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Investment Ideas The trade that got away, why Canada’s energy sector looks appealing, and the ethics of investing in pot

I received research on Palo Alto Networks on Monday and it made me very sad. Palo Alto is a leading cybersecurity-related software provider and that sector is, for me, the trade that got away.

I was watching the sector closely in 2015 and wrote a column about the bright growth outlook. For the next 18 months I followed Palo Alto, mystified, as the stock price headed steadily lower despite a series of hacking episodes that threatened corporate and government information networks across the planet.

Why wasn’t the price jumping higher as the need for higher cybersecurity levels became more and more obvious?

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Then in early 2017 I gave up on the whole idea, at exactly the wrong time. Palo Alto’s stock price went from US$109 in April 2017 to a recent September 2018 high of US$236.23. I was upset.

The stock is now down 12.6 per cent from its September 2018 peak. There are significant management changes underway but Citi analyst Walter Pritchard has an optimistic outlook for Palo Alto, noting “the tone of business appears strong to us … in recent checks for September-end quarter companies, we continue to hear from PANW partners that business is very robust. In particular, strong new customer signings suggest PANW is faring well in battle for mind share.”

So am I thinking about buying Palo Alto now? No. As much as I still love the growth prospects for network securities, it’s clear that now that I don’t understand the industry well enough – or more accurately the interplay of business conditions and stock prices – to commit investment capital. Otherwise, I’d have a clear idea of why a rally didn’t occur in the sector when I expected it.

There is no shortage of investment ideas out there. It’s good to be selective in the sense that if there’s something investors don’t understand about an asset’s price movement, or the way a company generates part of its profit, they move on to the next idea or keep researching until things make more sense. I missed this one. It’s a bit aggravating but in the end I’m ok with it. Hopefully the process of demanding a full understanding of a company before buying a stock will offer paybacks in the future. Even if not, there’s plenty of other ideas to look at.

-- Scott Barlow, Globe and Mail market strategist

This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you, you can sign up for Globe Investor and all Globe newsletters here.

Stocks to ponder

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Orange SA (ORAN-N). The Contra Guys like the look of Orange, formerly France Telecom, which trades as an American depositary receipt on the New York Stock Exchange and which they acquired at prices ranging from US$10.25 to US$10.38. The annual revenue was greater than BCE, Rogers Communications and Telus combined. Orange currently trades near US$16, so there has been capital appreciation since the purchase. Plus, there has been a generous dividend, which is now north of 6 per cent. But with our sell target at US$27.74, the company has not performed nearly as well as we hoped. Hey, we’re not being greedy for anything close to the US$178 level where it traded at the millennium. What gives? They take a look at their pick and explain why they still like it (for subscribers).

The Rundown

Is it ethical to hold pot stocks?

Recreational cannabis is now legal in Canada, which is going to create a massive new market for marijuana – the long-held dream of early investors. But legalization raises a question: Will investors start to look at marijuana producers the way they look at tobacco companies, alcoholic beverage purveyors and other so-called sin stocks? The question carries some importance because the nascent marijuana sector is keen to attract a base of institutional investors. But these large investors, who bring credibility and stability, are increasingly leaning away from stocks associated with harmful products and services. David Berman reports (for subscribers).

Major cannabis ETFs have been paring back their pot-stock positions

Managers of cannabis-related exchange-traded funds have been trimming their exposure to pot stocks even as individual investors were buying in anticipation of the drug’s legalization Wednesday. The Evolve Marijuana Fund has been decreasing its exposure to the companies directly linked to the cannabis sector over the past two weeks, while the Purpose Marijuana Opportunities Fund has increased its cash position to just more than a 30 per cent weighting. The repositioning by the funds comes after the sector has experienced wild price swings in recent months with single stocks spiking and plummeting within short periods. Clare O’Hara reports (for subscribers).

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Why it may not take long for stock prices to rebound in the Canadian energy sector

The Canadian energy sector has a problem: Western Canadian Select (WCS) heavy crude is selling at a steep discount to U.S. oil, and Canadian energy stocks are suffering. But there may be buying opportunities in the Canadian oil patch for anyone willing to bet that this wide discount will soon narrow. Based on patterns over the past decade, now may be an especially good time to buy. David Berman explains (for subscribers).

Why long-term dividend investors should consider snapping up utility stocks right now

In an effort to balance the fear-mongering that rears its head every time the Dow drops a few percentage points, John Heinzl discusses the flip side of market anxiety: opportunity. If you aren’t planning to sell your stocks any time soon, and if you have money to invest, you shouldn’t fear a market pullback. Rather, you should welcome it as an opportunity to buy great businesses at lower prices. Most Canadians are still in the wealth-accumulation phase of their lives – about 83 per cent of the Canadian population is aged 64 or under – and for these people a market setback is actually a gift. He takes a look at some of the utility stocks that are worth a look right now (for subscribers).

