Cenovus Energy’s relatively small dividend

Cenovus Energy (TSX: CVE) is Canada’s second largest oil producer (behind CNQ), featuring two flagship oil sands projects, Christina Lake and Foster Creek. Unlike CNQ, they have downstream capacity just a shade short of their production levels. Needless to say they have been producing a lot of cash flow.

Compared to the top three (CNQ, Suncor and CVE), Cenovus’ dividend has been relatively paltry – the yield has been less than 2% and a very small fraction of the company’s free cash flow.

You might have been wondering why, and it likely concerns the warrant indenture. Specifically, the warrants have a price adjustment if “Dividends paid in the ordinary course” exceeds a certain level:

in the aggregate, the greater of: (i) (a) for the 2021 financial year, $170 million; and (b) for financial years after 2021, 150% of the aggregate amount of the dividends paid by the Corporation on its Common Shares in its immediately preceding financial year which were Dividends Paid in the Ordinary Course for such preceding year;
(ii) 100% of the retained earnings of the Corporation as at the end of its immediately preceding financial year; and
(iii) 100% of the aggregate consolidated net earnings of the Corporation, determined before computation of extraordinary items but after dividends paid on all Common Shares and first preferred shares of the Corporation, for its immediately preceding financial year, in each case calculated in accordance with Canadian generally accepted accounting principles consistent with those applied in the preparation of the most recently completed audited consolidated financial statements of the Corporation;

The relevant clause for 2021 is retained earnings, and it was $878 million at the end of 2021. $878 million divided by 2.016 billion shares outstanding gives you about 43 cents per share, and CVE’s current dividend was raised to 42 cents per share.

For the first half of 2022, retained earnings is sitting at $4.6 billion and this will likely go much higher by year-end. At June 30, CVE had 1.97 billion shares outstanding and thus they can practically increase their regular dividend to match their cash flow once the audited financial statements are released in March of 2023. Until then, they are stuck with their existing dividend and are busy buying back shares and paying down debt in the meantime, in addition to consolidating the 50% share in the Sunrise oil sands and Toledo refinery that they previously did not own. Once they get down to their $4 billion debt target, the company pledged to distribute 100% of its earnings to shareholders – practically behaving like an income trust if you remember those days when Penn West and Pengrowth income trusts were throwing out the cashflow in a similar manner. An annualized $2/share dividend is not out of the question, and this would likely result in the stock trading for higher than what it is currently trading for today.

Today’s contrarian sector – European Banks

This is likely in the “not yet” category, but it is something that I’m paying a little more attention to than most, namely the big European banks.

With the EU reacting to its poor energy policies by enacting demand restrictions, there will surely be further reverberations going forward in terms of the continent’s heavy industry. This will have spin-off impacts in terms of the credit that is extended to various corporations that are sensitive to energy input costs, and creating a whole financial cascade. Who ever thought that negative interest rates would actually have real consequences?

With that said, I’ve looked at various European banking entities, and just doing the most superficial analysis. Numbers are market cap (US billions), P/E, P/B and historical dividend yield.

UK
LYG: Lloyds Banking Group – 33 / 6.6 / 0.57 / 3.9%
BCS: Barclays PLC – 31 / 5.1 / 0.38 / 2.8%

France
BNPQY: BNP Paribas – 57 / 5.6 / 0.49 / 8.5%
SCGLY: Societe Generale – 18 / 7.0 / 0.28 / 8.0%

Germany
DB: Deutsche Bank – 17 / 5.4 / 0.25 / 2.7%
CRZBY: Commerzbank – 8 / 4.9 / 0.28 / 0%

Italy
ISNPY: Intesa Sanpaolo – 33 / 8.8 / 0.51 / 7.0%
UNCRY: Unicredit – 19 / 25.6 / 0.30 / 3.9%

Spain
SAN: Banco Santander – 39 / 4.6 / 0.44 / 4.6%
BBVA: Banco Bilbao Vizcaya Argentaria – 28 / 4.6 / 0.62 / 11.3%

