A Canadian investor's prayer ought to go something like this: God bless oligopolies and the middle-class wannabes in the burgeoning economies of the emerging world. Without them, Canada's profit picture would certainly have been dimmer in a tumultuous year marked by an unprecedented global credit crunch, extreme volatility in the markets and slowing growth just about everywhere.
As usual, our annual Top 1000 ranking is top-heavy in financial and energy firms. Indeed, these traditional generators of Canadian corporate wealth became more dominant than ever last year in an environment that grew ever harsher for such faltering mainstays of the economy as manufacturing and forestry. The year was also none too kind to the once-hot technology industry and the slowly shrinking retail sector. Even mining took a big hit to profit growth as a surge in costs outran the benefits from strong world demand mingled with speculative fever.
A quick glance at the bottom of The Top 1000 list shows where the pain is being felt most. There, we see the likes of hard-hit lumber giant Canfor (which plunged 943 places to 996), DVD maker Cinram International Income Fund (No. 993), fallen telecom idol Nortel Networks (999) and insolvent printer Quebecor World (1,000).
But let's leave this ward of misery and get back to where the money is still coming in. Canada's financial players and resource companies together accounted for two-thirds of the $104.7 billion in earnings piled up by the country's 1,000 largest publicly listed corporations in 2007. That oil producers would have another bumper year was entirely predictable. Finding and
producing the stuff may be getting increasingly pricey, but if
you can't make tanker-loads of money at $125-plus (U.S.) a barrel (to cite recent prices), you ought to be in another line of work. And as long as demand remains off the charts—thanks to the throngs of Chinese, Indians and others eager to acquire the consumption habits of the West—prices aren't likely to collapse.
But the surprising news that the big financial players managed to gain ground, too, was a testament to the enormous benefits—at least to management and shareholders—of being part of a small group that enjoys near total domination of its primary market. Thanks to their bread-and-butter activities at home, the major Canadian banks largely shrugged off the woes plaguing their counterparts elsewhere—the fruit of forays into the dark worlds of subprime mortgages, complex derivatives, structured investment vehicles and other toxic sludge.
Sure, some of the Canadian banks have had their share of heavy writedowns on dreadful bets, and they will go through considerably more pain before this year is out. What's the point of those plush carpets in the corner offices if not to sweep the mistakes under them? They also face the creative challenge of finding new ways to pile up revenue and slash costs if they want to keep expanding profits, because the shingles are starting to fall off Canadian housing, while arctic credit conditions are impairing other lucrative activities such as financing mergers, hawking exotic securities and underwriting public offerings.
"The attention has been on the big one-off writedowns, but it may shift instead to somewhat sluggish operating performance," suggests Avery Shenfeld, an economist with CIBC World Markets. "That sector is going to shift from being a pretty big win in operating earnings in '07 to one of the disappointments in '08."
But, so far, the banks have proved remarkably resilient. Of the top 10 companies in our ranking, half make their money peddling financial services. As a group, the banks managed to boost profit by 2.5% to $20.2 billion, while life insurers fell 14.4% to $11.4 billion. The undisputed earnings leader was Royal Bank of Canada, reclaiming the top spot it had ceded the previous two years to oil and gas heavyweight EnCana, which has slipped to fourth. Of the Big Five banks, Bank of Montreal suffered the most from its wayward gambling, sliding to 16th from 10th place.
What we're seeing are the benefits of tighter risk management exercised by the Canadians, says Douglas Porter, deputy chief economist at BMO Capital Markets. "It's quite a story, given the tumult in the U.S. and the global storms." Indeed it is. But don't try telling it to those investors who got saddled with asset-backed commercial paper—packages of securities filled with mortgages of dubious quality and other junk peddled by the banks' investment arms. The real story is a much older one that stems from the banks' tight control of the domestic market.
At least once a decade, the world's banking powerhouses blow their brains out on some wacky financing adventure. Even the supposedly conservative Swiss always get into the act. But time and again, the Canadians are saved from themselves by their redoubtable domestic retail customers and the occasional helping hand behind the scenes from the authorities. "There are times when having a non-competitive landscape tends to support profits," is one bank watcher's droll conclusion. "And the second half of last year was certainly one of those times."
It was also a time when things started to go downhill in other parts of the economy, and which will inevitably come home to roost in financial services. Even in resources, the strong loonie and rapidly rising costs for materials and labour finally caught up to key segments. Mining profits alone plunged 52%, while oil services were off 54%. Oil producers posted a gain of 14.4%, but not even sky-high prices can keep their margins safe from the ravages of inflation or the decline in conventional oil reserves.
"The stuff that you found historically is all of a sudden worth a lot more," observes Peter Tertzakian, chief energy economist with ARC Financial in Calgary. "The cost of going out and finding new reserves is very expensive. So when you see large, independent companies report good profits, the large part is coming from their legacy operations." But what the world needs at the current growth rate in consumption is new oil and gas. Which is neither easy to find nor cheap to produce.
The obvious conclusion? Profits are inexorably headed south, even if record prices can be maintained. "Yes, commodity prices are rising, but so are the costs of bringing the incremental new barrels to market," Tertzakian notes. So while this year's profits should still be healthy, what happens down the road could be another story, with a much less satisfying plot for Canadians.
One major trend of 2006 and early 2007—the rush by foreign buyers to swallow Canadian resources and other assets—all but disappeared in the second half of last year, when the credit squeeze hit and acquisitors suddenly found themselves badly lacking in takeover billions. "It was amazing how fast the taps were turned off on what had been a very free flow of credit," Porter says. "That chill could be with us for a while."
But in the meantime, the buyout spree has removed more illustrious names from the public rolls, eliminated the last publicly traded cement maker (St. Lawrence Cement) and left equity players with a smaller basket of stocks from which to choose. As a result, investors worried about overexposure to a single sector or two have been forced to look elsewhere. "The peril with investing in Canada is that your available investment options continue to narrow," says Arthur Heinmaa, managing partner with Toron Capital Markets in Toronto.
Although they could have fared far worse in other markets, not everyone wants to be loaded to the brim in Canadian bank or oil stocks, whose future doesn't seem quite so promising as in the recent past.
