In Investing: Air Canada took off, income investors got burned, and bitcoin bubbled
The bull is back
2013 turned out to be an unexpectedly good year for the markets. But can the QE-lubricated party continue?
Given all the high-priced investment advisers, stock analysts, fund managers, books and blogs purporting to offer financial advice, you would think that investing is a complex, intimidating process. But this year, investing was dead simple: if you held some large company stock, you made money. You needn’t have concerned yourself with market timing, digging into quarterly reports, or poring over economic research. Most major stock indexes had a phenomenal year. With startlingly few exceptions, every sector advanced.
This year, the Dow Jones industrial average surged by 23% and the S&P 500 by 26%, leaving behind their pre-recession highs in the spring without stopping to ask for directions. The Nasdaq, meanwhile, is up 32% and touched its highest level since 2000, at the peak of the tech bubble. In Canada, the S&P/TSX composite proved to be a relative laggard but still grew by nearly 9%. The good results were not limited to North America, either. Germany’s DAX index rose 22%. Japan’s Nikkei, which has been an underperformer for decades, fared best of all with a 50% climb.
Few investors and prognosticators saw it coming. “The stock market has been much stronger than I thought at the beginning of the year,” says Brandon Snow, a portfolio manager with Cambridge Global Asset Management. But after a year of unrelenting gains, and with the world’s best-capitalized indexes sitting at record highs, surely stocks are due for a correction soon, right? Concerns are already brewing that stocks are running ahead of fundamentals and getting increasingly pricey.
To even attempt to answer that question (spoiler alert: no one really knows), it helps to understand the reasons for the stock market’s stellar performance. Low interest rates are a major factor. When the recession hit, central banks around the world co-ordinated interest rate cuts to juice the economy again. Rates are still at record lows, and the U.S. Federal Reserve’s aggressive quantitative easing program shows few real signs of abating—chairman Ben Bernanke’s June 24 guidance on plans to “taper” QE notwithstanding. One consequence is that bond prices are pushed higher, returns diminish, and investors are left to pile into equities if they want to grow their portfolios. Stock prices naturally move higher, even if the underlying corporate and economic fundamentals are nothing to cheer about.
Canadian stocks are a bit of an outlier. The TSX trailed its peers, largely because the index includes a large number of mining and precious metals companies, which are taking a beating amid softening demand for commodities. But Canadian companies with an international focus, such as Alimentation Couche-Tard and CGI Group, outperformed and surged more than 50% and 60% respectively.
Low interest rates are not the only factor in the markets’ rise, though. The global economy is improving, albeit slowly, and major risks appear to be receding. “The best way to say it is things haven’t gotten dramatically worse,” says Ian Hardacre, head of Canadian equities at Trimark Investments. Some investors believe the U.S. housing market, the cause of so many problems, is rebounding. As of September, the Case-Shiller index, which tracks home prices in 20 American cities, had increased 13.3% year-over-year. Even though the Federal Reserve recently noted the housing recovery slowed in recent months, some economists see that as a temporary phenomenon. U.S. banks, which were hammered by the housing crash due to their exposure to home mortgages, are on better footing. Outside of North America, the European Union, while still in a weak state, no longer appears to be on the brink of breaking up, and China has so far managed to avoid a hard landing.
These moderately positive economic developments, combined with a low-interest-rate environment, is a recipe for a booming stock market. “We’re in a sweet spot,” says Bill Webb, executive vice-president and chief investment officer at Gluskin Sheff and Associates.
Any number of events could cause stocks to reverse, but there appears to be momentum still. Interest rates don’t appear to be moving anywhere soon, for one thing. The Bank of Canada turned more dovish this year, and incoming Fed chair Janet Yellen has said she intends to continue the central bank’s massive bond-buying program. Webb believes that other factors will influence stocks beyond abnormally (and temporarily) low rates, too. “Earnings growth will supply the next phase of the bull market,” he says. During the recession, corporations cut back drastically on staff and froze wages. While damaging for workers, these cutbacks have turned corporations into lean operations. Even a slight improvement in the economy translates into a big boost in corporate earnings. “There’s enormous operating leverage, and margins have improved,” says Terry Shaunessy with Shaunessy Investment Counsel in Calgary.
