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Portfolio Strategy

One thing we’ve learned in our years following the market, is that intense price competition is never good news for stocks as it tends to have a major deleterious impact on profit margins.

By Jim Johnston, SK

Commodity Outlook 

Another month, another commodity horror story. What we are referring to is “The Nightmare on Potash Street” which started when Uralkali , a major producer of this type of fertilizer which is so prevalent in Saskatchewan, decided to break ranks with the cartel and to focus on volume over price. It did not take long for investors to dump shares of publicly-traded Potash producers worldwide on the justifiable fear that a price war would break out sooner rather than later. One thing we’ve learned in our years following the market, is that intense price competition is never good news for stocks as it tends to have a major deleterious impact on profit margins.

Another major story in the potash world is the commitment from BHP Billiton to continue to develop their Jansen potash project in central Saskatchewan. The company announced a further$2.6 Billion investment in Jansen despite no formal project approval from the Board of Directors of BHP. This will bring the total investment in this project to $3.8 Billion. The continued development will continue to enhance the economy of Saskatchewan but it will also be positive for potash buyers as this increases the likelihood of additional production in the future potentially keeping prices reasonable.

The other big problem for agriculture-related stocks (and there are a number of them in Canada), is that grain prices are in full-blown downtrends. This is concerning as grain prices are the key driver of farmer income and in turn, lower farmer incomes lead to lower purchases of agricultural equipment and fertilizer, thus creating a vicious cycle which makes it very hard for us to see agriculture stocks working anytime soon. Not surprisingly, agriculture-related stocks are very highly correlated to grain prices. There are some benefits to lower prices of course. This puts downward pressure on animal feedstock costs which is very good for protein producers and helps grain processor profit margins. The societal benefit is far greater however, particularly for poorer countries, as this will tend to lower food prices, freeing up disposable income for other purposes. This is a very positive change after the relentless food price increases experienced over the last decade.

The reduction in corn and barley prices in 2013 is very good news for dairy farmers, particularly those farmers who purchase these grains instead of growing them.  Corn has dropped to approx. $5.00 per bushel from a peak of $8.00 per bushel in Aug 2012 with barley representing a similar reduction.

Since we are also very concerned about copper and gold equities, we are clearly recommending investors avoid most of the basic materials space. The one exception to this recommendation is lumber and OSB (Oriented Strand Board) stocks which are benefitting from the firmly entrenched U.S. housing recovery and a more rational industry structure.

 

Asset Allocation 

Since we believe the commodity super cycle is now behind us, we continue to strongly recommend Canadian investors diversify internationally. With 40% of the Canadian market in energy and basic material stocks (versus under 15% for the S&P 500 Index) and a loonie that is still overvalued by five to 10 cents according to BMO Capital Markets Economic Research , we believe the odds of the S&P/TSX Composite Index outperforming over the next several years are very slim. Our core long-term overweight recommendation remains the more balanced and defensive U.S. market, which also has superior dividend growth potential. We also recommend small positions in faster-growing emerging markets and high-quality, inexpensive stocks in Europe, where the economy is finally showing signs of life.

We continue to believe equities are the most attractive asset class —with a major preference for U.S. stocks — versus bonds and cash securities which are likely to produce negative returns after inflation over the next few years in our view. Despite some recent consolidation in stock markets, we are still very much of this view and would use any summer pullback as an opportunity to add to core positions and particularly to stocks exposed to our preferred investment themes: 1) the U.S. Housing Recovery, 2) the renaissance of the North American Auto Sector and 3) the Commercial Construction/Infrastructure Recovery and Reindustrialization of the US.

In our view, stocks continue to be inexpensive in absolute terms given robust corporate earnings and cash flow trends.

Despite the recent rise in rates, stocks continue to appear compelling relative to government bonds both in Canada and the U.S. In the last decade, the spread between the S&P 500 earnings yield (6.2%) and 10-year U.S. government bonds (2.6%) was only this wide during the recession of 2008/2009, which turned out to be a great entry point for investors. The S&P/TSX dividend yield is considerably higher than 10-year government bond yields, which is again something we only saw during 2008 and in the mid-50s. In other words, the relative value of stocks versus bonds is still as good as it’s ever been in the last several decades.

Looking at multiples, valuations are reasonable with both the S&P/TSX Composite and S&P 500 trading at around 15x forward expected earnings. This is not expensive by historical standards and is particularly attractive considering the current very low rate environment.

As always, consult your investment advisor prior to investing . This column is provided for information only and is not a solicitation to buy or sell securities. If you would like further information, please feel free to contact me at [email protected]

Jim Johnston
Vice President and Wealth Advisor
Professional Financial Planner
BMO Nesbitt Burns Saskatoon

Jim has been an advisor for 16 years and specializes in working with high net worth families in the areas of wealth management and estate planning.

 

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