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Investing In Canadian Natural Resources and Bank Of Nova Scotia With Tony Demarin of BCV Asset Management

This post was included in the ninth edition of The Wealth Builder Carnival

Is the Buy and Hold investing philosophy dead? Not according to the portfolio manager we spoke to for this next interview. Our interviewee invests exclusively in large, blue-chip, conservative, dividend-paying companies that are priced at reasonable values with high income potential. In the interview, you’ll hear about one stock that the interviewee has held for 20 years that pays a dividend equivalent to his adjusted cost base. He runs concentrated portfolios with approximately 20 holdings and each holding is assessed on the basis of its earning stability, financial strength and dividend growth potential. Keeping portfolio turnover low to minimize trading costs and taxation, in the interview you’ll find this portfolio manager’s detailed thoughts on 2 of his favourite stocks.

Biography: Tony graduated from the University of Manitoba in 1988 with a Bachelor of Commerce (Honours) degree and from McMaster University in 1990 with a Master of Business Administration degree. Tony received his Chartered Financial Analyst designation in 1996. Tony is a Certified Investment Manager and a Fellow of the Canadian Securities Institute and is a member of CFA Winnipeg (formerly the Winnipeg Society of Financial Analysts) and the CFA Institute in Charlottesville, Virginia.

Tony has eighteen years of investment and portfolio management experience. Prior to forming BCV Asset Management Inc. in 2007, he was Senior Vice President and Portfolio Manager at a leading Canadian investment management firm for seven years. As a senior member of the investment management team, he shared in the responsibility for the management of over three-quarters of a billion dollars of financial assets. Previously, he was a Senior Financial Consultant with MD Management Ltd., a wealth management firm dedicated exclusively to physicians.

Q: Can you tell us a little bit about the company Bank of Nova Scotia (its ranks among the other major Canadian banks in terms of market share, its’ focus be it in retail or wholesale)?

A: In terms of size, Scotiabank (BNS: TSX) is Canada’s third largest financial institution, Royal Bank and TD Bank, being one and two. All the banks have different areas of focus. Scotia’s very diversified, but what sets it apart from most Canadian banks, is its extensive international banking operations: the Caribbean, Latin America, developing Asia. I believe Scotiabank is currently the largest North American bank in the Caribbean. Having said that, it’s still a very large domestic personal and commercial bank and it does quite well in that category. It also has a very decent wholesale banking division (investment banking, corporate finance, securities trading). It’s also Canada’s largest corporate lender. So it’s a very diversified bank that is involved in many, many different areas of financial services. Recently, it’s carved out a fourth operating unit called wealth management. They’ve always been involved in wealth management, in stock brokering and in the mutual fund business, but they’re now making it a focus and they’re going to run it as a separate operating unit. They already own a part of CI Financial and a part of Dundee Wealth Management. My guess is they’re going to build in this area. Wealth management is very appealing because it doesn’t require the same regulatory capital as lending and it’s a very high margin, stable, revenue producing , free cash flow type of business. So I think all the banks are going to try to get more involved in wealth management compared to some other areas. So Scotiabank is a mixed bank of retail and wholesale with a very large focus on non-Canadian operations.

Q: Following up on the previous question: What about valuation - how does this company compare to its peers? Also, what does the company’s balance sheet look like?

A: The banking industry as a whole has moved up quite a bit in the last number of months, valuation-wise. So you know they’re not a screaming buy. This is not a sector that is out of favour and one that is facing fundamental challenges. A lot of problems that it had, go back a year, a year and a half, two years. So the banking sector’s not trading at the lowest valuation like it did approximately 2 years ago.

Scotia’s probably on the higher end of the multiple scale. They trade about 12 times earnings, possibly as high as 12.5 times earnings depending if you’re using forward-looking or backward-looking earnings. In the banking sector, it can trade as low as 9 times earnings and goes up about 13 or 14 times in the very exciting days when the banking sector is very much in favour.

