Time may be right for contrarians to wade into energy sector
With patience and homework, reward potential is worth it, Martin Pelletier says.
One of the biggest challenges when investing is going against the herd as it is human nature to find comfort in crowds. However, for those brave enough, it can be quite rewarding to do what everyone else isn’t doing.
In today’s investing environment we see two areas where this is playing out: Interest rate sensitive sectors and Canadian energy.
Speculation over the direction of interest rates and Bank of Canada policy have had a huge influence over certain segments of the market. In 2015 and into 2016, the consensus by most bank economists and those reporting on Canadian monetary policy was that interest rates were headed lower as the Bank of Canada turned dovish following the mid-2014 collapse in oil prices.
This isn’t surprising as these so-called experts also like to trend follow by making calls similar to everyone else. That said, the rate cuts by the Bank of Canada abruptly stopped in mid-2015 — something few if any predicted correctly.
But look at what happened to certain interest rate sensitive segments of the market during this period. A great example was the complete panic in the preferred market (especially the rate-resets) thanks to its illiquidity and heavy ownership by bank retail advisers.
The IShares S&P TSX/TSX Canadian Preferred Share Index ETF (CPD:TSX) fell a whopping 32 per cent from its peak in 2014 to its bottom in early 2016. In particular, it continued to sell off well into the first quarter of 2016 on calls for further rate cuts even though the Bank of Canada had kept its overnight lending rate at 0.5 per cent since mid-2015. If one was brave enough to buy while the brokers were selling they would be up nearly 29 per cent on the position.
The situation today is now the opposite with most economists and pundits being overly hawkish and calling for several rate hikes. From what we’re witnessing, few if any are willing to acknowledge that a lot of the economic growth over the past two years came from a recovery in the energy sector. We also have yet to see anyone question what this growth will look like under moderating oil prices and a housing market that appears to have topped out.
In this regard, we think a lot of interest rate sensitive stocks, such as those with high dividends, represent an excellent contrarian trade, especially if the Bank of Canada decides to go back into a holding position as it did three years ago. Meanwhile, some blue-chip companies within the utilities and telecommunications sectors are paying out dividends as high as 5 to 6 per cent thanks to their share prices collapsing 25 to 30 per cent on worries over higher interest rates. Sounds familiar, doesn’t it?
Finally, another area of the market that has had everything go wrong has been the energy sector. The Federal government pulled its support for all major pipeline expansions except for Trans Mountain, which recently got put on hold by a Federal Court ruling. Then there has been a mass exodus of capital from the sector as foreigners reallocate to more friendly operating jurisdictions.
This means producers have to cut their operating costs in order to accommodate the reduced access to capital and higher costs from increased rail shipments. As a result, size and scale mean everything now — leaving many in the junior and intermediate spaces unable to compete. That said, we think this is more than reflected in current valuations as the share prices of many of these producers are trading at the same levels as when oil was at $26 a barrel back in March 2015.
Looking ahead, we think this gap can’t continue indefinitely and there will eventually be some very rewarding consolidation opportunities. However, a key development to watch out for is the move away from all-share deals toward all-cash. We are also noticing that investors are finally beginning to lose patience and could soon push management teams to make deals and put an end to the ongoing “boiling frog ” syndrome.
Both of these contrarian trades require a bit of fortitude, patience and a lot of homework but we think the reward potential is worth it.
Financial Post
Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgarybased private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.