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Comments by U.S. Federal Reserve Board Chair Jerome Powell in early December indicated strongly that the Fed is looking at scaling back rate hikes this year. There are signs that headline inflation peaked last summer, even if the Fed’s preferred personal consumption expenditure (PCE) measure is still holding above 6%, and job creation is weakening. The fed funds rate currently sits at 4.25%-4.50%, with the next announcement scheduled for Feb. 1.
Many observers expect the so-called terminal funds rate to peak at 5% by early 2023. This would still leave the fed funds rate below headline inflation. However, the Fed is cognizant of the risks of continuing an aggressive rate-hike cycle. Already, the yield curve is currently steeply inverted, with the 2-year Treasury yield around 4.5% level compared with 3.6% for the benchmark 10-year bond. This has been a virtually infallible predictor of a recession since World War II.
Equity markets have rallied on the slower pace of fed fund increases. In Canada, the Bank of Canada also chose to ease back, increasing its target overnight rate by 50 basis points in October and December, down from the the 75 basis points in September. The policy interest rate sits at 4.25% with the next announcement scheduled for Jan. 26.
The S&P 500 Composite Index was up 7.1% in the fourth quarter of 2022, while the S&P/TSX Composite Index was up 5.1%. The indexes still ended the year with a steep loss, down 19.4% and 8.7%, respectively. The rally that started from lows in early October might yet prove to be another bear market rally, as valuations still remain elevated and sharp drops in earnings – especially for the large-cap technology stocks and semiconductor makers – have not yet been fully factored in by analysts.
Investors should retain exposure to energy and materials stocks, especially given the uncertain geopolitical situation and the possibility of a cold winter. Defensive sectors such as healthcare, consumer staples, utilities and pipelines, and defence stocks, most of which have substantially outperformed over the last year, should also be included in a diversified portfolio.
Short-term government bonds yielding over 4% provide a reasonable absolute yield and add some non-correlated assets to portfolios. While gold and precious metals have been flat over the last year, they should begin to benefit from higher levels of inflation over the next few years as interest rate increases are scaled back.
As for specific companies, I see gold miners as very cheap relative to both the metal itself and the overall market, while some exposure to the energy sector through an oil services company could still provide a performance boost.
In the gold sector, Agnico Eagle Mines Ltd. (TSX: AEM) is the largest listed Canadian gold producer, producing 2.33 million oz. of gold in the nine months to Sept. 30, 2022, following its takeover of Kirkland Lake Gold in February 2022. In November 2022, Agnico paid $1 billion in cash and issued just over 36 million shares for Yamana Gold’s Canadian mines. Agnico’s portfolio of eleven mines are located in mining-friendly jurisdictions, with eight in Canada, and one each in Finland, Mexico, and Australia.
The company reported net income of $465.2 million ($1.08 per share) for the first nine months of 2022, with cash generated of $1,716.1 million and forecast cash costs at $725-$775 per ounce and all-in sustaining costs at $1,000-$1,050 per ounce, both near the top end of the range for the whole year. The company has forecast production for the whole year of 3.2-3.4 million ounces.
In 15 years, Agnico has grown from one operating mine to becoming one of the three largest gold miners in North America by market capitalization and production. Down 20% from its all-time high reached earlier in 2022, and up only 25% over the last five years despite more than doubling its gold production, Agnico is attractively valued. It also yields more than 3%, making it a great way to play increasing production as well as a likely rise in the gold price, given the persistence of higher inflation.
In the energy sector, Pason Systems Inc. (TSX: PSI) is a Calgary based oil services company, which provides specialized data management systems for the oil drilling industry. Its solutions include data acquisition, wellsite reporting, remote communications, and web-based information management. It describes itself as providing the “Internet of Things” for the oil drilling industry. It also has a small but rapidly growing information management system for solar farms. With a market capitalization of $1.2 billion, it is a mid-sized stock with decent liquidity, trading over 100,000 shares most days.
Pason reported revenues up 60% in the third quarter ending Sept. 30, 2022, to $95.2 million, generating $46.2 million in adjusted earnings before interest, tax, depreciation and amortization (EBITDA), representing a gross margin of 50%, and net income of $34.2 million ($0.42 per share) compared with net income of $13.1 million ($0.16) in the corresponding quarter last year. North American operations generated revenues of $75.2 million, up 63% from 2021, and revenue per industry day of $871 was an all-time record. International revenues of $15.8 million were up 52%, and solar revenues of $11.4 million rose 23%.
Pason has no debt, and cash on the balance sheet of $206 million is up $30% from $158 million at the end of 2021. CEO Jon Faber noted that revenue in the third quarter was the highest since the first quarter of 2015. Adjusted EBITDA is the highest since the fourth quarter of 2014, while North American rig counts were back to the level of the first quarter of 2020, the last before the onset of Covid-19. Reflecting the improved conditions, Pason has recently raised its quarterly dividend by 50%, to $0.12 per share from $0.08, equivalent to a 3% yield.
Pason has survived the most severe downturn in the drilling industry in 40 years thanks to its rock-solid balance sheet and effective cost control, including reducing capital expenditures by 75% to less than $10 million in 2021. Now that the industry is recovering strongly, its operational leverage is delivering dramatic increases in adjusted EBITDA and earnings. Although the share price is up 56% over the last year, compared with a decline of 19.4% for the S&P 500 Composite and 8.7% for the S&P/TSX, it is still down 12% from its price five years ago. Selling at less than 16 times its last 12 months’ earnings and with a rising dividend, Pason Systems is an attractively valued play on increased activity in the drilling sector.
Gavin Graham is Chief Strategy Officer of Calgary-based SmartBe Investments. He is a veteran financial analyst, money manager, and a specialist in international investing, with over 35 years’ experience in global investment management.
Notes and Disclaimer
Content © 2023 by Gavin Graham.
The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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