It’s a sector that’s improving. Loan loss provisions are dropping. Capital ratios are very much on side for the Canadian banks. And there’s a huge expectation that if the economy continues to grow for the next couple of years, that dividend increases will come to Canadian banks for the first time in a couple of years. And as the global economy recovers, these banks will benefit more than many other International banks. They will have the purchasing power to pick up the divisions of more challenged financial institutions. Scotiabank’s all time record high stock price is around $55/share. You know in the last couple weeks, it’s been trading pretty close to $53, $54/share so, you have to take more of a medium to long term approach with Scotiabank if you think you are going to make greater than just nominal profits in a stock like this. Having said that I can see this being a $60 stock one year from now if we continue to see economic improvement in North America, loan loss provisions continue be maintained, with some dividend increases and possibly some share buy-backs. The stock will earn you money. You will make a return in the next few years. Even their ROE is again approaching the high teens, 17, 18, 19 percent. And those are, good returns of a very overcapitalized balance sheet. So the valuation is not cheap but the fundamental’s really good.

Q: What catalysts do you see that could move the stock?

A: I covered a bit of that already but continued growth in the emerging markets. You know we just saw another purchase by the bank of Nova Scotia in Brazil. Many of the Canadian banks have made it known to the market that they’re on the lookout for bolt-on acquisitions from other financial institutions that are not as well capitalized and may have to shed some banking units based on the new capital rules that are coming in. The Canadian banks should be net beneficiaries there. Continued growth in wealth management, like I said, they’ve carved out a specific division and they moved one of their very senior executives into this new category. So there’s no question, there’s going to be more of a focus on selling more wealth products and protection products like insurance. And so those areas are going to help the stock move higher as well as continued improvement in the credit area. Even though there’s not much scope for continuing provisions to go lower, if the economy continues to improve and employment in Canada continues to grow, you could see further recapturing of loan loss provisions to help the stock go higher.

Q: In the race to raise dividends among the big Canadian banks, where do you see the Bank of Nova Scotia?

A: It may be one the laggards, only because they earn about a dollar a share per quarter right now and are paying 49 cents out. So their payout ratio, let’s call it, 49 to 50 percent. There’s banks like Canadian Western Bank (CWB:TSX), that have a payout in the 20% range. Laurentian Bank (LB:TSX) is in the 30% range. National Bank (NA:TSX) at 40%. TD Bank (TD:TSX) at 42%. And then CIBC (CM:TSX) , Royal Bank of Canada (RY:TSX), Bank of Montreal (BMO:TSX), and Scotia (BNS:TSX) are in that low 50% category so it really depends on where the management wants the payout range to be. Once you get over 50%, you’re going to need to see the earnings grow closer to 8, 10 percent in 2011, to see that dividend increase from Scotia. It maybe just a nominal increase, you know, a couple of pennies but it will be in next calendar year. All the banks are going to want to reward their shareholders for being patient in the last couple of years. I mean, CIBC, has even made motion that they might pay a special dividend to kind of make up for the last couple of years of no dividend increases. So that’s the next strategy for the banks.

Q: Moving on, you mentioned a shuffling in management with regards to Scotiabank’s wealth management division. In terms of the overall bank, what do you think is management’s focus/growth strategy? Maybe you can dig a little deeper into that Mr. Demarin?

A: Well, Scotiabank is very well known for two things. One is the cost containment when they run their business. Their cost to income ratio is the lowest amongst all of the banks. They’re kind of frugal in the way they run their operations, which is a good thing for a shareholder. And secondly, they’re very prudent with their lending. They’re very conservative lenders. So those two philosophies will likely continue. We have no concerns with the management team. Rick Waugh’s been at the helm now for a few years now. He’s actually from my hometown of Winnipeg. They’ve done a strong job in terms of being good stewards especially through the worst credit crisis kinda in the history of mankind.

I think they are going to continue to focus on growing in areas of the world like southeast Asia, Latin America and the Caribbean where you can take Canadian banking practices, you know good scoring techniques, good credit lending practices and overlay them in a less efficient type banking environment that may not have the same standards as a Canadian industry. That’s is definitely where management will focus on.

Insurance will be another area that banks are going to continue to penetrate deeper into that category because there’s good returns there and the banks are still quite small in that area. I think Scotia will have great focus on wealth management. There’s no other reasons that they’re carving a fourth division now. They’re going have their personal, commercial banking. They’re going to have their international banking, their wholesale banking and now wealth management. Look for CI Financial (CIX:TSX) to be brought completely in house. Look for Dundee Wealth (DW:TSX) to be completely brought in house. Maybe an additional purchase of another mutual fund company. AGF (AGF.B:TSX) is still kind of independent firm that could be bought by one of the larger financial institutions. So, management, we have no concerns about. And they do have a strategy to continue to grow in the bank. One of the better growth strategies given that they have all these international banking relationships already established in all parts of the world.