Still, the strength of the market this year is making some people nervous. “While low interest rates justify higher stock values, the gains of the past year can’t be explained by improved fundamentals, as the economy has grown less than 2% year-over-year and profits have risen a pedestrian 4%,” wrote BMO senior economist Sal Guatieri in a recent note. Emotions are driving the market, and that can cause things to get out of hand. Jeremy Grantham, chief investment strategist at GMO, expressed his worries in a recent letter to investors. “I would think that we are probably in the slow buildup to something interesting—a badly overpriced market and bubble conditions,” he wrote. Activist investing legend Carl Icahn piped up recently too, saying he’s “very cautious” on U.S. stocks, which “could easily have a big drop” now that they’re repeatedly posting record highs.
For portfolio managers, even finding stocks to buy is becoming a challenge due to high valuations. “Everything is just going higher regardless of anything going on,” Hardacre says. “Our whole investment team is finding it very difficult to find new ideas.” Though many portfolio managers will say stocks are fairly valued for the most part, the gap between cheap and expensive equities is narrowing. Goldman Sachs tracks the price-earnings ratios of companies on the S&P 500, and found the disparity between inexpensive and pricey firms shrank to the lowest level since 1990 in June, and hasn’t changed much since.
Heading into next year, the question for investors is whether to hold on or take some chips off the table. “Probably the worst thing for the market is if we continue at this pace,” says Snow at Cambridge. “If stocks keep getting more expensive because people feel better about them, that sets us up for a significant pullback.” Snow says he and his team are still finding investment opportunities, but they’re waiting for the right price before buying. Hardacre at Trimark sounds even more cautious. “I don’t want to lose money, and I think we’re heading for a difficult time,” he says. Most Trimark equity fund managers are net sellers these days.
Shaunessy recognizes some investors will be hesitant leading up to 2014, but doesn’t expect them to stay that way. “Greed will overtake that caution,” he says. “Once they start to see the market moving, and they’re seeing their colleagues making big moves in the market, they’ve got to get in.” Even Grantham concedes stocks will likely continue their bull run into next year. He estimates U.S. stocks, particularly non-blue-chip firms, could rise another 20% to 30% next year on the back of low interest rates and investor zeal.
What equity investors choose to do next year is ultimately a matter of risk tolerance. “Be prudent and you’ll probably forego gains,” Grantham wrote. “Be risky and you’ll probably make some more money, but you may be bushwacked and, if you are, your excuses will look thin.” Indeed, while investors could sit back and watch their portfolios grow this past year, making money in 2014 without getting burned could require considerably more effort. Joe Castaldo
A bad year for income investors
For years, income investors could do no wrong. This year the tables suddenly turned
While equity investors as a whole had a great year, those weighted toward income-generating stocks and bonds—including many retirees—did not do nearly as well. Canada’s real estate investment trust sub-sector was down 11.5% as of late November, and utilities were off 7.3%. Long-term bonds fell too, dragging the DEX Universe Bond Index down nearly 4% in 2013. You read that right, ye of short memory: bonds can lose value.
This marked a break from the pattern since the 2008 crash, when there was no better investment to own than an income-generating one. The inflection point came in June, when the U.S. Federal Reserve announced that it would start tapering its quantitative easing purchases. The interest rates on long-term debt immediately began rising on the expectation that an improving U.S. economy and creeping inflation would force the Fed to eventually raise overnight lending rates. When rates climb, bond prices drop and certain yielding stocks start looking less attractive, explains Josh Peters, Morningstar’s director of equity-income strategy.
