Canada – Page 18

Indexing Illusions

Article: This $100 Billion Fund Manager Says Canadian Stocks Are About to Bounce.

The argument is that because the TSX has underperformed the S&P 500, there will be a regression to the mean that will have the TSX align to the S&P 500 (or vice versa).

This article implies that over-weighting the TSX and under-weighting the S&P 500 would outperform an even-weighting of both indicies.

I’m not predicting the future of each index, but the relevant variable to consider is that the top two sectors of the TSX currently are roughly 35% financials (think the big banks, insurance, etc.) and 20% energy, while the top two sectors of the S&P 500 are roughly 24% IT (think about the FAANGs – Facebook, Amazon, Apple, Netflix, Google, etc.) and 15% financials.

Very roughly speaking, if you think financials and energy will do better, invest in the TSX. If you believe in the FAANGs and want a flatter distribution of sectors, invest in the S&P 500. (Intuitively, it would appear to me that if you bought the S&P 500 and shorted the high P/E components such as Facebook, Amazon, Netflix, Google, and others such as Tesla, you’d probably have a comparable value index – I’m sure some quants out there have already done this simple work years ago).

An index always consists of components that can be individually analyzed. Conventional financial literature suggests that an index somehow is better than investing in components, but the only inherent benefit of this is the risk-reduction power of diversification rather than any basis in valuation.

Implications of Canada-USA trade disruption

All of this talk about Donald Trump liking Justin Trudeau in the media was a fantasy perpetuated by the current government to try to paint a picture of how we can “get along”.

Of course, the undercurrents were anything but – not only were there significant trade disputes ongoing (softwood lumber to name one), but the rumblings of NAFTA being pulled and other Canada-US relationship issues are significantly material issues that were not being given sufficient attention.

So now the USA is firing another salvo in the attempt to negotiate a better deal – steel and aluminum tariffs. This is part of a broader negotiation strategy relating to NAFTA and will continue to hurt Canada’s (and Mexico’s) economies because of capital investment uncertainty.

Already with the election of Donald Trump it is perfectly evident that relatively fewer want to invest in Canada when the relative risk/reward ratio is being seriously skewed by corporate hostility in both federal and provincial governments in Canada, coupled with a very business-friendly climate in the USA. This pressure will likely continue with the current presidency.

The gross incompetence of our existing federal government at getting anything done (other than throwing money down a black hole) will be costing Canadians dearly in terms of continuing to decrease our standard of living.

The math on trade disputes is pretty simple.

The United States represents the vast majority of the Canadian export economy (about 75%).

Canada represents about 15% of the United States’ trade exports.

As a result, the USA can inflict much more economic pain to Canada than the other way around. As a result, when the USA decides to tighten the screws (like they are with this speculated tariff on steel and aluminum), it is one more step to negotiating a more beneficial trade deal.

What does this mean for the markets?

Likely in Canada, a lower interest rate as the economy will slow further. This would also decrease the value of the CAD/USD pair.

Canada Budget 2018: Speculation

I speculated this earlier in my 2016 annual report, but these options for the Canadian government are most certainly still in play:

1. Flow-through share deductions will be eliminated.
2. Employee stock option deduction will have a full, instead of half inclusion rate, OR the amount will be capped to some nominal amount (e.g. CAD$50k allowed or something).
3. Taxation of capital gains on principal residences is going to have some restrictions (time, or value) placed.
4. Partial inclusion of capital gains will rise (right now a Canadian taking a capital gain will include 50% of the gain as income; I speculate this will increase to 2/3rds or even 3/4).
5. I do NOT believe the non-tax exemption for private and public health plans will be scrapped. This would be a political nightmare for the government compared to the rather esoteric notions on the items, but this was floated around last year.
6. The GST will rise (probably to 7%).
7. Corporate income taxes, on large corporations, will rise.

The Canadian government is going to be more and more desperate for money – with rising debt and rising interest rates, the interest bite will expand once again (the debt is roughly $650 billion, so a 1% rise is a $6.5 billion interest hike on a $300 billion budget). It is also very unlikely the existing government will focus on cost reduction, hence, they will be looking at every corner to pick away revenues. The items above seem to be the lowest lying fruit, although they each will come with their own political costs. The botched implementation of a corporate tax reform on passive income was met with a significant amount of opposition. The politically easier route would be to simply rack up the deficits and not offend anybody, especially since there will be an election within 20 months.

Marijuana companies – smart moves

Marijuana companies have to know at this time their primary objective is the following: obtain real assets other than market goodwill, and do it quickly as possible.

To this effect, you have companies raising cash like mad. Canopy Growth (TSX: WEED) raised $175 million earlier this year. Aurora (TSX: ACB) is buying other marijuana companies like crazy with its inflated stock.

The recipients of these gushes of cash are the ones that will be making the better deals. Here’s an example: Today, an announcement that Aurora is buying nearly 25% of Liquor Stores NA (TSX: LIQ) with warrants to buy more of the company if the stock goes higher.

This works very well for Liquor store management, who will be getting a huge cash injection at an equity price well above market. It works for Aurora, who is trying to desperately diversify into other assets beyond their own stock price.

How did Aurora pay for it? A $200 million bought deal convertible debt financing, earlier in January! Some people have money to throw away I guess!

General Comments – Canadian Debenture Market

I’ve finished my comprehensive sweep of the Canadian debenture market. Nothing much has changed except a bit of price weakness which can likely be attributed to the volatility seen this week. Very broadly, I’m not finding anything overly attractive in this marketplace.

On the TSX side, the exceptional items on the radar include the question of when Lanesborough (TSX: LRT.DB.G) will be formally going belly-up – you can buy their zero-yielding debt for under 10 cents on the dollar. Another luminary is Discovery Air (TSX: DA.DB.A), where you can gamble that the controlling entity (who controls most of the senior secured debt outstanding) will be generous enough to let the unsecured debentureholders get away with some cash.

There are quite a few of the smaller oil and gas issuers that are showing signs of financial stress. This is likely due to the fact that Alberta and Saskatchewan oil producers are facing a CAD$22/barrel selling price deficit with no signs of this going away. It turns out that it’s really difficult to sell crude oil when you can’t transport it anywhere! I’m guessing the majors (Suncor, etc.) are just licking their lips and are preparing for an acquisition spree once the less solvent juniors are forced into CCAA submission. I still maintain, for now, that fixed income investors in fossil fuel producers will be likely to make more money (or perhaps lose less of it) than the equity side.

It is also interesting to see how Kinder Morgan Canada Limited (TSX: KML) has not traded down much given the news from British Columbia’s government that will be implementing further regulations on the transport of diluted bitumen. The payload is in the last line of the backgrounder of the release:

In order to protect B.C.’s environmental and economic interests while the advisory panel is proceeding, the Province is proposing regulatory restrictions to be placed on the increase of diluted bitumen (“dilbit”) transportation.

KML does continue to operate the existing Trans Mountain pipeline (map), and since there is effectively a moratorium on long-distance fossil fuel pipeline building in the country, it does make existing pipeline infrastructure more valuable.

This hostility to fossil fuels is one reason (high taxation is another) why retail gasoline prices in Vancouver are the highest in Canada, short of remote northern areas. This will continue to go higher as the provincial government will be raising carbon taxes over (at least) the next four years.

As an interesting side note, retail gasoline in Vancouver, BC is currently at $1.43 per litre, while a little down the border in Washington State, it is US$2.68 per gallon, which works out to about 87 cents per litre.