Cameron Hurst, chief investment officer at Equium Capital Management
FOCUS: U.S. Equities
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MARKET OUTLOOK

Negative on Canada

Back in early June we discussed the increasing likelihood of a rally in the Canadian dollar, principally owing to extremely negative trader positioning coupled with the best GDP growth in the G7. At a minimum, those drivers set the stage for a rebound from oversold levels.
Since then, the Bank of Canada (BoC) raised rates, maintained a hawkish tone and the CAD has risen almost 10 per cent against the USD, now threatening to break out to multi-year highs.
To be clear, we believe the BoC is in the midst of what will be viewed – retrospectively, of course – as a policy mistake.
Although recent economic data has been strong, we do not view the trend as sustainable and point to consensus forecasts of a slowdown to only 2 per cent GDP growth in 2018. Our caution further revolves around our neutral view of commodities along with weak consumer balance sheets and record high home price-to-income ratios, which are susceptible to further rate increases.
Additionally, the recent spike in CAD/USD creates a headwind for the domestic manufacturing recovery as well as reduces inflation that was already well below the Bank of Canada’s 2 per cent target. Throw in uncertain NAFTA negotiations and oil price risk from a teetering OPEC agreement and we see a decent probability that the currency has seen its short-term highs.
As global investors based in Canada, we need to proactively manage currency risk in order to effectively protect client capital in local Canadian dollar terms. Our foreign exchange positioning is therefore an outcome of our disciplined investment process, which combines both top-down and bottom-up perspectives. Technically, Canadian equities continue to perform poorly on both an absolute and relative basis driven by weakness in the three largest sector weights: energy, financials and materials.
Until the TSX begins to exhibit positive momentum, our unemotional top-down lens is likely to maintain the current underweight bias.

Narrowing our focus in the U.S.

We have made several other adjustments to more precisely reflect our global view for positive, yet moderate growth, and subdued inflationary trends. Although we assume some benefit from U.S. tax reform in 2018, we no longer expect a sustained cyclical uplift as growth slows and liquidity conditions tighten.
Further to our reduction in info tech exposure, we have recently refined our industrials exposure into the aerospace & defense sub-sector and expanded our position in U.S. capital markets & asset managers, which are not dependent on a steeper bond yield curve. We wouldn’t hold our breath for a higher and steeper yield curve in the foreseeable future.
We are more favourable on the USD over CAD again, believing the mean-reversion trade has mostly run its course. But with mixed indicators at present, cash generated from exiting equity positions is being held in cash, which now sits close to 10 per cent.

TOP PICKS

E*TRADE FINANCIAL CORP. (ETFC.O)

• Sector: Financial services
• Market cap: $11.3B 

• Performance: 
• 1 year absolute: +60% 
• 1 year vs financials: +28% 
• 1 year vs S&P 500: +44% 

• Valuation: 
• Top line growth: CY16 +36%, CY17 +20%, CY18 +8% 
• Bottom line growth: CY16 +48%, CY17 +30%, CY18 +10% 
• P/E multiple: CY17 18.4x, CY18 16.7x 

• Multiple drivers of organic growth with potential for takeout
• New management in September committed to growing top line or realizing value other ways 
• Higher rates are a natural revenue tailwind 
• Management guided to low “270s bps" NIM for 2017 vs 274bps in the most recent quarter – so clear to see management conservatism
• Previously noted a 25bps rate hike in June would increase this by 10bps, so pass through is significant 
• Just announced a $1 billion share buyback to be completed before the end of 2018
• Mortgage loan book is now down to $3b billion, -25 per cent year over year, and fully amortizing
• Tax reform beneficial because they’re a 38 per cent payer 
• If management hits a revenue wall (pricing competition) and wants to sell, AMTD would be more interested now that the mortgage book is running off aggressively 
• All adds up to a nice 1-2 year story with a chance to buy on the pullback from pricing risk 

iSHARES MSCI INDIA ETF (INDA.US)

