Contributing editor Gavin Graham joins us this week with an in-depth look at how the escalating war in Ukraine is affecting the entire European economy. Gavin is chief strategy officer at Integris Pension Management, a provider of Personal Pension Plans (PPPS) for incorporated individuals. Previously he was chief investment officer at Guardian Group of Funds and director of investments at its parent company BMO Asset Management, where he supervised over $30 billion in mutual fund assets. He is an expert in international investing and divides his time between Toronto and his home in southwest England. Here is his report.
Gavin Graham writes:
On July 17, Malaysian Airlines flight MH17 with all 298 passengers and crew was shot down by a missile while flying an internationally approved route over the disputed region of eastern Ukraine.
Global opinion has denounced Russia and its President, Vladimir Putin, for their support of the Russian-speaking Ukrainian rebels who are believed to have been responsible for the outrage. The missile that shot down the airliner is believed to have been launched by a Russian anti-aircraft mobile system, as it is the only weapon available to the rebels that could reach the 33,000 feet level at which the aircraft was flying.
Experts noted that it could only have been provided by Russia, as the Ukrainian government forces had no equivalent system located in the rebel area that could have been captured when the region was taken over in late March. Radio traffic by the separatist militia monitored by the Ukrainians on July 17 revealed units in the area confirming that they had hit an aircraft, apparently believing it to be a Ukrainian military transport, at least one of which had already been shot down in the previous few days.
The U.S. and other western powers, especially the European Union, condemned the downing of the plane and demanded access for investigators to the crash site, which the rebels at first refused. After several days, most of the dead were transported to the Netherlands, from whence the plane had departed, for identification and burial with the appropriate ceremonies. The "black box" flight recorders were handed over, but fighting near the crash site prevented investigators from gaining access until late this week and some passengers' remains are still scattered through the countryside.
The response of the western powers has been to widen the economic and financial sanctions originally imposed on individuals and companies in Russia after the takeover of Crimea in March by Russian-backed forces. Amongst those originally targeted were several well-connected tycoons and the St. Petersburg based bank that is associated with Mr. Putin and his allies.
On July 28, the EU joined the U.S. in widening sanctions, announcing it would publish a list of Putin's "cronies", especially those in vital industries such as energy, defense, and finance, on July 30, subjecting them to asset freezes and travel bans. This marks a stiffening of the attitude of the continental European powers, especially Germany. Chancellor Angela Merkel is being pressurized by lawmakers in her own GDU party and the opposition, as well the heads of industrial organizations, to impose economic punishment on Russia.
Understandably, Germany has been somewhat more reluctant than the U.S. or the U.K. to strike at Russian trade. One-third of German energy imports come from Russia, principally gas. It comprised 75% of Russia's $50 billion in exports to Germany in 2013, making it Germany's eighth biggest supplier of goods. Germany, in turn, exported $37.8 billion worth of products to Russia, making it the EU's top exporter to Russia.
The head of the German Engineering Federation said Russia is the fourth largest market globally for its machinery exports. Hannes Hesse told Bloomberg that the Federation "explicitly recognizes that Berlin and Brussels have for a long time attempted to avoid hard and massive sanctions. In the light of the latest escalation, new sanctions were virtually unavoidable."
In the same vein, Ulrich Grillo, president of the Federation of German Industries, wrote in the newspaper Handelsblatt: "As painful as economic sanctions will be for European business development, German exports, and individual companies, they can't - and may not - be excluded as a way to pressure the Russian government."
A poll taken by Der Spiegel magazine on July 26 found 52% of respondents backed tougher measures against Russia even that meant the loss of "many" jobs in Germany. That was up from 25% who favoured such action in March.
Of course, this still doesn't mean that sanctions will actually have much of an effect on Russia, although the IMF has downgraded its forecast for Russian GDP growth from 1.3% to 0.2% this year due to capital flight fuelled by the Ukraine crisis. Being included on the list of sanctioned individuals is apparently a badge of honour for Mr. Putin's close allies. Most of them have already moved their financial assets away from regimes that might attempt to freeze them, as occurred before the Cyprus banking crisis in 2013 when the EU's attempt to freeze deposits only succeeded in inconveniencing small depositors and businesses rather the offshore Russian deposits it was supposedly aimed at.
The Russian Micex stock index is down 15% in U.S. dollar terms so far this year but a large amount of the fall occurred back in March when Crimea was occupied and some is due to the weakness of the ruble as a result of capital flight. In local currency terms, the index had recovered to near its 52-week high of 1,538 in early July before the shooting down of MH17, and is still trading 15% above its early March level, closing at 1,365 on July 29.
Through July 29, the iShares Russia ETF (NYSE: ERUS) was down 15% in U.S. dollar terms in 2014 but only 10% over one year. With a p/e ratio of 10.7 and a price/book ratio of 1.5 times, the ETF is undoubtedly cheap. About 40% of its holdings consist of energy stocks such as Gazprom, Lukoil, and Rosneft and another 6% is in nickel giant Norilsk. With expenses in rubles and revenues in U.S. dollars, these benefit from a weaker currency.
Of course, corporate governance in Russia is dependent upon the state's relationship with the company. The $50 billion international arbitration judgment against the Russian state handed down on July 29 over its bankrupting of former oil company Yukos demonstrates this. But the major holdings in the ETF are run by allies of Mr. Putin, or at least by those who have not actively opposed him, unlike former Yukos boss Mikhail Kordokovsk who is still serving time for opposing Mr. Putin a decade ago.
More importantly, European stocks in general are shrugging off any negative effects from Russian sanctions thanks to the wave of cheap financing available due to the European Central bank's quantitative easing (QE) policy. Ever since ECB governor Mario Draghi promised in July 2012 "to do whatever it takes" to preserve the euro, Eurozone bond yields have fallen to levels never before seen, at least in the last century. The yield on the benchmark German 10-year Bund fell to a record low of 1.1% this week, France to a record low of 1.5%, and Spain to a 200-year low of 2.45%. Two years ago, when the euro looked to be on the verge of collapse, Spain's yields were 6.5% against Germany's 1.13%, the previous all-time low.
Germany's 10-year yield has fallen from 1.93% at the beginning of the year, meaning German bonds have returned 5.6% year-to-date. The average Eurozone bond is up 8.2%, reflecting the narrowing of the spreads of Spain, Italy, and Portugal against Germany.
European stocks have done a bit worse than bonds, with the iShares Europe ETF (NYSE: IEV) up only 1% year-to-date. However, the ETF has gained 14.8% over the last year, in part because three of its top 10 holdings are Swiss companies and another three are British, both of whose currencies have strengthened strongly against the U.S. dollar. While there was some weakness in July, with the ETF off 1.5%, at present European investors seem content to ignore the tensions arising from the Ukraine crisis and possible Russian sanctions.
When the colder weather of autumn arrives, they may become less sanguine. In the meantime, taking profits on European stocks and especially bonds seems a sensible way to reduce risk. Investors should check their global bond funds to see how much Eurozone debt their managers have, and their global equity funds to see the percentage of European holdings. A further escalation in Ukraine could see a sharp sell-off in European markets for both types of assets. Russia itself is a cheap market but the uncertainties associated with its government's policies make it unattractive to all but the bravest.
Home Capital Group (TSX: HCG) (HMCBF)
Originally recommended on Aug. 19/13 (#21330) at C$31.35, US$31.76. Closed Friday at C$52.64, US$45.88 (July 10).
Mortgage provider Home Capital Group continues to go from strength to strength. It has been aided by the strong Canadian housing market but, more importantly, by its concentration on non-conforming mortgages to immigrants, entrepreneurs, the self-employed, and those employed in industries perceived as "risky" by the banks, due to the irregular nature of borrowers' cash flow. These include entertainment and media.
In the year ended Dec. 31, Home Capital increased its assets under administration from $19.7 billion to $22 billion. The company saw its revenue rise from $887 million to $950 million and its net income from $222 million ($3.19 per share after adjusting for a 2 for 1 split in March 2014) to $257 million ($3.66 per share). While its Return on Equity (RoE) fell slightly from 25.5% to 23.9%, net interest margin (the difference between borrowing and lending rates) rose from 2.09% to 2.17%. Return on Average Assets (RoA) rose from 1.2% to 1.3%, while its Tier 1 Capital remained strong at 16.8%.
The company announced a 14.3% increase in the dividend to $0.16 a quarter at the same time as the stock split. Since then, it reported a 16.8% increase in net income to $69.7 million ($1 per share) in the first quarter. It also announced a $32-38 million pre-tax exceptional profit from the early termination of its $236 million water heater rental financing portfolio when Just Energy sold its water heaters subsidiary National Energy to Reliance Comfort in June.
As the icing on the cake, the company's second-quarter results, which were released on Wednesday, showed a year-over-year increase in revenue of almost 20% to $73.4 million. Fully diluted earnings per share came in at $1.05, up from $0.88 in the same period last year. For the first six months of the 2014 fiscal year, the company earned $2.04 per share compared to $1.74 in the same period of 2013.
To celebrate, Home Capital raised its dividend again, this time by $0.02 per quarter to $0.18 per share ($0.72 a year). This is the 17th dividend increase in the past 10 years and it is effective with the payment due Sept. 1 to shareholders of record as of Aug. 11.
Home Capital stock is up by almost 68% since it was recommended last August. We have received dividends of $0.46 a share since then.
Action now: Home Capital remains a Buy for its earnings growth, reasonable valuation (12.2 times 2014's forecast earnings), and conservative management.
Copa Holdings (CPA)
Originally recommended on July 15/13 (#21326) at $134.67. Closed Friday at $152.52. (All figures in U.S. dollars.)
Panamanian airline Copa Holdings has done well operationally since being recommended in July 2013. The airline operates 94 modern jets, of which 68 are Boeing 737-700s and 800s, and 26 Embraer 190s. Copa is a member of the Star Alliance and flies to 67 destinations in 29 countries in North, Central, and South America and the Caribbean from its hub at Tocumen Airport in Panama City. Its central location, sea level altitude, and competitive labour costs make Panama one of airports with the best on time records (92.3% in first quarter 2014) and allows passengers to reach anywhere in the Americas with only one stop.
Copa saw its revenues increase 11.5% to $714 million in the first quarter (to March 31). Net income excluding special items was $154 million ($3.46 per share), up 23.5% from $124 million ($2.80 per share) in the same quarter last year. Operating revenue per available seat mile (RASM) increased 1.9% to $0.142 and the load factor was up 1.2% to 78.1%.
However, of Copa's $1.1 billion in cash, $497 million is locked up in Venezuela, where Copa is the second largest airline, and only a portion was accessible at the official exchange rate of 10.8 bolivars to one U.S. dollar at the end of the first quarter. The black market rate was 65 bolivars at the time and has weakened sharply since then.
While Venezuela accounted for 15% of Copa's revenues in 2013, the airline cut its capacity in that market by 40% in May and estimated that even with lower margins on the routes to which the aircraft were reassigned it would only reduce its operating margin by 1%. It reiterated its estimates for 2014 of about 10% revenue growth with a load factor about 77% and RASM of around $0.137.
Action now: The stock, which is up 13% since being recommended, remains a Buy for its exposure to the growing Latin American middle class, sound balance sheet, and well run operations.