Q: You mention that they might want to implement the conservative lending standards that they have in Canada elsewhere, where they have their branches. Was that maybe their intention when they announced their purchase of Dresdner bank in Brazil on September 16, 2010? It’s a relatively small bank that they bought in Brazil. So what is their strategy? Are they planning to buy more …?

A: Yup. That’s been Scotia’s strategy all along. Whenever they go into a new market or a market that they’re not as familiar with, they tend to start small. They take a stake in the 5th, 6th, 7th, 8th largest financial institution in that country and as they get to understand the local banking market, they’ll sometimes make additional acquisitions. To the part where they sometimes they become the first, second or third bank in that market. Brazil has a very large population that’s improving its standard of living. The level of income is rising dramatically because of its strong resource-base in that country and they do business down in many Latin American nations. I’m not certain if this is their first acquisition in Brazil. I would imagine Scotiabank was already there in some degree. They’ve been in Brazil before. This is an example of Canadian banks taking advantage of weaker European banks that have to throw away some of their less than core operations. Brazil’s got a really, really strong mining sector with Rio Tinto and CVRD being strong down there. It allows Scotiabank to participate greater in that industry and just, jretail banking in general. Brazil has one of the largest populations in the western hemisphere in the Americas. And they are moving up the income scale. So this is going to be economy you want to target if you believe that Latin America has got a good future. They’re already are in places like Chile, Columbia and Venezuela. They use to be in Argentina but they got out of that market a number of years when it has some financial problems but this is very much in line with the way Scotiabank does business where they, they take a small stake and they grow from there.

Q: So to wrap up the discussion about Scotiabank, what are some potential risks associated with Scotiabank that could hamper your investing thesis?

A: Well, you know one of the problems with the emerging markets, where Scotiabank have a lot of exposure, is that they tend to be quite volatile from a financial economic political perspective. So what helps Scotiabank sometimes, can also hurt it. If we do go into another economic slowdown, if resource prices start to really to back off a lot, if emerging markets slow down that will hurt Scotiabank. In fact, their Caribbean operations are experiencing softness simply because they’re not as many North Americans traveling to these destinations during holidays as North Americans are having their own income challenges. So, Scotiabank will be a net loser in that area. But if you think long term, we don’t think this is a major concern. I mean the biggest challenge to the banks in Canada is going to be economic growth or lack thereof - rising unemployment or rising employment because that feeds right back into credit quality. If the Canadian housing market is truly an overvalued bubble then that may cause problems for their lending operations. We don’t believe that to be the case but certainly that is something to watch. If the European sovereign debt issues come back again, where countries are restructuring or having difficulties rolling their government debt that kinda affects the European banks which through contagion will affect the Canadian banks. So, these are all risks that the banks face no matter what environment they’re operating in. Rising interest rates can also be quite negative for banks - if rates rise quite dramatically. Personally, I don’t think interest rates are going to rise that dramatically.

I think Canada’s going to show continued employment growth. I think Scotiabank’s operations in many parts of the world are very diversified and they are very good at managing risk in all of these countries so, any kind of setbacks that they experience would be temporary and likely a decent buying opportunity in our opinion. I’ve held Scotiabank as a stock personally for twenty years now, where I have a cost base of $2.50 on a stock that’s split twice. It pays a dividend of close to $2 a share and it’s trading near its record stock price. So there’s nothing that I’m concerned about with this financial institution. I think it’s one of Canada’s best financial institutions, among a couple of others.

That’s a good way to wrap up our discussion on Scotiabank. Let’s turn to your other pick, Canadian Natural Resources (CNQ:TSX).

Q: Can you tell us a little bit about the company (its revenue mix of oil and gas and areas of global operations)?