Dividend-paying equities had it worse than bonds because they ran into valuation issues. During the post-crash years, these stocks became so popular as a higher-yielding alternative to bonds that many of them became overpriced. Once bond yields began rising again, the investor exodus affected stock prices more than if they were undervalued.
Defensive stocks generally tend to underperform in a higher-growth environment too. “When the market is expressing optimism, these companies don’t gain as much, and they’re not as profitable,” says Peters.
The most affected companies were those with bond-like characteristics, says Douglas Burtnick, a senior investment manager with Aberdeen Asset Management. “They have stable income streams, and investors value them with the same basic principles as a bond,” he says. That’s a benefit in a volatile environment, but not in a rising-rate climate. “These equities go down the same as bonds do.”
Where income investments go from here largely depends on whether or not rates continue to rise, says Burtnick. Given that rates are still extremely low, investors shouldn’t be surprised if long bonds and dividend payers end up taking another hit. Income stocks are still worth owning, he says, but stick to ones that are reasonably priced and raise their dividend every year. Bryan Borzykowski
A Big Year for Big Fines
The high price of low-down finance
Steve Cohen, CEO of SAC Capital Advisors LP
SAC Capital Advisers: Steve Cohen’s hedge fund lost a $1.2- billion civil suit after six traders pleaded guilty to insider trading
Ed Clark, CEO of TD Bank
TD Bank: Paid out US$52.5 million to settle charges that its executives’ statements helped now-jailed Scott Rothstein perpetrate a US$1.2-billion Ponzi scheme
Jamie Dimon, CEO of JPMorgan Chase
JPMorgan: Agreed to a US$13-billion fine for selling risky mortgage-backed securities, plus a US$4.5-billion payment to institutional clients
Canada’s highest-flying stock
If you’d bought the long-maligned national air carrier’s stock back in January, you’d have almost quadrupled your money today. How’s that for a mid-air turnaround?
Last June Air Canada did something it has never done before: it held an investor day. It was a significant moment for the company, which has had a tumultuous relationship with shareholders over the years. You’ll remember it went bankrupt in 2004. Between November 2006, when it relisted on the Toronto Stock Exchange, and May 2009, the stock again disappointed, falling 93%. It was a penny stock as recently as 2012. For years, investors had been waiting to see its grand cost-cutting plans play out. Management’s promises always turned up empty.
This was the year the company finally delivered. In the third quarter, which ended Sept. 30, Air Canada reported net income of $365 million, a 59% increase over the year before. Earnings per share also grew 57% year-over-year. The second quarter saw strong earnings too, when EPS grew 460% over the year before. Air Canada’s margins are also improving, revenue is steadily climbing, earnings before interest, taxes depreciation and amortization (EBITDA) is breaking records, and other fundamentals are trending in the right direction.
Burned as they’ve been by Air Canada in the past, investors have taken notice. Since January the stock has climbed 292%. It is by far the best performer on the S&P/TSX composite—the Canadian stocks that matter. The fact that it held an investor day proves just how far it’s come with shareholders. “It’s a signal that they finally feel comfortable,” says Chris Murray, managing director of institutional research at Calgary-based AltaCorp Capital. “They’re starting to do what they said they were going to do in 2009.”
That was the year sometime lawyer and investment banker Calin Rovinescu became president and CEO. Rovinescu has succeeded where his predecessors, Montie Brewer and Robert Milton, failed—at winnowing down the national carrier’s once bloated costs. While the company didn’t lay anyone off, David Tyerman, Canaccord Genuity’s managing director of transportation and industrial products says, “nothing was left unturned.”
New, lower-cost maintenance partners, more favourable labour contracts and the introduction of its Air Canada Rouge carrier has helped the company achieve what it says are cost savings of $530 million a year. Rouge, in particular, will be a “major driver” of cost reductions going forward, says Cameron Doerkson, an analyst with National Bank Financial. Rouge pays its pilots and other staff less than what they’d make at the parent line. It’s also going to be flying A319 planes with 22 more seats than what it’s currently using. Tyerman points out that many of these routes are already being serviced by the main airline, so all it has to do is repaint old planes, add those seats and watch costs dwindle.
