OB Report
July 2019
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Love the Unloved

Murray Leith By Murray Leith CFA, Executive Vice President & Director, Investment Research


lead image 310Contrary to the drubbing stocks took in the fourth quarter of 2018, equity markets have been kind to investors this year. For the year through to mid-June, the Canadian and U.S. stock benchmarks have risen 15% and 14% respectively, including reinvested dividends. The all-equity Odlum Brown Model Portfolio* has also participated in the rising equity tide, generating a total return of 14% over the period.

Despite the satisfying results, there is a sense we could be doing better. There are some dogs in our portfolio that have weighed on results. Our most frustrating stock is Peyto Exploration and Development; down 45% year-to-date, after falling by half last year. Over the last five years, Peyto has lost 90% of its value, making it our worst investment currently in the Model Portfolio.

Investor sentiment towards energy stocks is extremely negative, with global oil and natural gas prices well off their highs. Canadian energy stocks are even more out of favour because domestic oil and natural gas prices are further depressed due to a uniquely Canadian supply and demand imbalance. Canadian energy producers have maintained production at a relatively high level despite constraints on pipeline takeaway capacity.

Peyto has fallen more than many other Canadian energy stocks for three reasons:

  1. It is focused on natural gas, which is more depressed than oil.
  2. Its debt leverage, while manageable, is greater than other producers.
  3. It is relatively small, and smaller companies tend to underperform when a sector is out of favour.

Understandably, clients wonder why we haven’t given up on poorly performing Canadian energy stocks altogether and Peyto in particular. In hindsight, we clearly should have. In fact, we would have been well served to avoid natural gas-focused energy producers for the last 11 years. Tourmaline Oil Corporation, Canada’s second-largest natural gas producer, was added to the Model Portfolio in 2014 as an alternative to Encana, another large natural gas producer. Shares of both Encana and Tourmaline have plummeted since.

While patience is often necessary when investing in cyclical commodity sectors, the magnitude and duration of the beating we have experienced in Canadian natural gas-focused stocks has far exceeded our worst nightmare. We first bought Encana in 2008, believing natural gas prices were on the cusp of a cyclical rise. We couldn’t have been more wrong.

There are many reasons why natural gas prices have trended downward over the last decade. The 2008/09 Financial Crisis and Great Recession reduced demand. Dramatic improvements in drilling technology and prolific new discoveries reduced the marginal cost of finding and producing natural gas. The era of ultra-low interest rates meant the industry had abundant access to cheap capital, which it used to grow supply faster than demand. Delays in expanding or building pipelines contributed to the supply and demand imbalance, and more recently, geographic shifts in Alberta production have created bottlenecks in the domestic pipeline system. The North American shale oil boom also contributed to the pain in the natural gas sector, as natural gas is a by-product from much of this production.

We didn’t correctly anticipate many of the adverse developments that have undermined natural gas prices, and consequently, investing in natural gas-related stocks has been very painful. While we have significant regrets, we think it would be foolish to give up at this juncture.

When it comes to commodity investing, it is often said that the cure for low prices is low prices. That’s because low prices create economic incentives that naturally help balance an unbalanced market. Indeed, many of the factors that weighed on the natural gas sector have either abated or reversed course. Capital is no longer abundant and cheap; investors are reluctant to give the industry new money and internal cash flow generation is depressed due to low prices. With industry capital spending dropping dramatically as a result, supply reductions are likely not far away. Conversely, natural gas demand should improve as bottlenecks in the pipeline system are rectified and pipeline capacity and markets are developed. Investors shouldn’t forget that there is considerable opportunity for natural gas to displace coal as a more environmentally friendly fuel.

Looking out over the next three to five years, we think Canadian natural gas prices will improve materially. Consequently, we believe there is significant recovery potential in shares of Peyto and Tourmaline.

If the thought of hanging on to poorly performing investments makes you feel nauseous, it’s worth reviewing the performance of Starbucks. It was easily the most disliked stock in our portfolio during the Financial Crisis in 2008/09; the paper loss on our initial investment was more than 75% at the worst point. However, over the last decade, Starbucks has handily been the biggest contributor to our performance, with the stock producing a total return of 1,500% (in Canadian dollars).

We have distanced ourselves from the S&P/TSX Total Return Index over the last decade (255% versus 110%) largely because we have favoured high-quality American growth businesses like Starbucks over Canadian resource stocks. That strategy has worked well because our American investments have gone from unloved to loved, while sentiment toward Canadian resource stocks has gone from loved to loathed.

We believe investors will be rewarded for holding loathed stocks that are currently trying everyone’s patience. The odds are good that business fundamentals and investor sentiment will ultimately shift in our favour. Patience is warranted.

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*The Odlum Brown Model Portfolio is an all-equity portfolio that was established by the Odlum Brown Equity Research Department on December 15, 1994, with a hypothetical investment of $250,000. It showcases how we believe individual security recommendations may be used within the context of a client portfolio. The Model also provides a basis with which to measure the quality of our advice and the effectiveness of our disciplined investment strategy. Trades are made using the closing price on the day a change is announced. Performance figures do not include any allowance for fees. Past performance is not indicative of future performance.

Odlum Brown Limited is an independent, full-service investment firm focused on providing professional investment advice and objective research. We respect your right to be informed of relationships with the issuers or strategies referred to in this report which might reasonably be expected to indicate potential conflicts of interest with respect to the securities or any investment strategies discussed or recommended in this report. We do not act as a market maker in any securities and do not provide investment banking or advisory services to, or hold positions in, the issuers covered by our research. Analysts and their associates may, from time to time, hold securities of issuers discussed or recommended in this report because they personally have the conviction to follow their own research, but we have implemented internal policies that impose restrictions on when and how an Analyst may buy or sell securities they cover and any such interest will be disclosed in our report in accordance with regulatory policy. Our Analysts receive no direct compensation based on revenue from investment banking services. We describe our research policies in greater detail, including a description of our rating system and how we disseminate our research here.

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