Market Conservatism Gets Rewarded

by: Chris Damas

Here are two excerpts from The BCMI Report of last Thursday when the stock market was hitting new 2010 highs (titled “Fishing in a Plentiful Market”):

The secret when the scales are flying is to concentrate on the targets that you have pre-researched, have a risk/reward profile consistent with your tolerance and that you can catch within your capital limitations and knowledge base.

We are not recommending fertilizer stocks or gold stocks for people just getting into the market at these levels, due to the high volatility inherent in these sectors.

Looks like that was fairly decent advice, given the big market reversal in gold (down, then up), the USD (up), and Canadian bank stocks (down) we witnessed Tuesday.

At 2pm, we had the S&P/TSX Canadian market index even at 12,915.8, after being down more than 150 in the morning.

We had the DJIA US bellwether at 11,357 up 10 points after hitting a low of 11,255 earlier.

Gold, the fright/greed metal, climbed back to $1,401.50/oz (December futures) after scaring the dickens out of speculators, hitting a high of $1,424.30 Tuesday morning, only to plummet in the afternoon and drop further to a morning wake-up call of $1,383.40.

Can I say it again?

Commodities are not for those with weak stomachs or high blood pressure.

What has caught my eye over the past several days has been acceleration in the backing up of US and Canadian government bond yields (also known in casual conversation as “funny money”).

We have the US ten year note at 2.73% - it was 2.57% Tuesday after the $24 billion US treasury auction netted buyers an average yield of 2.636%.

A month ago, the ten year Treasury yielded 2.35%. A disconcerting trend towards higher rates.

The Government of Canada ten year bond is flirting with 3% - a month ago it was yielding 2.69%.

The commodities market has been sucking money out of the bond market and my fear – out of good dividend paying stocks like Bank of Montreal (NYSE:BMO), BCE (NYSE:BCE), and the like.

The back up in bond yields here reflect growing concerns over the solvency of Ireland/Irish banks and Greece.

I’d been looking for the credit problems in Europe to resurface and last Spring predicted the Greeks would have defaulted by now.

But the Chinese came in and basically gave the Greeks a credit hand-up, guaranteeing help in the form of big orders for shipbuilding. So I figured the Greek problem would not resurface until later.

But, obviously, credit problems in Europe are rattling our markets again.

In spite of this, I recommend sticking to conservative, dividend-paying names and small industrials that are under-valued based on our earnings forecast.

Of the Baker’s dozen stocks we recommended last Thursday, most are actually up in price, in spite of a savagely down market.

The Canadian banks' BMO and Royal (NYSE:RY) are down, as is BCE marginally, but TELUS (NYSE:TU) and Nexen (NXY) are up.

On the small-cap side, I am happy to report four of the six stocks we recommended are up (Canexus Income Fund (OTCPK:CXUSF), Cascades (OTCPK:CADNF), Noranda Income Fund and Tembec (OTCPK:TMBCF).

Only Fibrek has lost its fibre and Interfor is marginally down on low volume.

Here’s what we are doing today:

We hedged BMO as it is subject to an OSC hearing on an old lawsuit against its brokerage arm, BMO Nesbitt Burns, which could shave $200 million off profits.

As I once worked for Nesbitt Burns and have followed their activities for years, I didn’t find the allegations of poor due diligence, shoddy salesmanship, and abuse of clients particularly surprising.

Not that BMO is alone in Canadian banks being sued over bad investment dealer behavior. CIBC (NYSE:CM) is being sued by the bankruptcy trustee of Lehman Bros.

I like BMO because its US exposure is its ownership of Harris Bank, which is centred in Chicago, where hopefully the agricultural commodity boom is creating business.

But I bought some BMO Nov 58 Put options to protect against a sharp downside reaction from a particularly onerous OSC settlement levied against BMO.

We also are buying more TELUS for the good yield and because it would be a take-over candidate given a likely relaxation in Canadian telecommunications foreign takeover restrictions. Possible buyers include the major US wireless players or even an international telecom.

We bought a small-cap gold stock Tuesday – Exeter Resources (NYSEMKT:XRA) (XRC.TO at $6.24-6.41). It’s down on the gold price downdraft, but I believe this company has a very good quality gold and copper deposit in Chile. We’ve had good success predicting gold/copper small cap takeovers in the past (Aur Resources, Northern Peru Copper, etc.).

Exeter recently completed a $50 million financing at $6.20, which knocked down the stock from above $7 when it was announced. For me, this removes one of the major risks of holding a small-cap mining stock in development – that they will do a financing and knock your stock down.

Finally, we have completely sold the last of our position in Noranda Income Fund. It has been more than a double off the $2.40-2.50 level we accumulated the units at. Although our valuation has $7-8 written all over it, we tend to avoid fighting big multinational conglomerates.

Noranda Income Fund’s Q3 results released Tuesday were in line with our expectations. But we don’t like the recent saber-rattling by Xstrata Canada, which says it has no obligation to guarantee the refinancing of NIF.UN’s senior notes due Dec 20, even though they have guaranteed their debt in the past. We believe it is unlikely a cash distribution will be reinstated soon. At best, the Fund will declare a year-end distribution of units "in kind" to avoid being taxed on net income.

Next earnings release of note: Cascades Inc. on Friday.

In deference and in salute to our Veterans and Remembrance Day, The BCMI Report is coming to you a day earlier than our usual Thursday afternoon delivery date.

Disclosure: Long all stocks mentioned