Air Canada has also been able to get its pension deficit under control. At the beginning of 2012, the company’s pension deficit hit $4.2 billion. Thanks in part to rising long-term interest rates, which help boost a pension plan’s rate of return, the shortfall is now at about $1.7 billion. If it can achieve a return of 6.7% a year, then it thinks it can cut its deficit to zero by 2020.
While costs are going down, it also helps that the economy is improving and that people are flying again. According to the International Air Transport Association, global revenue passenger kilometres are up 5% year-to-date over the same time period in 2012.
In the past, that would be the airlines’ cue to wage price wars and add capacity, but they’ve “got religion” around long-term sustainability, says Murray. “Air Canada and WestJet are engaging in strong capacity discipline.”
It’s unlikely that Air Canada will see the same types of gains next year—it’s done so well this year partly because it’s coming off such a low base—but most analysts who follow the company still think it’s a Buy. Many have 12-month price targets that range from $7 to $9. Marc Gagnon, a portfolio manager with Industrial Alliance Investment Management, points out that the stock still has a cheap forward price-to-earnings ratio of five times and a forward enterprise-value-to-EBITDA of 4.3 times.
Gagnon values Air Canada in terms of operating momentum. As far as he can tell, its going to continue to grow its revenues going forward. And though revenue increases will be modest, it has so many cost-cutting levers—many that still haven’t been pulled—that the bottom line will continue to improve.
The inexpensive P/E suggests that investors are still worried about the airline’s execution, and it’s hard to blame them after so many bad years. But all signs seem to show that Air Canada’s turnaround has finally taken flight. “There’s no question that this stock still has upside,” says Tyerman. Bryan Borzykowski
Market Stars & Dogs
It’s been a year of surprises, both good and bad. These are the stocks that produced the most joy (and despair) in 2013
293.7% (TSX: AC.A)
To say that this perennial stock market loser has finally turned itself around is an understatement. It was the best-performing Canadian large-cap by far and blew away pretty much all the estimates this year. Analysts point to its aggressive cost-cutting, new deals with employees and a dwindling pension deficit as reasons for its stellar return.
109.4% (TSX: MX)
Not all commodity stocks were in the dumps this year. This Vancouver-based methanol producer saw big gains thanks to rising prices for its product and a plan to move two underused Chilean plants to Louisiana to take advantage of North America’s cheap natural gas feedstock. Analysts expect it to increase production in the years ahead as a result.
Element Financial Corp.
104.2% (TSX: EFN)
For this Toronto-based industrial-equipment leasing company, big growth equals big returns. Earnings are expanding by 20% a year, and with little competition, Element has nearly cornered its market. CEO Steve Hudson has a history of creating valuable companies, and Element’s inclusion into the S&P/TSX composite index in March helped attract new investors.
Detour Gold Corp.
-84.9% (TSX: DGC)
It’s hard for any gold producer to contend with falling gold prices these days, but poor forecasting also played a role in Detour’s weak performance. Its stock price dove in November after it said production could end up 11% below what was originally projected. It costs the company $1,214 to produce one ounce, which is only slightly below gold’s current price.
Rio Alto Mining Ltd.
-69.7% (TSX: RIO)
This Vancouver-based gold miner, which operates a mine in Peru and has prospects elsewhere in Latin America, has also been affected by weak gold prices. It reported a net loss of $3.2 million in Q2, but the news isn’t all bad. Rio Alto’s all-in production costs are dropping, it has about $30 million in cash and most analysts think it’s a Buy.
Centerra Gold Inc.
-64.9% (TSX: CG)
Plummeting gold prices are the least of this company’s worries. The stock has fallen in large part because of a deal gone sour. The Kyrgyzstan government initially demanded a 33% stake in Centerra’s Kumtor mine, then it wanted a 50% stake, and now it wants 67%. Opposition parties want it nationalized. It’s not clear how this mess will work itself out.
