The Manager's Commentary - February 2011
In 2010, about half the return generated by the TSX was accounted for by materials stocks, particularly the shares of mining companies. Because these businesses are highly cyclical, extremely capital intensive, and have difficulty generating free cash flow with any consistency, they don’t meet Dixon Mitchell’s investment criteria and do not generally appear in our portfolios. Given that resource stocks top many buy lists for the year ahead, however, it is worthwhile to temporarily suspend our reservations toward the sector and appraise its attractiveness from a fundamental perspective. The blue line on the chart below shows the actual annual earnings generated by the TSX materials group at various points over the past four years.
The first thing that should jump off the page is that, despite one of the greatest commodity price rallies of all time, earnings for this subset of companies have actually declined (not a great start to our evaluation). Though earnings have not grown, share prices have exploded. Instead of being buttressed by fundamentals, however, this appreciation has come on the back of valuation expansion: over the period examined, the price/earnings multiple on the materials sector has roughly doubled from about 16x to over 30x. The chart’s red line represents what the analyst community was forecasting for earnings 12 months earlier. Plotting these two measures together gives us an idea as to how accurate analysts are in the sector and how much faith we should place in their predictions. As you can see, the investment community has been wildly optimistic on materials earnings, with actual results exceeding expectations for just two brief periods (the circles on the graph). For the year ahead, analysts are collectively forecasting earnings of $262 for the group, or about double the income generated through the 12 months just ended. With high starting valuations and towering expectations, these stocks are truly ‘priced for perfection’. Any pullback in commodity prices would not only pressure actual earnings, but could result in a reconsideration of valuations and accompanying share price downdraft.
Dixon Mitchell Investment Counsel
February 28, 2011