A: Canada only has small number of very large oil and gas companies and then Canadian Natural Resources is one of Canada’s largest. It’s an extremely well managed oil and gas company. It’s not really integrated. It’s more of explorer and a producer. It began back in the last 1980s, when the British Petroleum decided to leave Canada and an individual named Murray Edwards started this firm and has grown into something, you could argue is Canada’s largest independent oil and gas company. It has more oil than natural gas about 65% Oil, 35% natural gas which is good. It’s mostly a western Canadian firm but it does have operations in the North Sea. It also has a small stake off the coast of West Africa. These are smaller positions for this company but they’re still meaningful. Their biggest growth and wealth driver is their horizon oil sands project which recently completed phase 1 at a reasonable cost compared to other oil sand operators and they are now producing about 110,000 barrels a day from this particular site with the intent of going up to half a million barrels a day over the next number of years as they go through phase 2, 3, 4 and 5. This is going to be where they’re going to drive their capital expenditure and where they’re ultimately going to achieve significant free cash generation, which will likely allow them to continue to dramatically increasing their dividend. They started paying a dividend in 2001, at 4 cents a share. The expectation now is that they are going to continue to pay about 30 cents/share. So, it’s risen 7.5 times in the last decade. Overall they produce about 650,000 barrels of oil equivalent a day, so it’s gas and oil. There is no reason that they can’t get close to million barrels of oil equivalent a day over the next, 7 to 10 years. So we really like this company, it’s well-managed, got great assets and got good growth ahead of it. It’s primarily in Canada so it’s in a politically stable part of the world. They do have a couple of other oil sands projects, Primrose and Pelican Lake, that are much smaller in scope but it’s further development that will allow them to continue to increase their production. They have reserves of energy that could be as long as 40 years and this is really a mining operation not exploration as they know where the oil is and they just have to efficiently get it out of the ground, upgrade it and ship it.

Q: What about valuation - how does this CNQ compare to its peers? Also, what does the company’s balance sheet look like?

A: The balance sheet is in good shape. Canadian Natural Resources has generally carried a higher level of debt compared to some of its peers but they’ve been spending a lot of their capital on creating the oil sands project and the upgraders. So now with a lot of the free cash being generated, they will rapidly pay down the debt. Their debt is probably about 30% of total capital. Their market capitalization is 35-37 billion dollars and their total debt is about 9 billion. So it’s still quite a large number but we don’t have any concerns that this a balance sheet debt problem. Valuation-wise, it pays just a small dividend about one percent, which is very typical for most oil and gas companies but it’s growing rapidly. The cash flow is definitely increasing. The stock trades at about 13 times earnings. Now most oil and gas companies don’t trade based on earnings but because they are generating continued net profitability that it would be something to share. In terms of cash flow per share, they’re expecting to earn about $6 a share. They’re currently a $34 stock, so trading about 5.5 times cash flow. Not cheap but not significantly overly expensive. When you start getting to 7 or 8 times cash flow, I would say it would be getting a little bit more expensive. I remember this was a $55 stock a couple years ago at the height of the oil boom, granted that we were dealing with $140 oil. So I think there’s still lots of room for share price appreciation over the next 12 and 24 months. Obviously it’s going to be very dependent on what the price of crude oil is going to be over time.

Q: What catalysts do you see that could move the stock?

A: They’re expecting to spend about 5 billion dollars this year in capital expenditures. Most of this is going to be allocated toward their crude oil which is, which is good. More attractive than natural gas.

Again their production of their synthetic crude at the horizon oil sands is certainly going to be a continued focus. So, there’s not going to be a eureka moment where they’re going to find a new field that’s going to take that project from 110,000 barrels a day to, 500,000 barrels a day over a short period of time. This process is going to occur over the next number of years as they go through phases 2, 3, 4 and 5. They still do have Pelican Lake and Primrose, which is a thermal (in-situ oil sands) project and that will also increase some of their capacity. They’re also on the offshore of West Africa, where they should get some production growth but again, we’re starting at a very low base there. The finding and the developing costs off of the coast of West Africa are very, very low so there’s potential for some really good profitability. So, they have some conventional as well as some unconventional projects that are going on but they’re not a exploratory firm where they’re up in the high Arctic or off the coast of Brazil where you’re make this major discovery. It’s more about managing costs and managing their capital expenditures properly so it’s a good long term growth story over the next, call it 5 plus years.

Q: What is your opinion of the company’s management? You spoke about Mr. Edwards earlier and said that he’s done a fabulous job. Is he still leading the company or is he…?

A: Very much so. You know, there’s him and Allan Markin. I think Allan Markin is the, the Chairman and their President is Steve Laut. But Murray Edwards is the founder of this firm.