300.2% (Nasdaq: NFLX)
Netflix has finally proven that streaming video over the Internet can compete for audiences with cable TV. The company rebounded from a tough 2012 by jumping into the original-programming arena this year. Its Emmy Award–winning shows helped attract 1.3 million new U.S. customers in Q3—it’s now bigger than HBO—and post a record US$1.1 billion in revenue.
Best Buy Co.
262% (NYSE: BBY)
This may be the turnaround story of the year. Increasing competition, especially from Amazon, put a major dent in the electronics retailer’s earnings last year, and a sex scandal involving its founder didn’t help. The new CEO, though, is fixing Best Buy’s problems. Investors have praised the company’s renewed focus on cost-cutting and increasing online sales.
Micron Technology Inc.
231.6% (Nasdaq: MU)
In February, this American semiconductor company shook things up by buying Japan’s Elpida Memory for US$2.5 billion. It’s now the world’s second-largest chip-maker, and it’s better positioned in Asia. Thanks to that deal and rising chip prices, its net profit was US$1.2 billion in Q3—a big reversal from the US$1-billion loss the year prior.
J. C. Penney Co.
-50.6% (NYSE: JCP)
Wonder what a turnaround gone wrong looks like? See J. C. Penney. The department store has been struggling for a while, but several more missteps by ex-CEO Ron Johnson made things worse. His predecessor is back in charge, but the company still bleeds. It posted a net loss of $489 million in Q3 and its revenues fell 5% year-over-year.
Newmont Mining Corp.
-40% (NYSE: NEM)
Nearly all miners have suffered, but America’s largest gold producer has been hit harder than most. A falling gold price was the main catalyst for the stock’s decline, but production at its Yanacocha mine in Peru dropped 28% in Q3 and only grew 2% at its mine in Nevada. All this added up to 20% year-over-year drop in revenues.
Cliffs Natural Resources Inc.
-28.5% (NYSE: CLF)
It’s not surprising that this iron ore producer has done so poorly—its commodity’s price fell by 25% between February and June. Sales volumes also declined in the U.S. and Asia, with sales in the latter region falling by 8% in Q3. There’s another concern for investors, say analysts: new supply from the Great Lakes could eat into future volumes.
Vestas Wind Systems A/S
423.5% (CPS: VWS)
After two years of poor performance, this Danish wind turbine manufacturer’s turnaround is finally taking shape. It ousted its CEO in August, and its aggressive cost-cutting measures—including 5,500 job cuts since 2011—is now showing results. Orders are surging, and while it still posted a net loss in Q3, it cut its loss per share in half from the year earlier.
227% (EPA: ALU)
This Paris-based telecom solutions provider is another turnaround story. Its share price has climbed, mostly due to a restructuring plan that was announced in June. The company, which has experienced six quarters of losses, plans to cut 15,000 jobs by 2015 and slim down into a smaller, more narrowly focused company.
Bank of Ireland
153.3% (LON: BKIR)
While shares of Ireland’s largest bank are nowhere near their pre-recession prices, investors are getting excited about a possible return to profitability. Pre-tax losses were halved during the first six months of 2013, compared to the year before, while its net interest margin increased. Its CEO thinks it will turn a profit in 2014.
Newcrest Mining Ltd.
-65% (ASX: NCM)
This Australian precious-metals producer has been hit particularly hard by falling commodity prices. It laid off several hundred workers this year, and production will be well below 2012 levels. One problem is that all-in production costs are pushing US$1,280 an ounce, more than the current price of gold. It hopes to get that closer to $1,000 an ounce.
Cia De Minas Buenaventura SA
-64% (NYSE: BVN)
Latin America’s largest gold producer hasn’t just seen its own production fall this year. Peru-based Buenaventura has also been hurt by Newmont Mining’s output declines—it owns 44% of that company. Rising exploration costs have also put on the pressure, while a 16-day strike over working conditions at its Orcopamapa mine added to its headaches.
