Oil Dives With Markets - By Dan Good - January 9, 2019
Oil Drops by 1/3 in 3 Months
Stock prices got a little ahead of themselves during 2018 and corrected primarily in the last 3 months with the TSX dropping some 12% and the MSCI World Index 11% for the year. Oil also dropped with West Texas Intermediate declining from $75 per barrel at the end of September to trade at under $50 today. Along with this our “petro” dollar has dropped from 81 cents per one U.S. dollar to roughly 74 cents at year end. The only good news for investors was a play on our dollar falling as the U.S. dollar gained just under 10% in Canadian dollar terms. As a value investor and contrarian I would think it fair to say the markets are relatively cheap now and our dollar has been oversold.
High Growth Stocks Fall
This was the year high growth stocks got absolutely hammered. Back in the day of the leveraged buyout you could borrow to buy whole companies by making a play for 100% of their public shares and then taking them private. This is profitable to the buyer when the return from the equity outweighs the interest on the debt. Nowadays, Bain Capital (Mitt Romney was a founder) out of Boston has put a different spin on this idea by selecting companies with growth potential, getting management to go along with them by giving them stock options and then loading up the public companies with debt. This debt is used to finance growth. Then you get the public to buy back the shares you originally purchased at a cheap price by doing secondary stock offers at a higher price.
A few of the Canadian companies manipulated this way include Sleep Country, Canada Goose, Dollarama and BRP (Bombardier Recreational Products). An American example that just got into trouble is Toys Are Us which recently filed for bankruptcy. I like to follow Dollarama and BRP since this gives me a pretty good gauge on the optimism in Canadian growth stocks as both Companies have negative shareholders equity.
From its high of $74, BRP shares have fallen roughly 50% to trade at $37 today; Dollarama has dropped from a high of $56 to trade at $32 today and Canada Goose from $95 to trade at $60 today. Let’s just say 2018 was not a good year for high growth stocks. Will they make a comeback in 2019? Along with Bitcoin and marijuana stocks? This is speculation and I am not willing to throw out all my investing text books to get on this bandwagon. The share’s are priced without a margin of safety should something go wrong.
The Flat Yield Curve
Basically, bond yields in the short term are paying just as much as longer dated maturities. For example a 2 year Government of Canada bond pays 1.88% and a 10 year bond 1.95%.This means banks, which borrow in the sort term - like your savings accounts, and invest in longer term assets – like in stocks, bonds and mortgages are not making as much money. They need a spread between short term borrowing and long term investing or they simply will not lend out. This is why a flat yield curve has spooked investors as a lack of bank stimulus will slow economic growth. In the past flat yield curves have predicated recessions. For example the yield curve was inverted in 1981as rates were higher in the short term than long and we had a long lasting recession starting in 1982.
Corporate Bonds Attractive
The spread between U.S. Government Bonds and high yield corporate bonds widened rather dramatically near the end of the year. According to FRED (The Federal Reserve Bank of St. Louis) the spread on CCC U.S. corporates widened from 6.69% October 1st to 11.04% December 31st. What this means is that U.S. corporations rated CCC or below had yields on their debt some 11% above treasury (Government) yields at the end of the year. The last time spreads were this high was in 2016 when oil prices last faltered. When you realize roughly 15% of corporate high yield debt is from oil and gas producers and pipelines you can better understand why the performance of corporate bond funds is highly correlated to oil and gas prices.
The Fidelity U.S. High Yield corporate bond fund has a current yield above 5% and I feel this is quite attractive considering Canadian 10 year bonds are yielding under 2% and with the current yield spread flat generally interest rates go down from here not up. As of January 8th, 2019 this CCC spread has narrowed to 9.92% as oil prices have improved since Christmas. So with a high yield fund you should receive above average returns and potential capital gains when spreads narrow. I would suggest hedging the currency risk in case our dollar climbs from 75 cents.
It Can’t Get Much Worse
Calgary recently released its tax assessment notices and with vacancy rates in downtown Calgary apparently at 27 % it is a little shocking though not surprising. According to the 2019 City of Calgary property assessment the value of Bankers Hall has dropped some 20 % and Suncor Energy Centre some 20.8 % from 2018. Other properties in the top 10 non-residential properties also include Centennial Place assessed almost 20% lower, Brookfield Place 21.9 % lower, and Eighth Avenue Place, East tower 22.4 %. The Bow Tower was assessed at close to $1 billion in value in 2018 so these declines represent huge drops in the source of tax for Calgary. This extra tax burden is picked up by other businesses outside of the core and could substantially hurt business.
A Time to Buy
There is phrase that goes something like this “the best time to buy is when you see the light at the end of the tunnel.” John Templeton would quip the best time was actually before you even saw the light. I have bought and am buying shares of real estate developer Melcor that trades at roughly $13 and has a book value of over $30. I remember looking out over at the Melcor building when my office was on 105th street and Jasper avenue in 1987. Melcor was one of the first companies I focused on as their shares traded at 50 cents on the dollar. They were cheap because real estate collapsed in the early 1980s and they got into trouble with their banks. Now the shares are even cheaper.
I am hopeful 2019 will bring positive returns to clients as I can see pockets of value in shares like Melcor and in corporate bonds where the yield spreads have finally widened to make them attractive as well.