The other sector that has garnered huge interest in Canada recently is the Telecom group.  After leading the stock market for most of the past two years, including an 11% gain in the first five months of 2013, the sector has given back all the 2013 gain and then some as the rumour that U.S. phone giant, Verizon, will be entering the Canadian market sent investors fleeing.  The sector was probably ripe for a pullback anyway and had started declining in late-May as interest rates started to move higher and defensive stock groups such as Telecom started to lose their excessive valuations.  The Verizon rumour just seemed to accelerate that pullback.  The chart below shows how the Telecom group had been trading above their average cash flow valuation despite the fact that cash flow growth had slowed down to under 4%, versus 8-10% in the 2007-09 period.  The stocks were even more historically over-valued on an earnings basis, trading at multiples of 14-16 times versus long-term averages closer to 10 times earnings.  The fact that the stocks tend to have high dividend yields had also sustained the higher valuation.  That story seems to be over for now.  We had not owned any telecom stocks this year.

Canadian Telecoms too Expensive

In terms of the Verizon threat, that has yet to be played out.  On their recent conference call, the company did say they were looking at not only the upcoming Spectrum Auctions in Canada, but also the capital survival needs of the marginal players in the industry, including Wind Mobile and Public Mobile.  They also indicated that their initial interest would probably be in the core areas of Toronto and Montreal.  The three large encumbent Canadian players, BCE, Telus and Rogers, have all made very public pronouncements urging the Federal government not to let Verizon bid on the new spectrum or be treated as an upstart.  We don’t like to make investments in front of potential ‘game-changing’ regulatory moves, particularly in an industry where growth is slowing and valuations still remain above historical levels and therefore continue to avoid the sector for now.  For those wanting continued exposure to the sector, Telus would seem to make the most sense to us.  The stock price has fallen by over 20% and it would also be the least negatively impacted by the entry of Verizon due to the concentration of its subscribers in Western Canada.

Speaking of ‘game changing moves’ in stock sectors, the fertilizer industry was ‘turned on its head’ on July 30th when a member of the BPC potash cartel, Uralkali, announced that it was leaving the cartel and would also increase its annual potash production from 9.4 million tonnes to about 13 million tonnes.  Uralkali warned global potash prices could fall 25 per cent as a result, to under $300 a tonne by the end of the year.  Moreover, it would be sending rail shipments to china, thereby undercutting sales and dealing a serious blow to Canpotex Ltd., the potash marketing group made up of Potash Corp. of Saskatchewan Inc., Mosaic Co. and Agrium Inc. The shares of all three companies were hit hard; combined, they lost nearly $9-billion in stock-market value immediately. Potash Corp., one of Canada’s biggest mining companies, fell by over 15%.  Analysts warn Canpotex’s pricing leverage could soon disappear, clobbering profits for each public company.  BPC and Canpotex account for more than two-thirds of global potash sales, with about 43 and 25-per-cent shares, respectively, according to recent estimates.  This announcement would be the oil industry equivalent of having Iran and Venezuela announce that they were leaving OPEC and planning direct sales to Europe!  We know what direction that would send oil prices.  For the potash industry, this will push prices lower almost immediately and will also reduce the multiples for stocks in the industry since their profits will now be more volatile.  While political pressure from Russia could conceivably force Uralkali to reverse their stance, we don’t see any ‘quick fix’ for the stocks.  Given the global recovery taking place, we would rather focus on companies producing commodities which are not going through such dramatic changes.  While we were ‘undeweight’ the potash names, we have sold the remaining positions and shifted the funds into the oil, copper and coal stocks in our portfolios.

Our overall investment strategy continues to favour stocks over bonds and cash.  With economic growth on the mend, profit margins remaining high and interest rates below long-term averages, stock prices should continue to rise with earnings growth and some further expansion of valuation multiples.  Overweight sectors include the cyclical groups such as industrials, technology, energy and basic materials.  While focusing on Canada, we have also shifted some funds recently from U.S. stocks to emerging markets stocks due to substantial valuation differentials in favour of the emerging markets.

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