It Seemed Like A Good Idea At The Time Charlie Munger’s Story Applies To Some Canadian Stocks

Last summer it seemed like a good idea to buy into several large-cap Canadian stocks that had a long history of paying out ever more generous dividends. Unfortunately, their shares have fallen, making last year’s good idea look bad.

The fortunes of these investments parallel the story told by Charlie Munger, co-chair of Berkshire Hathaway Inc., after the company made a questionable investment in wallboard maker US Gypsum Corp (USG).

“Our investment in USG obviously hasn't worked out very well,” Mr. Munger said in a speech in 2002. “It reminds me of a story about a man who had a wife and three kids. He conceived an illegitimate child with a woman he'd just met. When asked why he did it, he said, ‘It seemed like a good idea at the time’.”

Despite Mr. Munger’s misgivings about USG, the company’s share price eventually turned around. This year it was taken over by Germany’s Knauf KG in a U.S.D. $7 billion deal worth U.S.D. $44 a share, about eight times what it was when Mr. Munger lamented Berkshire’s decision 16 years ago.

Many of last year’s bad investment choices in Canadian markets are energy stocks and miners whose fortunes are tied to commodity price swings. A few others, like content creator Corus Entertainment Inc., and publishers such as Torstar Corp. and Postmedia Network Canada Corp. are struggling with long-term downturns in their industries. (Although tied to media and publishing, Quebecor Inc. and Transcontinental Inc., both based in Montreal, are doing just fine.)

The fortunes of the companies mentioned below are not connected to commodity prices, nor are they in declining industries, although they have suffered over the past year. Most analysts see them as sells or holds, making them, in my opinion, a good value for income-seeking investors in search of high yields and a long record of increasing dividends. Just don’t expect big gains.

ATCO (ACO.X/TSX)

ATCO, founded by the late Ron Southern and his father as Alberta Trailer Hire Co. in 1947, is well known for the portable buildings and workforce housing that appear on construction sites everywhere. Atco’s structures are made in seven manufacturing plants on four continents. ATCO owns 52% of Canadian Utilities, detailed below, and the fortunes of both companies are closely tied.

It seemed like a good idea to buy ATCO’s non-voting shares last year, after the company reported 2016 adjusted earnings of $360 million, up from $293 million in 2015. The share price reached $50 last year after the results were released in March 2017 and stayed there through to the end of May. In June, the merits of the idea then turned questionable, and ATCO shares now trade for less than $40, a 20% decline.

ATCO has increased its dividend every year for the past 25 years, and although it does not offer a Dividend Reinvestment Plan (DRIP), Canadian Utilities does. At $40, ATCO’s annual dividend of $1.51 yields 3.7%.

In late July, ATCO announced second-quarter 2018 adjusted earnings of $61 million, or 53c per share on revenue of $1.103 billion, compared to $69 million, or 60c per share on revenue of $1.069 billion in the second quarter of 2017. While revenue has climbed, earnings were dragged down by its stake in Canadian Utilities.

ATCO’s long-term debt to capital ratio climbed to 58% at the end of 2017, but both ATCO and Canadian Utilities enjoy A or A- credit ratings, indicating that credit rating agencies have few concerns about their debt levels.

Canadian Utilities (CU/TSX)

CU is effectively the generation, distribution and transmission arm of ATCO’s electricity and natural gas assets, with industrial water supply added to the mix.

By Canadian standards, CU is a blue-chip stock. Incorporated in 1927, Calgary-based Canadian Utilities has assets of $21 billion and 5,200 employees, together with a market capitalization (shares times share price) of nearly $9 billion.

Canadian Utilities has electricity generation and distribution grids and natural gas pipelines in western Canada and Australia. It owns or operates 15 generating stations in Canada, two in Australia and one in Mexico, with a second Mexican facility to come. So far this year, Canadian Utilities invested $1,186 million, part of the $4.5 billion in new projects the company has planned for 2018-2020.

Canadian Utilities gets almost all its revenue via regulated rates, which can be a mixed blessing, as while governments dictate the rates that will be paid, an allowance for a reasonable profit is usually provided for and there is almost no need to provide for doubtful accounts. CU’s other revenue comes from long-term contracts with solid customers. Regulated utilities provide consistent dividends for investors, but they are vulnerable to rising interest rates as

they are usually heavily indebted and will have to refinance at higher rates as their debt matures

as interest rates on GICs and bonds improve, shareholders who had sought a safe source of income may sell utility stocks and jump to interest-bearing securities.