Sociedad Quimica Y Minera Chile SA
-54.2% (NYSE: SQM)
This Chilean fertilizer company has been ravaged by falling potash prices, weak European demand and slower iodine market growth. Its earnings for the first nine months of the year were 27% lower than the same period in 2012. Increasing demand for lithium—another of its products—could offset some losses, but it still has a rough road ahead.
Revenge of the nerds
After years of being the butt of jokes among the financial set, Bitcoin is having the last laugh
On Nov. 22, 2013, at 5:38 p.m. Greenwich time, a person unknown transferred 194,993 bitcoins into a virtual wallet. At that day’s exchange rate of about US$735 per bitcoin, the transaction was valued at roughly $143 million, easily the largest single transfer of Bitcoin wealth ever seen. Whoever received this unprecedented payment clearly sensed the historic grandeur of the moment: in the permanent public ledger of all Bitcoin transactions—the “block chain” that forms the mathematical foundation of the currency—he or she tagged the transaction for all time with the note, “Shit load of money!”
“One small step for man” it ain’t, but it does perfectly capture the combination of high finance and outlaw attitude that surrounds this “cryptocurrency.” Bitcoin has been around since 2008, but 2013 is the year it truly caught the public’s imagination.
With that attention has come the accompanying gold-rush sideshow—including rags-to-riches stories such as the man whose 2009 purchase of 5,000 bitcoins on a whim for $27 was worth $886,000 by the time he remembered he owned them in October. Publicity-hungry small businesses have hopped on the bandwagon too, each claiming to be the first to accept the new currency: a sushi restaurant in Lyon; a curry house in Vancouver; a grilled-cheese truck in Seattle.
The scent of money has brought out bandits as well. It’s “still very much a Wild West when it comes to the regulation of Bitcoin,” says Calgary lawyer Matthew Burgoyne, who is advising several clients on their still-unclear legal obligations when dealing with Bitcoins. The currency also has given cover to small-time drug dealers, whose skittish clientele appreciate the semi-anonymity of Bitcoin transactions. Others have been more ambitious, such as the crooks who set up an online Bitcoin exchange ostensibly based out of Hong Kong, built up a sizable customer base and shut down abruptly in October, vanishing with $4.1 million.
For the Bitbugs who hold Bitcoin, however, there’s no such thing as bad publicity: while the supply marches steadily upward, demand has boomed, inflating the exchange rate to tulip-craze levels. On Jan. 1, 2013, one bitcoin was worth US$13.56; on November 30 the price spiked to more than $1,200.
That bubbly behaviour has made a small number of people rich; but it also makes Bitcoin a lousy way to buy grilled cheese. Bitcoin’s faithful have spent the past 12 months hyping it up and trying to polish its image. They’ve successfully shown off its raw financial power; now they need to show it can be tamed enough to be as useful buying a Coke as it is buying cocaine. Graham F. Scott
The Year in Currency
Who needs virtual money when physical currency is still so exciting?
This year was the end of the line for the Canadian penny. Society showed little lament for the pocket-and-purse-clogging coins—it took only weeks for everyone to cheerfully adapt to the new 5¢ rounding rule and never look back.
Bank of England governor Mark Carney announced that beloved British author Jane Austen would be the next face on the £10 note, replacing Charles Darwin in 2017. Still, critics decried Austen’s portrait as “airbrushed,” and complained that the Pride and Prejudice quotation on the reverse of the bill—“I declare after all there is no enjoyment like reading!”—was uttered by deceitful Miss Bingley while only pretending to enjoy reading in order to snare the wealthy Mr. Darcy.
U.S. Bureau of Engraving and Printing
Originally scheduled for 2010, a series of printing errors delayed the new U.S. $100 bill. The first batch were partially blank due to a printing error, and the next were so over-inked they looked like they’d been coloured in with crayon. In the end, 30 million of the bills had to be reprinted at a cost of nearly $4 million.