• Sector: Emerging markets
• Assets:$5.4 billion
• Expense ratio: 0.71%

• Performance: 
• 1 year Absolute: +13%, -6% vs EM, flat vs MSCI ACWI, +7% vs TSX
• Fundamentals (MSCI India Index):
• Top line growth: FY16 +12%, FY17 +30%, FY18 +11%
• EPS growth: FY16 +8%, FY17 +18%, FY18 +20%
• P/E multiple: FY17 19.3x, FY18 15.6x

• INDA has recently broken out to multi-year highs with strong relative performance since the de-monetization scare in Q4 2016
• Cautious short-term on GST implementation risks however
• Fastest growing G-20 economy (7 per cent real GDP growth through 2019 est.) on the basis of strong domestic demand, growing labour force and positive reforms
• The Modi government has enacted many positive reforms including de-monetization, which removed 87 per cent of cash in circulation and spiked deposits, which helped improve financialization of the economy and reduce graft
• Aadhaar biometric identity cards resulted in 95 per cent of the population now having digital proof of identity, which in turn led to the opening of 270 millin new bank accounts and $10 billion of deposits entering the formal banking system since 2014
• Significant infrastructure program, including the plan to build 50 million homes by 2022, should speed urbanization and provide significant economic stimulus ($1 trillion if fully enacted, but that’s a big ask)
• New bankruptcy code, including bankruptcy specific courts, should help speed the clearing of bad debts, but this system is new and untested and level of NPLs significant
• On the downside, growth has slowed recently as investment and credit growth have been anemic as a result of significant NPLs and uncertainty/disruption from de-monetization and the GST roll out
• Multiple is above peers and its own historical average which could lead to a short-term pullback

RAYTHEON (RTN.N)

• Sector: Industrials
• Market Cap: $50.4 billion 

• Performance: 
• 1 year absolute: +27%, +9% vs industrials, +12% vs S&P 500

• Valuation: 
• Top line growth: FY16 4%, FY17 5%, FY18 4% 
• Bottom line growth: FY16 1%, FY17 11%, FY18 12% 
• P/E multiple: FY17 22.8x, FY18 20.5x

• We like RTN’s specific defense market exposures (missiles, missile defense & cyber) and its higher margin international exposure
• Technicals show a strong uptrend
• Positive on the defense space – DoD budget pivoted towards growth & heightened threat environment globally
• Geared towards current defense market priorities (missiles, missile defense & cyber) – DoD focus on missile spending vs ISIS
• Platform ‘agnostic’ – RTN subcontract into major defense programs but are not main supplier, therefore mitigates risk of Trump interference (as seen with LMT [F35] & BA [Air Force One])
• Leader in international defense sales (31% per cent revenue) which are higher margin sales
• Significant balance sheet capacity therefore room for dividend increases and share buybacks
• Q2 earnings - EPS beat & guidance raised: sales strong, driven by missile systems, some weakness at cyber security business (ForcePoint) due to restructuring - transitory
• Trading at premium to peer group average 21.0x (2017 P/E): believe premium can be maintained, exposure to defense niches of critical near-term importance, largest exposure to higher margin international sales

PAST PICKS:  FEBRUARY 8, 2017

ALPHABET (GOOGL.O)

• Sector: Technology
• Market cap: $645 billion

• Performance from Feb 8, 2017: +14% absolute, -2% vs technology, +5% vs S&P 500 

• Valuation: 
• Top line growth: FY16 +20%, FY17 +21%, FY18 +19% 
• EPS growth: FY16 +21%, FY17 +17%, FY18 +16%
• P/E multiple: FY17 23.2x, FY18 20.1x

