Bull Market: Taking Stock


Has the bull market run its course? Does the recent tax legislation mean it’s time to dump income trusts? Investors enter this RRSP season with more than the usual dose of nerves as they ponder their investment options. For advice, BCBusiness met with two experts who spend their days making investment decisions. Carl Hoyt is managing partner at Cypress Capital Management Ltd., a Vancouver firm owned by AGF that oversees $4 billion in assets. Hoyt manages the AGF Diversified Dividend Income Fund and the AGF Monthly High Income Fund. Patrick Reddy is an analyst at Leith Wheeler Investment Counsel Ltd., which has more than $6 billion under management. Reddy specializes in energy investments. The consensus from the experts? Stay the course. Trying to time the markets is futile – even for seasoned experts, much less amateur investors. Yes, stock markets fluctuate and the TSX and Dow are at historic highs. But trying to guess the timing of the next correction is a fool’s game. Over the long run, you’ll do better by choosing the asset mix that’s best for you and sticking with it. As for income trusts, the tax hit in 2011 has already been factored into unit prices, and most will probably convert back to a corporate structure. There may even be some windfall profits thanks to buyouts from private investors. BCBusiness: A lot of investors feel we’ve reached a turning point, with stock markets at historic highs and income trusts dealt a major blow by the federal government. Are they justified in feeling under pressure to make some investment decisions? Carl Hoyt: That’s a common question and it illustrates a potential error that a lot of investors make in trying to change their asset mix in response to short-term expectations. Very few investors, and investment counsellors for that matter, are very good at market timing. It serves investors much better to set an asset mix that meets their long-term objectives and constraints, and stick with it. I’ve always believed that equities will give you the best long-term performance. I think we’re in a relatively low-inflation, slow-growth environment, and equities in the long term are likely to give you returns in the high single digits. BCB: Patrick, you cover the energy sector; what sorts of options are you looking at and what kind of decisions are you making? Patrick Reddy: My view of the energy sector is rather unique compared to the consensus that’s out there. On a long-term basis, I use lower-than-consensus oil-and-gas price expectations, and that does limit the range of investment opportunities. I see oil prices in ’07 probably in the low fifties and I see gas prices pretty much where they are right now. From there, some of the opportunities we’re looking at are Nexen and EnCana. We like EnCana because of the management team, and it has a tremendous portfolio of opportunities in North America. BCB: Carl, what in the small-cap sector looks interesting to you today? CH: At various times in history, small-cap equities will trade at discounts to large-cap equities, but right now they’re pretty closely valued, so small-cap stocks are essentially valued appropriately relative to large-cap stocks. Where we do think there’s an opportunity is in the income-trust sector, where small-cap and mid-cap income trusts tend to trade at fairly significant discounts compared to their large-cap counterparts. BCB: But what about the new legislation that will start taxing income trusts at the source as of 2011? Does that mean income trusts have a lifespan of four years? CH: We’re likely to see some income trusts choosing to convert to corporations and some, because of their compelling valuations, subject to takeover bids either by private-equity investors or by corporations. And some will choose to remain income trusts, perhaps even beyond 2011. BCB: In the case of either a conversion to a corporation or a takeover, would that mean a windfall for investors? CH: It’s an opportunity to the extent that there are takeovers. We just recently saw a hedge-fund investor indicating an interest in acquiring Calpine Power Income Fund, and as a result the shares rose 30 per cent. The possibility of takeovers represents an opportunity for capital appreciation in the income-trust sector that I think has been absent for some time. BCB: If a trust is neither acquired nor converted to a corporation, what happens if you’re left holding an income trust in 2011? PR: I don’t foresee a situation where an income trust would prefer to stay a trust beyond 2011, rather than convert to a corporate structure. Throughout the next four years, depending on the trust, some will stay right to the end and some will likely convert over the next few years. BCB: Even in the energy sector, where trusts have been longer established, will companies be thinking of converting to a corporate structure? PR: It’s tough to generalize within the royalty space, because it depends on the firm’s strategy and how much they want to grow. Some firms may want to convert back to being a corporation that focuses on production growth, or they may just focus on playing out their assets and paying as much back as they possibly can to the unit holders. CH: It’s interesting that the income trust space really began in the oil-and-gas sector and it continues to be dominated by oil-and-gas royalty trusts, because most oil-and-gas royalty trusts really have very few of the attributes one would think of as ideal for an income trust: things like long-life assets, stable cash flow that is not dependent on commodity prices and a defined level of capital expenditures that are sufficient to sustain the business. [pagebreak] Oil and gas has none of those features, so it is not the poster child for the income trust structure in the first place. I think there are some real problems in the sector for investors. So we think there are very few oil-and-gas royalty trusts that meet the suitability criteria of an income trust. BCB: So for the average investor, oil-and-gas royalty trusts certainly aren’t a long-term investment. What about income trusts? CH: The other segment of the trust market would be business trusts, such as power and pipeline trusts or real-estate-investment trusts. Certainly at Cypress we see opportunities within those sectors, specifically within the smaller, mid-cap trusts where valuations are somewhat more attractive than the larger-cap income trusts. PR: At Leith Wheeler, we’ve always looked at business trusts as businesses and at how these businesses compare to their corporate peers. So from our perspective, the only thing that has really changed is the one-time tax hit at the expiry date of 2011, and that has already been reflected in the stock price. So from our perspective, nothing has really changed. CH: I would add that one lasting implication of the income-trust phenomenon beyond 2011 is that I think we’re going to see corporations and/or income trusts, depending on which survive beyond 2011, really move toward higher payout ratios, or increasing the amount of retained earnings that are paid out as dividends. Investors have signaled a clear preference in their valuation of income trusts for receiving dividends, or distributions. I think that phenomenon will survive the income trusts and I think that’s a positive for investors. BCB: Moving on from royalty and income trusts, what opportunities do you see in Canadian equities? PR: Financials and telecom investments are one area we’ve always highlighted as an opportunity. Financials have attractive yields and attractive valuations versus the marketplace; they have diversified businesses and good management teams. The Canadian market, from an international investor’s perspective, is a resource-based environment, but financials are a way to minimize your exposure to that resource base. They have been consistent achievers; they do well in recession. BCB: When I think financials, I think the big five banks and the two or three big insurance companies. Are there other opportunities? PR: We see the greatest opportunities in both the banks and the insurers. Manulife on the insurance side, Royal Bank, TD Bank, Bank of Nova Scotia – those are the names that we think will deliver the best value for shareholders over the next few years. CH: I’m going to have to echo Patrick. Financials are wonderful long-term investments for individual investors. They are not subject to a lot of economic sensitivity. We do think there is a significant chance of the economies in the U.S. and Canada slowing, and we would expect the banks to perform pretty well in that environment. BCB: Let’s return to small-cap. When I think small-cap, I think tech stocks, speculative stocks. Is that the kind of thing you mean by small-cap? CH: No. Canada is predominantly a resource market. We do have some investments in the resource sector in small-cap, but we tend to find better opportunities in the media sector and consumer stocks. BCB: Can you name any in the media sector? CH: It’s very difficult to find small-cap stocks in the media sector, but I would call mid-cap stocks like Alliance Atlantis Communications and Astral Media companies that deliver solid returns and have valuable properties. We see very limited media properties in Canada, and those that do become available have a wonderful franchise value that eventually will be realizable in some cases. For instance, Alliance Atlantis put itself in play and CHUM was recently sold for a pretty hefty valuation. So we think that’s an attractive sector that can be expected to generate relatively stable cash flow, even in a slowdown. The telecom sector is another area that’s perhaps not small-cap, but we think valuation levels are pretty reasonable – and again, the companies are not subject to much economic sensitivity. BCE and Telus have some growth opportunities in areas like high-speed Internet and wireless. The traditional wire-line businesses are on the decline and are subject to increased competition from cable, etc., but we think they’re still very viable franchises that offer good long-term investments. BCB: It used to be that telecoms were safe havens for Granny’s nest egg. Is that still the case? PR: The one interesting thing about the telecom business in Canada is that there are so many restrictions that the government has put in place in terms of foreigners coming in and entering the business, and therefore it’s essentially an oligopoly between the cable operators and the traditional telcos. So from our perspective it’s been a great operating climate, and telecom companies were one of the top performers in 2006. And we really like Rogers because it is essentially a quadruple play, with wireless, cable, high-speed Internet and Internet phone service. BCB: One sector we haven’t touched on is mining. Is there a future for mining? CH: I think we’re in the late stages of the bull market for base metals. The way we try to evaluate any commodity, including energy or base metals, is to look at the marginal cost of new production; what would it cost to find a new deposit, bring it into production and earn an acceptable return on capital? In the case of copper, for example, the cost of bringing a mine into production has certainly gone up recently, but it doesn’t explain the magnitude of the move we’ve seen in copper prices. The good news is that the companies are fairly reasonably valued in terms of the spot price of base metals; however they’re a little bit expensive in relationship to the long-term sustainable price of metals. So the race is on to generate cash flow and take advantage of the high current prices. The issue is whether investors are likely to earn exceptional returns by investing in the sector at this point in the cycle, and we don’t think so. PR: We’ve always had a tough time investing in these businesses because generally, throughout history, they’ve had a hard time earning the cost of capital. There have been times when we have seen commodity prices move up, but costs move up just as rapidly so at the end of the day, they aren’t going to make great returns on capital invested. CH: One of the opportunities remaining in this space is due to the billions of dollars of free cash flow in big-cap metals companies, and they don’t have their own deposits to bring into production. So we do believe we’ll see an acquisition cycle where world-scale deposits owned by small- and mid-cap metals producers are likely to be acquired by the large-cap producers that have this staggering cash flow. An example would be First Quantum Minerals, a copper producer that has shown tremendous ability to bring on new projects in Africa on time and on budget, and offer a really significant production profile to larger-cap copper producers. BCB: What about the big question: are we due for a stock market correction? CH: That question makes interesting cocktail-party conversation, but that’s about all. Short-term capital-market forecasts are not worth the paper they’re written on. I’ve been in the investment business for 20 years, and I have not come across anybody who is a reliable short-term forecaster for things like equity markets. It’s really important for investors to try to put aside the short-term fluctuations and risks, have a concise and rigorous long-term investment philosophy and asset mix, and stick with it. PR: When we structure a portfolio we look out one to three years, and we look at market corrections as an opportunity to add to positions that we think are attractive. It’s just too tough to predict market sell-offs. You win just as much as you lose, so you’re better off focusing on the fundamentals of the company you’re buying. BCB: So don’t try to predict a correction, but if it happens look at it as a buying opportunity? PR: Exactly.