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While resource stocks have been a ‘thorn in the side’ for Canadian investors over the past two years, we seem to be doing almost everything else right in Canada and should get rewarded at some point with better stock valuations. In fact our economic model is receiving accolades from some impressive sources. The World Economic Forum has ranked Canada’s banking system as the best in the world for five consecutive years. Meanwhile, Moody’s Investors Service gave all Canadian banks its top credit rating, among the highest in the world. The British also looked to Canada as a success story. Canada “brought together the best brains both inside and outside government to carry out a fundamental reassessment of the role of the state.” This helps explain why Mark Carney, governor of the Bank of Canada, will become the Bank of England’s next governor on July 1st. Oddly enough, the Canadian economy has survived the global economic crisis in large part due to two distinctly anti-capitalist measures: extensive state regulation and restrictive foreign-ownership rules. Both of them have been in place for decades and, while Canadians obviously believe in the free market and support private enterprise, state rights often trump individual rights in matters of public policy and business.
The protectionist measures of the Federal government may have helped the economy weather the downturn but it hasn’t helped the valuation of many of the larger energy and resource companies whose assets might be coveted by foreign investors at higher valuations. This was clearly shown when the offer to buy Potash Corp by Australia’s BHP Billiton was turned down by the government. Even though they ultimately approved the $16.4 billion purchase of Nexen by Chinese oil giant CNOOC, the stipulations put on for future deals makes the probability of such transactions getting approval less likely. This valuation difference shows up in two major Canadian oil companies, Suncor Inc. and Canadian Natural Resources. Their undervaluation was highlighted in a recent issue of Barrons:
“The two companies are valued on par with U.S. exploration and production companies at about five times estimated 2013 pre-tax cash flow, yet have more attractive assets than their U.S. peers. Both companies could become targets for activist investors given their valuable asset bases and low share prices. A takeover of either Suncor or Canadian Natural Resources by a larger international energy company is a long shot, however, because the Canadian government probably wouldn’t permit it. Suncor now limits any holder to a 20% stake. There’s a different investment case for each company. Suncor, an integrated energy company with a big presence in the Alberta oil sands and lucrative refining operations, is the safer of the two because it’s producing significant free cash flow. It has the ability to sharply boost its dividend, now 1.6%, and faces investor pressure to do so. Canadian Natural Resources generates little free cash flow because of weak prices for heavy oil and natural gas, which account for 70% of its output.”
Other issues dogging the resource sector are the ongoing write-down of the large resource acquisitions made at substantial premium prices over the past five years. Companies are now having to ‘come clean’ on the fact that they probably overpaid for the assets at the time and are now writing down the associated goodwill and long-term values of those purchases. Two of Canada’s largest gold companies, Barrick Gold and Kinross Gold, announced a combined $7-billion worth of write-downs related to takeovers of gold and copper companies since the start of the decade. That’s just the tip of the iceberg. In the past year, global mining companies have erased billions of dollars from the value of acquisitions they once announced to shareholders as “transformational” deals, certain to create new wealth for investors. Most striking was Rio Tinto PLC’s decision to slash $14-billion of value, mostly from aluminum assets acquired with the takeover of Montreal-based Alcan in 2007 in this country’s largest-ever takeover deal.