Sunday, March 25, 2012

It’s diversification in sectors ma’me!

Why is the TSX underperforming other stock market indexes in the world by so much? Is our economy on the decline? Far from it! Neither is the TSX’ underperformance compared to other stock markets justifying the traditional excuse for diversification overseas. In the past we noted that diversification of a portfolio can be achieved by investing in market sectors rather than in different countries. This because more and more companies are multinational in their operations and are even listed on several stock market exchanges throughout the world. Best known are ADR s(American Depository Receipts) of numerous non-U.S. based companies listed in New York.

If you dissect your portfolio of Canadian stocks you may have noticed quite a divergence in performance. Natural gas producing companies are one of the poorest stock market performers, but oil producers are not far behind. Neither are precious metal miners such as Barrick and Gold Corp. In spite of rising commodity prices the stocks of many of these producers have severely lagged. Take for example the share price of CNRL (Canadian Natural Resources Ltd. – symbol CNQ) with oil near all-time highs, the stock is trading 40% below its peak of $57 at $33.66.  Not all is rosy for CNRL; it had an operational set-back at its Horizon mine, but considering that the mine is now barely a year and half old, initial problems should be expected. The company is diversified in its oil production with as much production coming from its SAGD operations as from the mine; not to mention natural gas production – both conventional and resource type plays. Oops, and then there are its North Sea and West Africa operations were undiscounted world oil prices are realized. Of course, like most Canadian oil companies, CNRL is suffering from its forced subsidizing of the U.S. economy, i.e. the constraints imposed by Barack Obama on the Keystone pipeline. These are temporary setbacks while CNRL is cranking out record production and cash. Its balance sheet is healthy with debt/book value ratio a mere 27% down from nearly 71% at the end of 2008 when Horizon was completed. The company trades at a share price that is less that 6x its annual cash flow. If you look at shares of gold producers you can find similar stories.

In the meantime, dividend paying stalwarts such as TransCanada Pipelines, Enbridge, BCE and Telus are trading at 14 to 20 times earnings, i.e. at historically high valuations. In fact these companies were the star performers of last year’s stock market but over the last three months their performance has cooled off. There was yet another group of laggards last year that makes up a major component of the TSX – the financials. Lately this sector is celebrating a come-back. Their performance, especially that of the banks, has been on fire. Finally there was our own low P/E moderate dividend portfolio – I will release its quarterly performance next week. But this group of shares have performed very well indeed – thank you very much, etc., etc.

All this good performance in the TSX was hidden under the cloud of the commodity stocks – the hot sectors had no problem keeping up with the Dow and the S&P500 (heavily weighted towards APPLE). Yes, the bull market that started in Feb-March 2009 is alive and well; that in spite of the corrections during the summers of 2010 and 2011. Last summer’s correction was a truly nasty one and there were moments that I thought we were heading into another bear market. This was especially so with all the decent and good economic news being drowned out by media hysteria over the U.S. Debt Ceiling, the paralyzed acrimonious U.S. politics and the European debt crisis. But now, that these fears have abated we’re seeing the underlying economic recovery at a moderate rate. We finally see the U.S. housing market bottoming and even revive – an enormous economic head wind over the last 4 to 5 years, now this market is quickly turning into a tail wind.  Corporate profits in U.S. manufacturing and technology are solid and the large multinational oil companies such as Exxon and Chevron which are not as land locked as their Canadian peers are doing fine as well.  No wonder the Dow and S&P500 are one of the stronger markets in the world. Just a heads up: This summer we may get yet another market correction, especially here in Canada - this time hysteria over the slowing Chinese economy!

So, why is the TSX underperforming? It is because of the dominant economic sectors that make up the TSX: Commodities, Finance and Real Estate. Especially commodity stocks are underperforming, but this sector often lags in the earlier stages of an economic recovery. Financials, technology and manufacturing are doing best in the current phase of the recovery; just like consumer stocks such as Wal-Mart, MacDonald’s, Proctor and Gamble and even Starbucks did better than the rest of the market during the earliest part of the recovery. Thus, it is not that Canada is going back into recession; it is just that our resource industries are typically late bloomers in the business cycle. If your portfolio comprises the heavily resources oriented TSX combined with U.S. Dow and S&P stocks that represent the consumer, technology and manufacturing sectors overall you will do well. It’s diversification in sectors ma ’me not in countries that you experience.

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