Scandinavia
NRDBY: Nordea Bank (Finland) – 34 / 10 / 1.1 / 16.7%
DNBBY: DNB Bank (Norway) – 29 / 9.9 / 1.17 / 5.6%
SVNLY: Svenska Handelsbanken (Sweden) – 16 / 7.4 / 0.89 / 6.8%

Other notables
UBS: UBS Group (Switzerland) – 55 / 7.0 / 0.97 / 1.6%
ING: ING Group (Netherlands) – 32 / 7.8 / 0.62 / 4.0%

Note that all of the institutions above have international operations and hence they are not entirely exposed to the risks of their domestic markets.

Let’s compare this to Canada (market cap is in billions of USD):

Canada
RY: Royal Bank: 130 / 10.8 / 1.8 / 4.2%
TD: Toronto Dominion: 118 / 10.7 / 1.6 / 4.2%
BMO: Bank of Montreal: 63 / 7.3 / 1.7 / 4.6%
BNS: Bank of Nova Scotia: 65 / 8.7 / 1.3 / 5.8%
CM: Canadian Imperial Bank of Commerce: 43 / 9.4 / 1.3 / 5.4%

One immediate observation is that Canadian banks have much larger market capitalization than their European counterparts. Indeed, looking at the global picture, the USA and China have the largest banks by market capitalization, while the largest European one is BNP, very much behind in the standings.

Needless to say, some of these European bank valuations look compelling at a glance. However, to do the proper analysis of these large (and for the most part, incredibly opaque) institutions, one has to have a grasp on whether their loan portfolios will actually perform and to get a sense of where the geopolitical risks lie. But overall, Europe is trading like a disaster at the moment for obvious reasons (they are a slow-moving financial train wreck happening at the present time) – if, for whatever reason, it is better than a disaster, there perhaps may be some gains to be had in the future from the current depressed levels.

Unfortunately I am not skilled enough to make a nuanced differentiated bet on any specific company above – there are tons of analysts working in the usual institutions that are properly able to gain an edge on which of the above will do better than the rest, but my suspicion is that at some point, an unsophisticated player like myself can probably generate some alpha by constructing an equal-weighted ETF of some of the components above.

I do think I have a better “home field advantage” with the Canadian banks above, but that home field advantage tells me to back off for better values in the future. As far as Europe goes, however, the time is likely closer to a reasonable value bet.

That said, you may wish to disregard anything I say on international bank stocks simply because it does not look like that my investment in Sberbank (a couple days before the sanctions hit) will be materializing anytime soon – my largest one-shot loss in my investing history, assuming it goes to zero (which it effectively is at the moment for non-Russian investors).

Late Night Finance with Sacha – Episode 21

Date: Wednesday August 31, 2022
Time: 7:00pm, Pacific Time
Duration: Projected 60 minutes.
Where: Zoom (Registration)

Frequently Asked Questions:

Q: What are you doing?
A: The summer is ending – some economic thoughts, quick performance review, and taking some Q&A. There should be a few minutes left for Q&A, so please feel free to ask them on the zoom registration if any.

Q: How do I register?
A: Zoom link is here. I’ll need your city/province or state and country, and if you have any questions in advance just add it to the “Questions and Comments” part of the form. You’ll instantly receive the login to the Zoom channel.

Q: Are you trying to spam me, try to sell me garbage, etc. if I register?
A: If you register for this, I will not harvest your email or send you any solicitations. Also I am not using this to pump and dump any securities to you, although I will certainly offer opinions on what I see.

Q: Why do I have to register? I just want to be anonymous.
A: I’m curious who you are as well.

Q: If I register and don’t show up, will you be mad at me?
A: No.

Q: Will you (Sacha) be on video (i.e. this isn’t just an audio-only stream)?
A: Yes. You’ll get to see me, but the majority will be on “screen share” mode with MS-Word / Browser / PDFs as I explain what’s going on in my mind as I present.