On July 26, 2018, Canadian Utilities announced second-quarter adjusted earnings of $107 million, or 39c per share compared to $126 million, or 47c per share in the second quarter of 2017. Lower earnings were mainly due to adjustments in the regulated rates for its natural gas and electric distribution businesses.

Canadian Utilities has increased its annual dividend every year since 1972, a 46-year record. The current annual dividend of $1.57 per share yields 4.78%. Unlike ATCO, Canadian Utilities offers a DRIP.

It seemed like a good idea to buy CU shares in the spring of 2017, when the shares traded at more than $40 in the wake of record first-quarter earnings reported in late April of that year. The share price then started falling and as of this summer, chastened CU shareholders were willing to sell for less than $33, a drop of more than 20%.

If buying CU at $42 was a bad idea, buying it at $32.50 is certainly less risky. The shares have not been this cheap since the winter of 2015-16.

Cogeco Communications Inc. (CCA/TSX)

Cogeco Communications, a subsidiary of Montreal-based Cogeco Inc., is the eighth largest cable company in North America, operating in Quebec and Ontario, western Pennsylvania, south Florida, Maryland/Delaware, South Carolina and eastern Connecticut. The company changed its name from Cogeco Cable in January 2016. Cogeco Communications offers digital video services and programming, telephone and Internet packages, to residential and business customers.

Thousands of investors thought it would be a good idea to buy CCA shares last year, and the stock traded above $90 between August and December. Since then the shares have fallen more than 20% and now trade near $70, the cheapest the shares have been in more than a year and a half. At $70 Cogeco’s $1.90 annual dividend yields about 2.7%. The company has increased the dividend every year since it began paying them in 2009.

On July 11, Cogeco Communications reported that its third-quarter revenue increased by 12.7% (15.0% in constant currency), to reach $637.1 million, while Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) increased $33.1 million, or 13.0% (15.2% in constant currency), to reach $287.3 million. Free cash flow was $108.5 million, an increase of 3.6% (3.4% in constant currency) compared to the same period of the prior year.

On a constant currency and consolidated basis, the company said it expects fiscal 2019 revenue to grow between 6% and 8%, adjusted EBITDA between 8% and 10% and free cash flow between 18% and 25%.

WestJet Airlines Ltd. (WJA/TSX)

Investors climbed aboard WestJet last year at prices between $25 and $27 per share. Buying seemed like a good idea at the time. Now, after the shares have fallen by more than 30%, with a steep 10% drop in the wake of a second-quarter loss, the price is a little more realistic. At prices near $18, WestJet shares are as cheap as they were for a week or so in February 2016, which turned out to have been a great buying opportunity. Aside from that brief dip, WestJet shares have not been this inexpensive since 2012.

The airline’s shares rode a wave of optimism last year. Then in March 2017, CEO Gregg Saretsky resigned, apparently catching investors off guard, although new CEO Ed Sims insisted the transition had been long discussed. In May, a looming strike by its pilots caused frightened passengers to flee and bookings plunged. The labour action was averted by an arbitration agreement reached in June. Throughout all this the airline has had to absorb jet fuel costs that are 30% higher than they were last year.

In late July 2018 the company reported a second-quarter loss of $20.8 million or 18c a share on revenue of $1.09 billion, down from a year-earlier profit of $48.6 million on revenue of $1.06 billion. Although the loss was smaller than what analysts had expected, the shares fell again.

At $18, the stock trades at just 7.7 times trailing earnings, while the annual dividend of 56c yields 3.1%.

CONCLUSION

Large-cap, blue-chip companies whose shares have fallen by 20% or more in the past year may not turn out to be bargains, but at the very least they are trading at more reasonable valuations. The lower price means recent bad news and pessimism about the future is already “priced in.” By their nature, utilities, cable companies and airlines are less risky than cyclical commodity stocks, and unless their industries are in a long-term decline, they are in no danger of bankruptcy anytime soon. Even Berkshire Hathaway’s bad idea eventually paid off.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca