Smart Money Is Buying These 6 Canadian Large-Cap Dividend Stocks

Published Mon, 18 Feb 2013 09:00 CET by

Academic research shows that ownership flows of institutional investors engaged in active portfolio management –including mutual funds, bank trust departments, pension funds, and insurance companies– are positively correlated with returns. In fact, with the notable exception of small-cap stocks, “the evidence is consistent with a conclusion that institutional trades lead stock prices,” says a 2003 study published in The Journal of Portfolio Management. This means that stocks that informed institutional investors, or “smart money” investors, as a group buy realize positive benchmark-adjusted returns, whereas stocks that these institutions as a group sell produce negative benchmark-adjusted returns. Given that institutional trades are reported publically, individuals who wish to replicate the money moves of the big institutional investors may be able to achieve the same investing success. However, sometimes even the large investors make poorly-informed decisions, which may lead to investment underperformance. Hence, this strategy is not without risks.

With a focus on the Canadian equities traded on the U.S.-based exchanges, six large-cap Canadian stocks have seen notable positive institutional transaction flows over the past three months (see table below). Based on the evidence from the aforementioned study, these increases in institutional ownership may suggest that investments in the six stocks are expected to produce positive returns in the forthcoming period. However, while some of the stocks seem likely to experience better days ahead, a few still look mired in a prolonged slump. A closer look at these stocks offers more insight about each one’s likely prospects.

Canadian Large-Cap Dividend Stocks Table
Bank of Montreal (TSX: BMO)(NYSE: BMO), Canada’s fourth largest bank by assets, saw a net increase in institutional ownership of 8.72% over the past three months. BMO’s institutional ownership currently stands at 55.86%. The bank generates large free cash flow, and is thus undervalued based on its free cash flow yield of 20%. Its price-to-book of 1.5 is below the banking industry average of 2.0 but on par with the bank’s five-year average ratio. The bank’s return on equity (ROE) of 16%, on a trailing-twelve-month basis, is almost double its industry average ROE of 8.3%. However, BMO’s ROE, while high, is still lower than the ROEs of its peers Bank of Nova Scotia (TSX: BNS)(NYSE: BNS) and Royal Bank of Canada (TSX: RY)(NYSE: RY). The bank is growth-oriented, and may seek to expand its presence in the U.S., primarily in Wisconsin, Illinois, and Missouri. Its long-term EPS CAGR of 7.1% is among the highest in its peer group. Still, at the end of last month, concerned about significantly high levels of consumer debt and elevated house prices in Canada, Moody’s Investors Service downgraded six of Canada's major financial institutions, including BMO. Moody’s is worried about BMO’s high exposure to unsecured and non-real estate secured consumer loans and a significant contribution to earnings from a potentially-volatile capital markets activity (the second highest in the bank’s peer group). Based on the analysts’ median price target of $65.00 per share, BMO has an upside potential of about 4.4%.

Kinross Gold (TSX: K)(NYSE: KGC), a gold producer, registered a net increase in institutional ownership of 5.82% over the past three months. KGC’s institutional ownership currently stands at 75.1%. Last year, the company achieved gold production above initial guidance and reported estimate-beating revenues and earnings. However, the company’s 2013 gold output and cost guidance misses analysts’ expectations. The company estimates it will produce 2.4 million-to-2.6 million gold equivalent ounces, less than the 2012 output of 2.61 million gold equivalent ounces. However, the cash cost of production will be $740-$790 per ounce, higher than the 2012 cash cost of $706 per ounce. Given the prospect of lower gold prices, likely dragged lower by a gradual reduction in the global monetary stimulus, the company could easily see lower EPS ahead. However, with its stock price down nearly 26% over the past year, the stock seems to be attractive on valuation. It is trading below book value (with a price-to-book of 0.9 versus 1.4 for its industry). Its forward P/E is only 9.3x and its five-year PEG ratio is 1.5. The stock also boasts a good potential for robust dividend growth in the future. Based on the analysts’ median price target of $12.25 per share, the stock has a 53.3% upside potential.

Methanex (TSX: MX)(Nasdaq: MEOH), a methanol producer, saw a net increase in institutional ownership of 5.05% over the past three months. Methanex Corp.’s institutional ownership currently stands at 74.77%. The company recently missed analysts’ expectations on both top and bottom lines. However, the company is optimistic about its outlook, seeing strong methanol demand and pricing in the future, as industry demand growth will significantly outpace new capacity additions (for demand/supply growth outlook, please see page 4 of the company’s investor presentation). The company is installing new capacity in New Zealand, Chile, and Louisiana, U.S., which will help the company absorb any demand boost in the future. Raymond James recently upgraded Methanex to outperform from market perform. The company’s long-term EPS CAGR of 24.0% for the next five years is especially robust. The stock is potential value based on a forward P/E of 10.9x and a price-to-book ratio of 2.3 (versus 2.9 for its industry). Based on the analysts’ median price target of $38.00 per share, the stock has an upside potential of about 7.3%.

Pengrowth Energy (TSX: PGF)(NYSE: PGH), an oil and gas driller, reported a net increase in its institutional ownership of 16.65% over the past three months. The company’s institutional ownership is still low at 24.28%. Pengrowth Energy shares have plunged by more than 55% over the past 12 months. The company has seen a drop in profitability amid output cuts and costs increases due to rising power prices and maintenance costs. The company’s 2013 midpoint output guidance is 86,000 boe per day. Amidst falling profits and rising capex, the company’s free cash flow has sunk into the red. In response, the company slashed its dividend in mid-2012 and decided to suspend its Premium Dividend program (as of December 17, 2012) that allowed shareholders to reinvest their dividends into new PGH shares at a 5% discount to the average trading price over the previous month. The company is divesting non-core assets so as to be able to cover its dividend and capex. The company has paid dividends for 25 years. Its dividend may be secured for 2013, but the dividend’s long-term sustainability at the current level is questionable. On top of that, the company’s debt is projected to rise substantially over the next several years, ballooning PGH’s leverage (see page 9 of the company’s investor presentation). Still, the company is priced at half its book value. Based on the analysts’ median price target of $8.00, the stock has an upside potential of nearly 80%. However, the likelihood of prices climbing to that target is low.

Penn West Petroleum (TSX: PWT)(NYSE: PWE), another oil and gas exploration and production company, reported a net increase in its institutional ownership of 5.78% over the past three months. The company’s institutional ownership currently stands at 32.13%. This is another oil and gas company trading at half its book value. However, its output is dwindling. Its 2013 production guidance of between 135,000 – 145,000 boe per day is down substantially from the 2012 average production of 161,195 boe per day. The company’s planned $900 million in capex for 2013 will be a significant drag on free cash flow. Hence, the dividend at the current level is at risk, and the elevated yield reflects the risk of the dividend’s sustainability. Given that it cannot finance its dividends out of profit or free cash flow, the company plans to sell its assets –between $1 billion and $1.5 billion– in order to continue financing its large cash outlays, including the dividend. Analysts expect the company to operate at a loss next year and see the stock price target at $20.00 per share, implying a possibility of a more than 100% gain from the current price level. Again, the likelihood of the stock price reaching this level is low.

TransCanada (TSX: TRP)(NYSE: TRP), an energy infrastructure company operating natural gas and oil pipelines and supplying energy, registered a net increase in its institutional ownership of 7.78% over the past three months. The company’s institutional ownership currently stands at 60.21%. TransCanada reported fourth-quarter adjusted (comparable) EPS of 45 Canadian cents, a 13.5% decline from the year earlier, due to lower profitability of its power business and some of its natural gas pipelines. Given the high expectations about its $5.4-billion Keystone XL pipeline to the United States from Alberta, which may be approved later this year and completed by 2014/2015, the company expects to put nearly $15 billion worth of assets into use by 2015. This is expected to boost both EBITDA and funds from operations (see page 8 of the company’s recent investor presentation). The current dividend is somewhat stretched, given the high payout ratio, but the situation may improve once free cash flow recovers as of 2015. The stock is up 12% over the past year. Given the analysts’ medium price target of $51.00 per share, the stock has a potential upside of 9.6% from the current price level.

In conclusion, several of the six aforementioned Canadian stocks picked by smart money have good long-term prospects for both dividend growth and capital appreciation. A few represent attractive value plays. A good example of a value stock with solid prospects for dividend growth is Kinross Gold. Methanex is a good example of a stock offering both value and growth characteristics. Bank of Montreal could be viewed as a solid income play with stable, low-rate dividend growth. However, while both Pengrowth Energy and Penn West Petroleum trade at half their book values and have monster dividend yields, they both are risky as income plays for prudent dividend investors. TransCanada could see more upside once the regulatory approvals for its Keystone XL pipeline are obtained and all hurdles are cleared for the pipeline’s construction.