• Technology has moved from positive to neutral as relative performance has started to break down
• Google continues to execute against multiple compelling opportunity sets that are driving significant 20 per cent revenue growth (Q217 30th straight quarter) though traffic acquisition costs
• Other bet investments continue to modestly weigh on earnings growth
• Core advertising business continues to be strong (19 per cent year over year in Q217; 66 per cent of ad spend still offline). Google sites 20 per cent
• Secular digital ad growth and mobile usage highly likely to continue driving superior earnings growth on their own
• Beyond the core, cloud service is growing rapidly with significant opportunity ahead (and within an oligopoly with Amazon, Microsoft). Machine learning, AI and autonomous driving are also significant initiatives for Alphabet but with uncertain future
• YouTube up to 1.5 billion monthly users and 60 minutes per day average
• Management attempting to get “Other Bet” spending under control (paused Google Fiber expansion), which should reduce the current $4 billion drag on operating income (~10 per cent of total). Q217 saw continued losses of ~$800 million however
• Significant international exposure (53 per cent of sales) could be helped by tax repatriation holiday ($95 billion cash, 15 per cent of cap) and recent dollar weakness
• Valuation of 23x near long-term averages (21x) and slightly below historical relative premium to S&P
• $2.7 billion fine from EU raises concerns that Google anti-trust attention is beginning to pick up and could weigh on the future outlook
• In sum, we like the company and the array of addressable opportunities, but margin weakness and high spending coupled with increased anti-trust attention gives us pause

• Then: $829.88
• Now: $941.39
• Return: +13.43%
• Total return: +13.43%

E*TRADE FINANCIAL CORP. (ETFC.O)

• Sector: Financial services
• Market cap: $11.3 billion 

• Performance from Feb 8, 2017: +18% absolute, +9 vs financials, +9% vs S&P 500 

• Valuation: 
• Top line growth: CY16 +36%, CY17 +20%, CY18 +8% 
• Bottom line growth: CY16 +48%, CY17 +30%, CY18 +10% 
• P/E multiple: CY17 18.4x, CY18 16.7x 

• Multiple drivers of organic growth with potential for takeout
• New management in September committed to growing top line or realizing value other ways 
• Higher rates are a natural revenue tailwind 
• Management guided to low “270s bps" NIM for 2017 vs 274bps in the most recent quarter – so clear to see management conservatism
• Previously noted a 25bps rate hike in June would increase this by 10bps, so pass through is significant 
• Just announced a $1 billion share buyback to be completed before the end of 2018
• Mortgage loan book is now down to $3b billion, -25 per cent year over year, and fully amortizing
• Tax reform beneficial because they’re a 38 per cent payer 
• If management hits a revenue wall (pricing competition) and wants to sell, AMTD would be more interested now that the mortgage book is running off aggressively 
• All adds up to a nice 1-2 year story with a chance to buy on the pullback from pricing risk

• Then: $35.06
• Now: $40.84
• Return: +16.48%
• Total return: +16.48%

HONEYWELL (HON.N)

• Sector: Industrials
• Market cap: $105.5 billion 

• Performance from Feb 8, 2017: +17% absolute, +9% vs industrials, +8% vs S&P500 

• Valuation: 
• Top line growth: FY16 +2%, FY17 +1%, FY18 +4% 
• Bottom line growth: FY16 +8%, FY17 +7%, FY18 +10% 
• P/E multiple: FY17 19.6x, FY18 17.9x

• Quality diversified industrial name exposed to rising theme of software connectivity
• Innovative and forward-looking industrial name led by strong management team (new CEO Darius Adamczyk)
• Well-positioned in the rising theme of software connectivity through connected aircrafts, autos, homes, etc. 
• Taking action to decouple growth from business cycle – software licenses, tech upgrades, aftermarket
• Growing sales mix in large developing economies aiding organic sales growth – integrating & innovating locally (especially China)
• Ongoing productivity and restructuring savings creating margin leverage
• Risks/challenges include unpredictable international sales (China, Russia, Brazil) & weakness in business jets OE market
• Q2 earnings - beat & raise: strong organic growth driven by aero and performance materials & tech
• Trades near 11 per cent discount to peers on a 2018 P/E basis and below the midpoint of its historical range (-15 per cent to 5 per cent)
• Discount not justified given HON’s operating improvements, which should place it closer to peer performance

• Then: $119.73
• Now: $138.48
• Return: +15.66%
• Total return: +16.87%

TOTAL AVERAGE RETURN: +15.59%
 

TWITTER: @equiumcapital 
WEBSITE: www.equiumcapital.com