In this email, we’ll continue working through our final model income portfolio here at Stocktrades.
These portfolios provide a ton of benefit from the strategy side of things, and they also add a lot of value when it comes to commentary on the holdings inside the portfolio.
**We are having some technical difficulties with the model portfolios at Ycharts and as a result we don’t have the updated files on the website just yet. These will be done tomorrow morning**
With that said, let’s dive right into it.
Equal-Weight All-Canadian Hybrid Portfolio
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With the launch of our income portfolios at the start of 2023, this was one of the more anticipated and unique model portfolios here. However, it largely disappointed, and there are a few reasons for this.
First, the portfolio is all Canadian holdings. The TSX, and Canada in general, struggled mightily in 2023 relative to the U.S. markets. With this portfolio being all Canadian, we have the following comments on our objectives on the website:
“However, it does so with an equal-weight strategy and is a pure Canadian portfolio. For this reason, we wouldn’t construct the entirety of our portfolios on this model. However, it could certainly be a subset of a larger portfolio.”
Why did we say this?
Our market is rate-sensitive and slower-growing than the U.S. markets. REITs, telecoms, banks, utilities, and other industries are particularly sensitive to rates. When interest rates go up, especially at the pace they did, these industries tend to struggle.
Telecoms and utilities can be deeply impacted because it hits their interest-related costs on debt. With finance companies, they generally benefit. However, with the rapid rate increase, the sharp reduction in borrowing plus heavy provisions needing to be set aside for expected defaulting loans hits earnings and, thus, stock prices.
This portfolio also highlights the importance of having exposure to the U.S. markets. Over the last 20+ years, there have been few instances of the TSX ever outperforming the S&P 500.
However, there was plenty of good inside of this portfolio this year. So, let’s talk about that first.
The Good
The main strengths in this portfolio lie in Foundational Stock Alimentation Couche-Tard (TSE:ATD), Bull List stock Equitable Bank (TSE:EQB), Foundational Stock Waste Connections (TSE:WCN), and Dividend Bull List stock OpenText (TSE:OTEX). All four stocks put up returns of 30.54%, 48%, 35%, and 18%, respectively.
We spoke in-depth about Equitable Bank in our previous model portfolio update, so we won’t talk about that again. Let’s examine the other 3.
Alimentation Couche-Tard (TSE:ATD)
Couche-Tard is evidence that investors shouldn’t have any issue buying stocks in outstanding companies at all-time high valuations. Despite routinely trading at 30%+ premiums relative to historical averages over the last few years, all it has done has made new highs.
Make no mistake about it, however; these new all-time highs are being set due to operational results, not just market speculation. The company has grown earnings by 90% over the last 5 years and free cash flow by just shy of 50%, and it is showing no signs of slowing down.
Its target market (gas stations) is so fragmented that there are plenty of opportunities for continued growth. Is the company expensive right now? At nearly 20x earnings, it is. However, one could argue this company has been expensive for three years now, and all it’s done is returned 105%.
This goes back to our concept of understanding the business before worrying about valuation. We’d have no problem adding Couche-Tard at these prices.
Waste Connections (TSE:WCN)
Waste Connections replaced Canadian National Railway as a Foundational Stock in 2023 due to our prediction of an economic slowdown impacting railways. These are two outstanding companies, but Waste Connections will undoubtedly be less cyclical.
Since that swap, Waste Connections has returned 17%, while Canadian National Railway sits at 5.75%.
Waste Connections is another company that often trades at such a high valuation that many investors ignore it. 40-50x earnings and 30-35x free cash flows are not uncommon ratios for this company, primarily due to its defensive nature and the fact that it has established a considerable economic moat in North America.
The company has some oil and gas exposure, which will be cyclical, but this is a small portion of the business, and most of its revenue will be generated from consistent waste disposal segments.
OpenText (TSE:OTEX)
Dividend Bull List stock OpenText is one of Canada’s more underrated technology companies. It’s slower growing, so it often gets overlooked. In 2022, it made a large-scale acquisition that required a considerable amount of debt. The stock sold off because the markets were so worried about interest rates at the time.
It has rebounded more than 70% off those 2022 lows and continues its strong momentum off the back of solid results.
The integration of this large-scale acquisition, Micro Focus, is one of the main reasons we’re still bullish on the stock heading into 2024. The company is trading at only 8.7x expected earnings at the time of writing.
In our opinion, there is little growth currently priced into OpenText. Although it is easy to see the stock lag in 2024 due to its great results in 2023, we could see another strong year for the dividend grower in 2024.
The Bad
Typically, we would isolate individual stocks here and speak on their performance. However, for the most part, we already spoke on the interest rate sensitivity for most of the portfolio, which was why it struggled.
Instead, we’ll focus on one company, Foundational Stock Franco Nevada (TSE:FNV).
Franco-Nevada suffered a significant setback in 2023. Cobre Panama (CP), a large open-pit copper mine owned and operated by First Quantum Minerals, is not producing as it has been put on preservation and maintenance. The mine, located in Panama, has been central to several disputes over the past few years.
You can read more about the details on our Foundational Stock page under the Franco Nevada section. What you do need to know is the mine accounts for 20% of Franco Nevada’s EBITDA, which is why the stock got hit so hard in 2023.
However, we’re not overly concerned at this point and feel like the issues are already priced in.
In fact, we feel that Franco Nevada could provide strong long-term value at these price ranges, as we do believe issues will be inevitably sorted.
The Changes
We’ve decided to make a small switch, opting instead for Pembina Pipeline (PPL) over Enbridge (ENB). This is not to say Enbridge isn’t among the best midstream companies out there; we just feel Pembina is better positioned now.
Both companies are similarly valued and have similar expected growth rates this year. Pembina stands out in its financial position relative to its larger peer.
Across the board, Pembina’s leverage ratios are far more attractive to Enbridge. For example, the company has a D/E ratio of 0.68 vs 1.19 for Enbridge, and its interest coverage ratio of 4.63 is almost double that of Enbridge’s 2.44.
Let us also not discount that Pembina has proved more efficient recently, with noticeably stronger returns on assets, equity, and invested capital ratios. This is true on both a 1YR and 5YR average basis.
The current rate environment favours those with better debt profiles, and should rates remain higher longer, Pembina would be better positioned. The company has little debt maturing this year, and ~92% of debt is fixed.
One benefit of having lower debt levels is that Pembina will have greater flexibility to fund growth through self-funding, given its strong free cash flow generation.
It could also choose to leverage its strong position to make deals, such as the deal to acquire the remaining 50% stake in the Alliance Pipeline and an additional 42.7% in Aux Sable, a deal that was announced in mid-December.
The company is taking on an extra $327M in debt but is expected to be immediately accretive to cash flow and will ultimately be a leverage-neutral acquisition.
The important thing to note here is that Pembina has more options than most in the industry. We’d argue that Pembina’s financial position is the best of all TSX-listed midstream companies.
Finally, lower debt ratios mean the company spends less of its cash flows on interest, which in turn leads to strong payout ratios. Over 80% of EBITDA is high-contracted fee-based business, and the dividend accounts for only 75% of distributable cash flow.
