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Cyclical sectors set to score with investors again

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846– Edited from an article by Elvis Picardo

The TSX Composite Index turned in a good performance in 2013, gaining 9.6 per cent for the year –  12.5 per cent, if you include the index’s 2.9 per cent dividend yield.

Yet, this pales when compared with 2013’s star performers such as Japan’s Nikkei Index (up 57 per cent), or even the S&P 500 (up almost 30 per cent).

Moreover, after lagging the S&P 500 for two years by an average of 10 percentage points, the TSX fell further behind in 2013, trailing by 20 per cent.

In addition, the loonie’s slide against the greenback meant that U.S. investors on the TSX realized gains of a little above two per cent.

For several reasons, Canadian assets have fallen out of favour, the disdain perhaps best expressed by the Economist magazine last November in a piece entitled “Uncool Canada.”

TSX may benefit

But this attitude may be due for a change in 2014, given that the TSX may benefit from growth in the global economy.

Admittedly, the Toronto exchange has been held back in recent years by its positive correlation with global growth. But the linkage may work to the TSX’s benefit this year, as the global economy gains momentum.

Global growth is expected to be led by America’s improving economy, as well as by the euro zone’s continued recovery. With macro-level risk having fallen a lot over the past few years, synchronous growth seems likely in most major economies for the first time since 2010.

Of course, faster growth brings the prospect of higher interest rates. And most market players expect both the Bank of Canada and the U.S. Federal Reserve in 2014 to leave rates near record lows.

Yet, the Fed’s winding down of its bond-buying program from January onwards could force U.S. bond yields higher. The prospect of such “tapering” gave Treasury yields a big boost in 2013.

Against this backdrop, interest-rate sensitive sectors like utilities and REITs may continue to underperform.

Investors may change

But as global growth gains ground, investors may become more open to taking risks, buying back into cyclical sectors like commodities and energy.

Together, both these sectors  make up about 37 per cent of the TSX Composite.

Not surprisingly, their poor performance helps explain why the TSX has trailed the S&P 500 since the beginning of the current bull market in March 2009.
Since then, energy has risen only 54 per cent, while the materials group has slid three per cent.

So, while the overall TSX has risen 80 per cent, the S&P 500 has more than doubled that number.

Now that commodities stands a good chance of redeeming itself, you might consider buying a major commodities player like Teck Resources Ltd. (TCK.B-TSX, $27.65). Our top pick for 2014, Teck is one of the world’s biggest miners of zinc and copper, as well as the world’s second-biggest seaborne exporter of steelmaking coal.

The Vancouver-based mining giant also boasts a world-class portfolio of exploration properties, as well as stakes in several assets in the Alberta tar sands.

Largely the victim of weak commodity prices, Teck finished up among the bottom 10 performers last year on the TSX-60.

The company did beat analysts’ earnings estimates in the third quarter as sales of coal climbed 36 per cent from a year earlier to 7.6 million metric tons, while mine operating costs fell 14 per cent to $50 per ton.

Then, too, Teck has staged a full recovery from its near-death experience of 2008, when its shares plunged more than 90 per cent to a record low of $3.35.
The plunge was precipitated by Teck’s $13.6-billion purchase of Fording Coal – a purchase that took place in the middle of the global credit crunch. The timing, needless to say, added to the company’s financial risk.

Yet, since the end of 2008, Teck, buoyed by strong cash flow, has cut its net debt by $6.8 billion.

Still, the company’s risk profile is now somewhat higher, given recent approval of the Fort Hills tar sands project in which Teck has a 20 per cent stake.

Fort Hills is set to produce its first oil as early as the fourth quarter of 2017.

Perhaps more important, it’s expected to achieve 90 per cent of planned production – 180,000 barrels a day – within 12 months of start-up.
Teck’s share of the output is expected to be 36,000 barrels a day, or 13 million barrels a year.

Over the 2014-’17 time frame, the company’s share of capital investment will likely amount to  $2.9 billion.

This year, Teck could benefit from renewed annual growth in China of above seven per cent. China is the world’s biggest consumer of metallurgical coal. And its imports appear poised to grow over the coming months.

Although the outlook for base metals such as copper and zinc appears mixed over the near term, prices may rise as the global economy gains momentum.

Analysts now peg Teck’s 2014 and ’15 net earnings at $1.90 and $2.35 a share, respectively, equating to annual EPS growth of 10 and 23 per cent, respectively.

