27.

· If and when oil prices move a fair bit higher, we will start to see a production response from the US, which could re-accelerate global production.

· The last six bear markets for oil have averaged 141 days with oil dropping 39% over that time (139 days, 32% ex. global financial crisis).

· The current bear market has persisted for 172 days with oil dropping 36% since June 13. If recent patterns hold, we could be nearing the bottom for oil.

 

Over the past 16 years (1998-2014), the global oil market has witnessed three major episodes of pricing collapse, each of which coincided with a dramatic macro economic or political event which either caused or was associated with a severe drop in oil demand growth. These include;

• 1997-98 (Asian Currency Crisis),
• 2001-02 (9/11 Terrorist Attacks), and
• 2008-09 (Global Financial Crisis).

On average, the aforementioned episodes displayed depressed or negative global oil demand growth for 2–4 quarters before staging a sustained demand growth recovery, which supported an oil price rebound. The Brent price pullback of late has not been associated with a major financial crisis at this juncture, but Saudi Arabia’s policy uncertainty has exacerbated the situation.

 

Canadian benchmark oil prices have fared relatively well by comparison to US oil prices, in part due to the insulation afforded by a softening Canadian dollar. Indeed, Canadian benchmark oil prices are based not only upon US benchmarks, but also the foreign exchange rate. As such, a softer Canadian dollar is favourable for Canadian oil prices. This stabilizer is often overlooked, but important in our eyes because an investor is buying a cash flow stream. As a simple illustration – holding all other factors constant, a US$0.01 depreciation in the Canadian dollar would largely off-set a US$1/b fall in WTI as it relates to Canadian light and heavy oil prices.

 

But you still need to be careful when looking at Canadian Oil & E&P, my Least Favourite Stock – is Canadian Oil Sands because it is;

• Oil Sands Pure Play - 100% light sweet un-hedged crude oil production (Syncrude)

•  Operating Performance Challenged - Recurring unplanned maintenance = lower volumes + higher operating costs

• Dividend Cutter -  Dividend recently cut by 43%, Further cut possible given low oil prices

Keep in mind that in most countries, the fall in oil prices is generally seen as a positive development as it relates to future GDP growth. Moreover, most central bankers have been quick to emphasize that they will look through the “one-off” effect of lower oil prices and, instead, focus on movement in core consumer prices as they set policy. The IMF looked at a supply-side exercise in last October’s World Economic Outlook— albeit in reverse—using its own macro model. They examined the likely impact of a reduction in Iraqi oil supply that would increase the price of crude by roughly 20%. Their work suggests the net GDP impact from a 20% decline in oil prices could be in the range of +0.4% to +0.7% after two years for countries such as the US, Japan and China as well as the Eurozone.

 

Portfolio Update - Alaris Royalty Corp.

 

Alaris Royalty Corp is a Calgary-based provider of capital to well managed and profitable private companies seeking alternative avenues of financing. Its  strategy is unique in the sense that unlike most private-equity firms, it provides alternative financing to private companies without seeking a controlling stake. Alaris’s long-term goal as a company is to create the optimal dividend stream available for its investors. With that goal in mind, it seeks private companies that generate predictable, low volatility, and low cyclicality cash flows for monthly cash returns.

 

Early in 2014 I began accumulating shares in Alaris Royalty, over the past 12 months, Alaris Royalty shares returned 36% in total returns, and they hit 52-week highs, grossly outpacing the 6% from the TSX. Alaris Royalty generates 40% of revenues from the US. I forecast this should rise well above 50% in the next two years as Alaris capitalizes on its US-focused investment pipeline. Given the rise in the USD, I expect positive tailwinds to revenues and earnings including sizeable unrealized gains on its US holdings. Alaris continues to benefit from having little to no exposure to oil and the Western Canadian economy.