Small-Cap Energy Stocks Have Hit Bottom: Steve Palmer

By The Energy Report, on July 25th, 2012

Steve Palmer Don’t panic, because things can’t get much worse. Instead, hold your cards and scout out buying opportunities. This is the strategy Steve Palmer employs at AlphaNorth Asset Management, a small-cap powerhouse with a track record of solid returns. In this exclusive interview with The Energy Report, Palmer gives a quick-and-dirty assessment of resource markets and explains why he now favors energy stocks over precious metals in the current environment.

The Energy Report: Steve, AlphaNorth created quite a stir when it returned 160% in 2009 and 113% in 2010. But this year’s second quarter has seen negative returns. What do you attribute this to?

Steve Palmer: It’s hard to generate positive returns when stocks across the board are a no bid. The small-cap Canadian market has been hit pretty hard. There’s zero investor interest right now, particularly in small-cap resource companies. I do expect things to get better, though, over the remainder of the year.

TER: Is the current market downturn unusual?

SP: The market is cyclical; every once in a while people head for the hills. The current downturn is related to concerns about Europe and the slowing of growth in China. My view is that concerns about Europe are overdone. There is a slowdown in Chinese growth, but it has been a policy-driven slowdown by the government to cool inflation and the housing market. That policy has been successful, but now investors are complaining about the slower growth. Going forward, the Chinese government will be implementing policies to reaccelerate the growth rate, now that inflation is not an issue. Meanwhile, China continues to increase its energy consumption. The latest data shows that the country’s oil imports are up 11% year-to-date.

TER: How do AlphaNorth funds weight the resource sector?

SP: We take a balanced approach. The Partners Fund is 50/50 in resource stocks versus tech and healthcare stocks. Our Growth Fund has a higher resource weighting; it is currently above 70%. But that has not been good for performance in the short term, given that small-cap and midcap resource stocks have been hit the hardest over the last few months.

TER: Why do you focus on small-cap equities?

SP: Historically, small-cap equities are the best-performing asset class over the long term. They are more volatile than fixed-income investments or large-cap equities, but they generate far superior long-term returns. One reason for this is that small caps are often priced inefficiently. I try to buy companies that do not have any analyst coverage or institutional ownership. Getting in early can mean multiplying your money many times.

TER: How does AlphaNorth exploit inefficiencies in small-cap firms?

SP: It’s based on risk versus reward. We try to identify situations that have limited downside with lots of leverage to the upside.

TER: Why do you limit your portfolio to Canadian firms?

SP: There are enough opportunities in Canada that we don’t have to go looking internationally. I’m more familiar with the players in the Canadian market and how things work here, as compared to the U.S.

TER: Do you favor investing in energy juniors over gold and other mining juniors in the current international economic environment?

SP: In the current environment, I prefer energy to gold. Small- and midcap energy stocks currently offer better value than gold stocks. There’s still some euphoria priced into gold by retail investors. Furthermore, energy is a finite resource. Once it’s gone, it’s gone. Gold, on the other hand, is not consumed; it sits around forever. However, I think both will do well over the balance of the year.

TER: Steve, you have been a strong proponent of uranium stocks in the past. Given the current economic climate, what upside is there for uranium? Are there any uranium juniors that you like?

SP: Uranium has been off the radar for a while because the situation in Japan has been a big negative for uranium companies. But I believe that the Japanese nuclear reactors will be restarted. In addition, China has a program to expand its nuclear energy infrastructure quite significantly. Over the longer term, uranium should do quite well. A micro-cap name we like is Athabasca Uranium Inc. (UAX:TSX.V; ATURF:OTCQX). It is one of the better small caps in terms of its potential to find an economic deposit in Canada. Denison Mines Corp. (DML:TSX; DNN:NYSE.A) is a larger-cap name that also has good prospects.

TER: Shifting to oil and gas, what regions in Canada are the most promising for juniors?

SP: Canada is a mature basin for energy. The most exciting opportunities are those companies that are exploiting new extraction techniques. New fracking technologies and horizontal wells have opened up areas that were previously uneconomic.

TER: How do you assess takeover potential for energy juniors in Canada?

SP: We look at the potential value of the company’s asset relative to some of the larger companies nearby and whether or not it will be a strategic acquisition for them. Quite often, larger companies acquire land surrounding an area where a junior company already owns land. Therefore, land value can imply a significantly higher market cap for the junior company.

TER: Do you have any advice for investors who are looking at junior equity stocks in Canada? Should they hold their cards, or go looking for cheap investments?

SP: It is a tough market environment. The TSX Venture index is down over 50% since March of last year. There have been very few winners for anybody. I see a similar situation to 2008 in the small-cap environment, where investor sentiment is extremely negative. But that’s also a positive sign because it can’t really get much worse than it is. That’s why I’m quite optimistic about the market going forward.

Investors should not be panicking and selling. Generally, almost all of the junior resource companies are trading at attractive levels. If the market rallies, as I expect, everybody will benefit.