Q: Will I need to be on video?
A: I’d prefer it, and you are more than welcome to be in your pajamas.

Q: Can I be a silent participant?
A: Yes.

Q: Is there an archive of the video I can watch later if I can’t make it?
A: No.

Q: Will there be a summary of the video?
A: A short summary will get added to the comments of this posting after the video.

Q: Will there be some other video presentation in the future?
A: Most likely, yes.

Short term interest rates

Exciting times in Canadian government interest rates – finally seeing some yields again (2 year Canada government bond chart below):

Short-duration bonds are yielding higher than they were before the 2008-2009 economic crisis. The one-year bond is at 3.67% currently, and the two-year at 3.53%.

I’ve talked about this before, but one theory in finance is regarding the term structure of the yield curve in that the total returns is invariant to the term one invests in – e.g. if you invested in 1-year government bonds 10 times, the net result will be the same as if you invested in 1 10-year bond. Of course, practice is different than theory, but if one were to take this theory and apply it with the existing rate curve, it would suggest that the target rate is going to rise significantly higher than the so-called “neutral rate” which, according to the monetary policy report, is between 2-3% nominal. I’ll leave it up to the reader to decide on the validity of these financial theories.

In the monetary policy casinomarkets, the 3-month Bankers’ Acceptance Rate is currently at 3.46% and has crept up slowly in anticipation of September 7, 2022’s expected rate increase – the September futures indicate a 3.89% 3-month rate. I am not sure if this translates into an expectation of 50 or 75bps for the September 7 meeting, but either way short term interest rates are going up. The next meeting of the bank on October 26 is anticipated to have a 25 basis point increase as well.

All of this means that money is coming harder and harder to come by. Governments will find it much more expensive to borrow money, so I would look carefully at your portfolio for entities that are government-dependent.

The big risk continues to be that interest rates will rise further than the market anticipates – and it likely will if inflation does not reach the magical 2% target.

The US dollar wrecking ball

By far and away, the largest surprise for many has been the relative strength of the US currency to the exclusion of others:

Since most international trade is denominated in US currency, it means that for foreign countries engaging in commodity purchases and most other imports, the trade currency becomes that much more expensive to transact. This has an effect on their cost inputs (in addition to the core commodity prices themselves being relatively inflated). For example, when Europe wants to import LNG, not only do they have to pay an extremely bloated premium to doing so, but right now they are dealing with record lows of “99 Euro-pennies” being equal to one US dollar.

The US Federal Reserve as well is raising interest rates, so holding cash (or liquid short-term treasury notes) is no longer a zero-yield option: indeed, you can lend your money to the US government for a year and get 3.3% for it. Cash is once again becoming more valuable.

It was widely anticipated that with inflation and the US government printing massive deficits that the currency would sink like a stone – indeed, it has gone in the opposite direction as people are demanding US dollars, especially as asset markets depreciate, and credit stress becomes apparent.

The future course of action appears to be that there will be some sort of crescendo event where the US dollar will gain so much strength and then when things break somewhere, the US dollar will be sold off. I don’t know when this will be.

All I know is that being levered long in this environment is dangerous – especially as the existing consensus is that the fed will drop interest rates again in 2023 – what if they don’t because inflation is still running well above 2%?

Prices are formed on the basis of the sentiments of the marginal bidder and marginal seller. In the event that there is an instantaneous drop in demand and consistent supply, prices will drop and they will drop quickly. As interest rates rise and central banks continue to pull capital out of the bond markets, it is like taking oxygen out of the room. Initially, nobody notices. Then there is a point where people actually feel better, despite the fact that the oxygen level gets below where it can sustainably maintain your cognitive function. We’re probably at that point in the markets. Then finally, you start to lose your functionality entirely before losing consciousness.

I’ve used the market rally that began in July to pull out the weed-wacker and trim the portfolio a little bit and raise cash. If things rise from here, I’ve got plenty of skin in the game. However, the suffocating effect of rising interest rates is increasingly apparent. It will be very difficult to generate excess returns at present.