Promise and opportunity in energy and banks

For Canadian equities expert Colum McKinley, looking for investment opportunities while managing exposures involves a lot of moving parts. He monitors sector trends, keeps an eye out for good-quality businesses with attractive valuations, and looks for market mispricing.

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These days, he finds banks and energy companies show promise.

“When we look at the energy market today, I think there are number of trends playing out in the favour of that sector,” said McKinley, vice-president of Canadian equities at CIBC Asset Management, during a mid-May interview.

One trend is higher oil prices, says McKinley, who’s a manager of the Renaissance Canadian Core Value Fund. These are being driven by a continuing strong demand for oil, he explains, while OPEC has cut back on its supply.

OPEC, Russia and other producers reduced their output by 1.8 million barrels a day in January 2017, and committed in November to extending those production cuts through 2018. The next OPEC meeting to set oil policy is scheduled for June 22.

Crude oil prices were 30% higher year-over-year at the end of May and ICE Brent averaged more than $70 per barrel (the highest price since 2014), said the June OPEC Monthly Oil Market Report.

The latest Oil Market Report from the International Energy Agency says demand for oil was strong in Q1 and Q2 of this year, but that a slowdown may occur in the second half of 2018. The agency’s first estimate of demand for 2019 “anticipates growth.”

Read: Higher prices mean it’s time for “torquier” oil names

McKinley says he’s monitoring supply forecasts, but that prices had increased substantially as of May.

“We’ve also seen a tightening in oil differentials [the price of Canadian oil relative to the global marketplace],” McKinley said during his interview. “We’ve seen that discount narrowing, [and] that is a substantial positive for the cash flow generation of Canadian energy companies.”

Also, companies have aggressively lowered their costs, he adds. The main reason? “They’ve thought long and hard about the costs in their business and they’re stripp[ing] out all the extraneous costs in their business,” McKinley says. “We’ve seen companies develop and focus more on capital discipline. So [they’re] deploying capital effectively.”

The benefit of cutting costs is companies are able to reduce their amount of leverage and pay down debt more quickly, which is why energy stocks are quite attractive.

Another boon is even though commodity prices are strong, McKinley says oil company stock prices are only just starting to react. To date, they’re still “trading at valuation[s] that are well below historic averages. We continue to see an upside in the energy sector from that.”

Financial sector still strong

Over time, Canadian banks have had an ability to generate above-average returns on capital, said McKinley, and offer dividend yields of 4% to 4.5%.

Banks “have proven their ability to grow their dividends over time,” he adds. “We think we’re going to continue to see further dividend increases for the Canadian banks.”

All of Canada’s Big Five banks delivered Q2 profits that beat expectations, earning a combined $10.6 billion—up nearly 11% from a year ago. Canada’s biggest banks also beat analyst estimates for adjusted profits, and most of the banks maintained their dividends for Q3 2018.

Read: Big 5 banks beat Q2 expectations with strong international growth

“What determines the growth in a bank’s earning and operating results is the strength of the underlying economy,” McKinley says. Canadian banks will be well supported as the Canadian and North American economies improve.

Canada’s economy grew at a rate of 1.3% year-over-year for Q1 2018, while the U.S. economy grew at a 2.2% annual rate.

Further, Canada’s unemployment rate held steady in May at 5.8% while the U.S. unemployment rate was at an 18-year low of 3.8% for the same month.

“We continue to see positive earning potential for Canadian banks that we don’t think is fully reflected in the bank stocks today,” McKinley concludes.

Also read:

Why financial sector will be strong this year

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