The takeaway point is that it’s been a very challenging market for investors in the junior energy space. This is not the time to abandon those investments. There may be some firms that are at risk of not getting further funding, and there’s potential for some to go bankrupt. Stick with the good ones that are funded with strong management teams, and wait for the market environment to improve, as it surely will.

TER: Thank you, Steve.

SP: You are welcome.

Steve Palmer, CFA, has served as president, CEO and a director of AlphaNorth Asset Management since founding the firm in 2007. AlphaNorth currently manages a long-biased, small-cap hedge fund. As VP of Canadian equities at one of the world’s largest financial institutions, Steve managed assets of approximately $350M. He also previously managed a small-cap pooled fund, achieving returns ranked #1 by Morningstar Canada. He has a BA in economics from the University of Western Ontario.



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Egregious Indian protectionism against trade in services

By Ajay Shah, on July 25th, 2012

For many decades, India was one of the most protectionist countries in the world. This did great damage to growth and knowledge in India. Tariffs dropped from ridiculous levels to ridiculous levels in the early 1990s and then got stuck there. Yashwant Sinha, as Finance Minister, initiated a remarkable program of cutting the peak rate by five percentage points every year. This worked very well: It steadily got rates down and also gave a roadmap to the domestic industry about what would happen next.

In January 2004, Jaswant Singh as Finance Minister announced further cuts to customs duties even though it was not part of the budget. This was criticised in the press as being a `populist’ move. I thought it was a big day in India’s history: when a Finance Minister feels that trade liberalisation is so important that it cannot wait for February 2005 (since Feb 2004 was to be a vote on account), and when he gets criticised on the grounds that this is populist.

While there is more ground to cover on removing barriers to trade in goods (e.g. barriers to trade in agricultural products), by and large, India is doing well on this. The old instinctive protectionism has subsided. Two big areas for work remain. First, all customs duty rates are not yet at zero. And, we have one big gap: the lack of a proper GST, through which we would get to residence-based taxation. The GST on imports would be charged on imports, giving parity between a factory just inside the border and one just outside. And, the zero-rating of exports would mean that the GST burden suffered by a non-resident is refunded to him. The fundamental law of tax policy in this age of globalisation is: You do not tax non-residents.

Does this mean that we’re in good shape on trade liberalisation? No. The big gaping problem is trade in services. Most of world GDP and India’s GDP today is services. Even if we do full free trade on agricultural and non-agricultural goods, that only covers 40% of GDP. The real story of international trade is now in trade in services.

With trade in services, old-style Indian protectionism reigns. For the first time now, we have some hard data on this. The World Bank has released a `Services Trade Restrictions Database‘ which measures protectionism in services across the world. To get the story about what was done, read the voxEU column by Aaditya Mattoo, Ingo Borchert and Batshur Gootliz. Here’s the key picture:

The graph puts per capita GDP (in log scale) on the x axis and the measure of barriers to services trade on the y axis. Values of 0 imply perfectly open and values of 100 imply perfectly closed. The regression line shows us that by and large, when countries get richer, they reduce restrictions. The score goes down from roughly 40 (on average) for the poorest countries to roughly 20 (on average) for the richest ones.

India sticks out as an outlier, with a score of above 65.7. We are more restrictive than Iran. Only Ethiopia is more restrictive than India, among all the countries of the whole world. Here is some more detail about what is going wrong:

This shows us the variation of India’s restrictions by sub-sectors and by modes. While there is some variation, it is all appallingly bad. If we only got to the conditional mean for the Indian level of per capita GDP, we’d have to get the score from 67.5 to roughly 37.5, which is a big decline. And there is no reason to stop there; we need to eliminate protectionism far beyond what’s seen in the conditional mean.

To be open to trade in today’s world is to be open to trade in services, given the preponderant share of services in GDP. What we are doing is profoundly wrong. We always had an instinctive sense that India does worse on trade in services when compared with trade in goods. The World Bank has made a great contribution by building a comparable database across countries, to give us a concrete sense of where we are and how bad things are.

If we want to harness gains from trade in goods, we have to open up to trade in services also. Finance, transportation, and other services are the vital glue that makes trade in goods possible. Our mistakes on services trade liberalisation are holding back our gains from trade in goods also.

You may like to also see older blog posts: Globalisation: the glass is half empty, 28 January 2011, and Getting to a liberal trade regime, 15 December 2009.



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Economic Events on July 25, 2012

By B.P.T., on July 25th, 2012

The Mortgage Bankers’ Association purchase index will be released at 7:00 AM Eastern time, providing an update on the quantity of new mortgages and refinancings closed in the last week.

At 10:00 AM Eastern time, the New Home Sales report for June will be released. The consensus is that 370,000 new homes were sold last month, which would be 1,000 more than the prior month.

At 10:30 AM Eastern time, the weekly Energy Information Administration Petroleum Status Report will be released, giving investors an update on oil inventories in the United States.



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