Murray Edwards has kinda got his fingers in a number of different investments. Whether it’s a hockey team in Calgary, real estate in Banff or financial services where he’s got a big stake in Jovian Financial (JOV:TSX). But Canadian Natural Resources is the company that he basically created out of a nothing when he bought the Canadian assets of British Petroleum and turned it into a world class operator. One of the advantages of this management team is they know how to control cost. They are one of the few oil sands operators that really didn’t blow themselves up by building the oil sands project and the accompanying infrastructure that goes with it a couple of years ago when costs were just exploding in both raw materials as well as human resources. So, this is a management team that knows how to run this company quite well.

Q: Have they indicated whether they’re, interested in making more acquisitions or …?

A: Well, companies don’t normally signal a lot of that in advance. I mean they have grown quite a bit by acquisition in the last few years. You know, this goes back probably a decade now, they bought Ranger Oil, which was an international oil and gas company. Rio Alto Exploration, they bought early in the decade, they bought the natural gas properties of Anadarko (APC:NYSE). They started with BP Amoco’s Canadian properties and have kind of grown from there, so they do have history of growing through acquisition. However, I’m not sure if they need to make any acquisitions, again their balance sheet has already got 9 billion dollars of debt on it and I think the goal is to slowly chip away at that with the free cash flow and reinvest in their own oil sands project, but sometimes companies will do things and you wake up one Monday morning and realize that you’ve been caught off-guard.

Canadian Natural Resources could be acquired by a global player. Just like the recent bid by BHP Billiton (BHP:NYSE) for Potash Corp of Saskatchewan (POT:TSX). There may be a very large, super major, like Total (TOT:NYSE) which does a lot of work in Canada. Maybe British Petroleum wants to rejoin back in the Canadian oil sands, as opposed to being in the Gulf of Mexico. So there’s a number of large international players that are really looking for production growth. And when you know, you’re going to add another 400,000 barrels of oil over the next 5 to 7 years, they may be a great candidate to be acquired. It would certainly be a large acquisition but so is Potash Corp. and it looks like there are some international players that could do it. So I don’t see any acquisitions on the horizons for CNQ but you never know what’s going on in the boardroom.

Q: With regards to adding that 400,000 odd barrel of oil capacity over the next 4 to 5 years, in the past when they promised something, did they come in on time and on cost or…?

A: Well, they certainly come in on cost. Timing is always hard for some of these major, dramatic projects, because a lot of the time things are dependent on whether human resources are fully available. I understand that the oil sands are starting to get active again and, and there’s a lot of people are already working back up there so they may have some issues with finding the right type of labour. But that’s one of the advantages of this company, they tend to do what they commit to and that’s why we think it’s one of the best managed oil and gas companies in Canada.

Q: Final question, what are some potential risks associated with this stock that could hamper your investment thesis?

A: The biggest challenge for an energy company is the price they are going to receive for their output. Natural gas has certainly been a very soft commodity, trading at around 4 dollars a thousand cubic feet. and this is something that traded much higher than that. I think it was in the mid-teens during hurricane Katrina a few years ago. And all indications are that natural gas prices are going to remain soft. Same thing with the price of oil, it’s maybe 75 to 78 dollars a barrel but if it drops back to the high 50s, it will certainly affect cash flow as well as the stock price. So that’s definitely a risk. But that’s really a risk that’s applicable to all oil and gas companies. Cost containment - you know if they didn’t maintain their history and their upgrades were getting done at a significant cost that could be a problem. There were some royalty changes that went on a few years ago with the government of Alberta. But I think they backed off on that so that is probably not a risk anymore. So commodity risk and cost containment would probably be their two biggest risks. Maybe making a stupid acquisition, I mean they could go out and buy something and overpay for it. With level of debt that they have, they don’t have a clean, clean balance sheet. S&P rates them as, I believe as a BBB. So they’re investment grade but they certainly don’t have a AAA balance sheet.

I guess the high cost involved with oil sands, upgrading projects - these are multi-billion dollar projects. As well with these oil sands projects, sometimes they have outages. They have fires and other shutdowns for problems. So that 110,000 barrels a day may go down to zero for a period of time. However, these are more shorter term, transitory risks. If we get high price of crude oil over the next five years, this company will benefit greatly, as they’re very levered.

On that note, we ended the interview.

Thank You, Mr. Demarin!

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