The smart thing a lot of investors are doing with bond funds

The mutual fund industry had a bad month recently, and mass selling of bond funds was a big part of the story. Where’d the money flying out of mutual funds go? Let’s just say that August was a great month for exchange-traded funds, notably those that invest in bonds. There are some very good bond mutual funds from low-cost fund families, and they’re an excellent way to add bonds to a portfolio. But the typical bond fund has fees that are just too high in this era of low interest rates. Bond ETFs are a much cheaper way to hold bond, and so they’re scooping up money from investors at an odd time. Rob Carrick explains (for subscribers).

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Looking ahead: The Retirementality

Listen to Rob Carrick’s new podcast on retirement, listen to here or download on iTunes or on Spotify. There are three episodes, one aimed at millennials, one at Gen X and one at baby boomers.

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Others (for subscribers)

Four charts, four reasons to buy value stocks (or funds)

9 stocks Warren Buffett might be buying in volatile markets: Wells Fargo

Thursday’s analyst upgrades and downgrades

Wednesday’s Insider Report: Chairman buys over $3-million worth of shares in this dividend stock

Wednesday’s analyst upgrades and downgrades

The best of Canada’s banks to weather a downturn

Ten solid, growth-oriented U.S. health-care stocks

S&P 500 earnings scorecard: How third-quarter results have fared

Holding firm through the market turbulence, this Aggressive TFSA Portfolio continues to gain over 8% annually

AltaGas prices Canadian IPO below marketing range, will raise $239-million

Others (for everyone)

Cannabis producer Aphria applies for New York Stock Exchange listing

With the markets in a generational pivot, we need a more modern approach to portfolio construction

Rising interest rates are hitting small stocks hardest

Still want to ride the cannabis boom? Six bets to play the green gold rush

Ask Globe Investor

Question: For dividends to be sustainable, shouldn’t the payout ratio be less than 100 per cent? For example, Brookfield Infrastructure Partners LP (BIP.UN) pays out well in excess of 100 per cent of its earnings. Does this mean a distribution cut is inevitable?

Answer: To determine the sustainability of a dividend, you need to examine companies on a case-by-case basis. Payout ratios can be measured in many different ways, and an acceptable payout ratio for one company might be a sign of trouble for another, depending on the industry, nature of the business and stage of growth. For these reasons, you need to dig deeper than the payout ratios provided on third-party financial websites.

Consider Brookfield Infrastructure. For the six months ended June 30, BIP distributed 94 U.S. cents per unit, yet its net income per unit was just 63 U.S. cents. On this basis, BIP’s payout ratio is close to 150 per cent, which seems like an accident waiting to happen.

However, earnings often contain non-cash accounting charges that may not affect a company’s ability to pay or sustain dividends. That’s why BIP – which owns a lot of large, long-lived infrastructure assets – calculates its payout ratio based on a cash flow measure called funds from operations (FFO), which excludes depreciation, amortization, deferred income taxes and other non-cash items.

Based on FFO, BIP’s payout ratio for the first six months of 2018 was a much more reasonable 59 per cent, which is slightly below BIP’s long-term FFO payout target range of 60 per cent to 70 per cent. In fact, for the past five fiscal years, BIP’s FFO payout ratio has been smack in the middle of that range, averaging 65 per cent.

It wouldn’t be fair to ignore depreciation altogether. After all, BIP has to spend money to maintain its toll roads, gas pipelines, electricity transmission lines and other infrastructure assets. To reflect such costs, BIP also calculates a more stringent payout ratio based on adjusted funds from operations (AFFO), which includes capital expenditures required to maintain its assets. Over the past five years, BIP’s AFFO payout ratio has averaged 79 per cent, which still provides a nice cushion. Indeed, BIP has raised its distribution for nine consecutive years, and I expect another increase early in 2019.

Bottom line: If you’re wondering about the sustainability of a dividend, there is no substitute for reading through the company’s financial statements, investor presentations and other material to see how the company measures its payout ratio and whether it is hitting its targets. The payout ratio on financial websites won’t give you a complete picture.

--John Heinzl

Do you have a question for Globe Investor? Send it our way via this form. Questions and answers will be edited for length.

What’s up in the days ahead

This Saturday, Rob Carrick hosts a face-off between the biggest Canadian dividend fund and the biggest Canadian dividend ETF. What’s the better bet for your investment dollars? The answer may surprise you.

Click here to see the Globe Investor earnings and economic news calendar.

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Compiled by Gillian Livingston

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