Market Call for Wednesday, August 23, 2017
Jason Mann, chief investment officer at Edgehill Partners
Focus: North American equities
- The value trade (a.k.a. the “Trump trade”) peaked in December of last year and has been falling steadily since then. This is reflected in the weak U.S. dollar, weak U.S. small caps, and lacklustre financials.
- Inflation expectations are falling again, and the yield curve is flattening.
- Growth stocks have once again become investor favourites. Growth stocks do well when overall economic growth is scarce and investors pay a premium to invest in the handful of stocks that are growing sales. Stocks like Tesla, Netflix, Amazon and Shopify exemplify this trend.
- The problem is that the market is already expensive, and these growth stocks even more so. You can’t stand in front of a freight train, but growth outperformance like this is typical of late-cycle markets. The best analogies are 1990, 1999 and 2007 — all periods that preceded meaningful market weakness.
- Over the long run, investors consistently overpay for growth stocks, and a strategy that favours them underperforms. But there can be shorter periods when the growth style dominates all others, and that has been true this year.
- We’ve been concerned about markets for a few months now, and more risk signals are piling up for us. There are times to make money in the markets and there are times not to lose money, and we believe it is now the latter.
- Canadian stocks have been weak collectively since the spring, and we’ve been “risk off” in Canada since May.
- The high-yield market, which is often an early indicator of overall market health, has weakened recently, and we’ve moved out of high yield and into the most defensive part of the bond market: long-dated U.S. Treasuries.
- The U.S. market is losing steam as well, with market breadth weakening and with increased volatility and technical damage being done.
- What is striking in the U.S. is how much of the gains year-to-date are concentrated in a handful of mega-cap growth stocks. The S&P 100 is up 8.5 per cent on the year while the mid-cap index is up only two per cent, and the small-cap index is actually down two per cent on the year.
- We hope we are wrong and that widespread economic growth and inflation is reignited and cyclical value regains its leadership, but until we see more evidence of that we need to be more cautious.
- Energy stocks have been beaten down over last few years, and while many of them have real balance sheet and cash flow concerns, Enerplus in contrast has a strong balance sheet.
- ERF is an 85,000 BOE/d producer with assets in Bakken, Marcellus and North Dakota, so it has both Canadian and U.S. production bases.
- Scores in the top 10 per cent of stocks for us on valuation: decent ROE at 10 per cent; 4.1x EV/EBITDA; 6.7x cash flow; and a recent beat on earnings. Importantly, it has a strong balance sheet, with net debt of about 25 per cent of enterprise value.
- And surprisingly, despite being an energy stock, it scores in the top 30 per cent of all stocks on price momentum, as well. Certainly very strong relative price momentum versus other energy stocks — they would be one of the strongest on this measure
- Has one of the lowest sustaining break-evens and one of the best free-cash-flow yields among its peers. They have less torque to a recovery in energy prices, so it will lag a major rebound in energy, but the difference is you won’t go broke holding ERF while you wait for an energy recovery to materialize.
- Norbord makes oriented strand board (plywood) with homebuilders as its biggest market, and experiences occasional spikes in demand during hurricane season, for example.
- Scores in top five per cent for us on valuation: 11x PE; 6.9x EV/EBITDA; strong ROE at 38 per cent; great balance sheet; and a nearly five per cent yield.
- Payout ratio is around 45 per cent of estimated free cash flow, so lots of coverage on the dividend, which they just raised. They are balancing capital spending with dividend and have room to raise both.
- Also has strong price momentum; scores in top 10 per cent of stocks for us on this measure.
- The OSB market is very tight right now; we’ve had good demand growth (homebuilding) and lack of supply additions. Pricing is at the highest levels since 2013.
- Norbord has a ton of leverage to even small increases in price. Raymond James for example estimates that a $10 increase in price (currently $400ish) is worth $7/share assuming multiples stay constant.
- Stock has been overhung a little bit following a sale of stock by Brookfield. That issue was repriced lower since it didn’t sell, but it has now cleared that overhang.
- No exposure to the softwood lumber dispute.
CI FINANCIAL (CIX.TO)
- Largest mutual fund company in Canada with $140 billion of assets under management.
- Much has been made about the death of traditional mutual funds and active management, but the reality is that while margins are in decline, CI has the scale to generate good returns, and the assets tend to be stickier than people give credit for.
- They are best in class in terms of cost to “manufacture” funds.
- Scores in the top 20 per cent of all stocks on valuation. Has low volatility and reasonable price momentum.
- In terms of value, it trades at around 14x PE (12x forward), big ROEs at 28 per cent, with solid balance sheet and yield of 5.2 per cent. There has been some discussion that they would consider trimming the yield in order to deploy that cash to buy back shares. We would be fine with either approach, frankly.
- They generate solid cash flow, and have been a pretty aggressive buyer of their own shares.
- Recent acquisition of Sentry gives them more scale as they can continue to grow by acquiring and rationalizing costs. They are experts at this type of integration.
PAST PICKS: SEPTEMBER 2, 2016
- Then: $53.40
- Now: $68.70
- Return: 28.65%
- Total return: 29.62%
CGI GROUP (GIBa.TO)
- Then: $64.94
- Now: $62.89
- Return: -3.15%
- Total return: -3.15%
SHORT: TESLA MOTORS (TSLA.O)*
- Then: $197.78
- Now: $346.00
- Return: -74.94%
- Total return: -74.94%
- Total return from short: -74.94%
* Our data shows that if a viewer shorted Tesla on September 2, 2016 and held the stock until today, they would be down 75 per cent. However, Jason said he got out in the spring, but we do the math from the past picks date up until today.
TOTAL RETURN AVERAGE: -16.15%
FUND PROFILE: EHP SELECT FUND
PERFORMANCE AS OF AUGUST 11, 2017:
- 1 month: Fund* -1.0%, Index** -0.8%
- 1 year: Fund* 9.4%, Index** 4.5%
- Since November 201 4 inception (annualized): Fund* 12.8%, Index** 4.1%
* Returns include reinvested dividends
** Index: S&P TSX Composite
TOP HOLDINGS AND WEIGHTINGS
- West Fraser Timber: 5.4%
- Canadian National Railway: 5.1%
- Interfor: 5.1%
- Norbord: 4.8%
- Western Forest Products: 4.7%