In the meantime, we’ve set a target price for Teck of $33 a share, suggesting substantial upside from current levels.

Teck pays a semi-annual dividend of $0.45 a share, for an indicated yield of 3.2 per cent.

In the interim, to capitalize on a possible recovery in the oilpatch, consider Suncor Energy Inc. (SU-TSX, $37.24). Teck’s partner in the tar sands, Suncor ranked in the middle of the pack on the TSX 60 in 2013, gaining roughly 14 per cent.

An integrated energy outfit, the company is also a global leader in the production of commercial crude oil from the tar sands.

Suncor’s operating results last year reinforced the value of its integrated business model. And 2013 was tough, being the year in which most Canadian crude producers took a big hit from the wide differential between Canadian prices for oil and prices elsewhere in the world. Yet, Suncor’s model allowed it to capture prices for Brent crude on most of its tar sands output.

Suncor shone on several other fronts in 2013, including profitability, reliability and capital discipline. Not only did it boost its quarterly dividend by 54 per cent to $0.20 a share, it announced a $2-billion stock repurchase in April, while beating analysts’ estimates with its first quarter results.

Those results marked a turnaround from the fourth quarter of 2012, which saw Suncor sustain its first quarterly loss in three-and-a-half years, the victim of a $1.5 billion charge for its Voyageur upgrader project.

Earnings rebounded

But for the third quarter of 2013, Suncor had operating earnings of $1.4 billion or $0.95 a share – an increase of 10 per cent year over year. The beat reflected record output, as well as earnings from its operations in the tar sands.

Elsewhere, the company saw total upstream production rise 11 per cent to 595,000 barrels of oil equivalent a day, as daily output from the tar sands surged 16 per cent to a record quarterly average of 396,400 barrels. At the same time, operating costs fell to $32.60 a barrel.

For 2014, Suncor sees production ranging between 565,000 and 610,000 BOE/d, an increase of about 3.5 per cent from estimated output levels in 2013.

Moreover, higher output should continue to drive down its operating costs, which are expected to fall about six per cent in 2014 to $31.50-$34.50 a barrel.

Suncor boasts a 40.8 per cent share of the $13.5-billion Fort Hills project. This, which equals a capital commitment of $5.5 billion, is expected to eat up about 15 per cent of its annual capital budget.

For 2014, Suncor’s capital expenditures are forecast to hit $7.8 billion, of which $4.5 billion is earmarked for the tar sands.

Thanks to its strong balance sheet, the company should be able to shoulder a higher debt burden in the years ahead. As of Sept. 30, its net debt stood at $5.8 billion. And at 0.6 times its operating cash flow, its debt-to-cash-flow multiple is well below the company’s target of less than 2.

Multiple is low

Over the past five years, Suncor has raised its dividends by a compound annual growth rate of 30 per cent. And although the company may find this pace difficult to sustain, its strong cash flow, as well as its long-term prospects, should enable it to keep boosting its payout in the years ahead.

Until 2020, Suncor expects its growth opportunities to yield a compound annual growth rate for the tar sands of about 10-12 per cent, while bringing in an overall CAGR of seven to eight per cent.

Last year also saw Warren Buffett buy 17.8 million of Suncor’s shares, as well as Bart Demosky, the company’s CFO, leave for a similar job at Canadian Pacific Railway Ltd. (CP-TSX, $160.65).

Although the departure of any top exec invariably raises eyebrows, if it doesn’t set analysts’ hearts aflutter, Mr. Demosky’s leave-taking will likely have no material impact on Suncor’s business.

EPS to rise and fall

In the meantime, analysts are pegging Suncor’s 2014 and 2015 net earnings at $3.51 and $3.38 a share, respectively. Those estimates suggest EPS will rise five per cent this year, but will fall four per cent the next.

Cash flow robust

In the interim, the company’s cash flow in 2014 is forecast to grow about five per cent to $6.75 a share, giving Suncor an attractive forward multiple of 5.5.

Our price target for Suncor is now $40, although we could see it rise to the mid-$40s. Now paying a dividend of $0.20 a share, the company has an indicated yield of 2.2 per cent.

In 2014, both Suncor and Teck will likely lead any rally in the TSX. Such a breakout could be the index’s best two-year performance since 2009-’10.

Elvis Picardo is vice president, research, as well as portfolio manager, at Global Securities Corp. in Vancouver. He owns Suncor shares.


Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846