Cameron Hurst, chief investment officer at Equium Capital Management
FOCUS: U.S. equities
When we were last on the show in early December, we reviewed a sketch outlook for 2018, highlighting the good, the bad and the ugly. Since then, we’ve seen some of the good, i.e. markets continued to melt up on the back of our virtuous circle of synchronized global growth, tight labour markets, higher business output driving rising capex and productivity growth. This carried the S&P 500 up nearly five per cent since December 7, which annualizes at 58 per cent — definitely in the category of melt-up.
Then just yesterday, we had a shot across the bow from the “ugly” category. One of the trickiest parts of investing is lining up events with timing because both matter. The easiest example of this would be buying a stock too early and languishing while it underperforms for a couple years before it finally picks up, all the while missing a great rally in other parts of the marker, i.e. a value trap.
Timing this year, we worry, may be more important than the risk of a value trap, i.e. the risk of significant actual loss instead of just underperformance versus stronger alternatives. In December, rising rates seemed more likely to garner uncomfortable attention in the second half of the year than now, owing largely to the strong market drivers and virtuous circle at play. However, this exemplifies well why our process is tactical and listens to markets instead of talking at them when things unfold differently than expected.
Now to use a few pictures, looking at the 30 year trend of U.S. 10 Year Treasury yields, you can see we’re right at the breakout level between 2.60 per cent to 2.65 per cent. This is primarily what has people concerned because the risk is that when we breakthrough that level, momentum players come in, convexity hedges have to be shifted and the game changes, resulting in something like the “Taper Tantrum” of 2013.
Looking at that period more closely, we see 10 year yields ripped higher from early May until the end of August, driving bonds, represented by the TLT government bond ETF, down 18 per cent. Now I can’t speak for everyone, but our clients and most of the investors we speak with would be shocked if they lost almost 20 per cent on a portfolio of government bonds in four months flat. This is why we argue that investors have to be able to shift portfolio exposures in a tactical fashion this year even more than most.
It's not easy because you can’t simply run into equities. A chart of the 10 year Treasury yield versus the S&P 500 Index over that same four month period shows volatility increase dramatically. There’s a little complacent rally to start, followed by a six per cent decline, then a deceptive nine per cent rally, followed by another five per cent drop. Equities didn’t know if they were coming or going! The Fed quickly changed tactics and moved to reassure markets, and the rest was smooth sailing history.
The subtle issue we face now is the P/E and EV/EBITDA on the S&P 500 are 39 per cent and 35 per cent more expensive, leaving much less tolerance and margin for error. We don’t think this infolds overnight, but we find it interesting that most of the recent interest in our strategy has been from advisors replacing some of their straight equity exposure with our Global Tactical Allocation ETF. From their perspective, this ought to maintain upside capture (we aim to deliver seven to nine per cent a year on average over the cycle) while reducing overall portfolio volatility and enhancing the downside protection if things go really downhill.
Equity replacement is a lot like prudent insurance when heading into a storm. If you believe we’re closer to the end of this cycle than the start, it’s a strategy that makes a lot of sense.
E*TRADE FINANCIAL (ETFC.O)
- Strong cyclical tailwinds and multiple drivers of organic growth with optionality from potential for takeout
- New management committed to growing top line or realizing value other ways; to date this hasn’t been a problem with top line acceleration for seven straight quarters and now in acquiring mode, buying RIA and Trust Co of America recently
- Higher rates are a natural revenue tailwind
- Management has been clear on interest rate sensitivity: a 25bps rate hike would increase revenue by $60M, which translates to ~22c EPS on a 2017 base of ~US$2.32/share earnings, i.e. nine per cent accretive!
- Announced a $1B share buyback to be completed before the end of 2018 boosting top line impact
- Share count expected to fall by 10 per cent in 2018
- Mortgage loan book is non-issue now, -25 per cent YoY, and fully amortizing
- Huge beneficiary of tax reduction: moving from 38 per cent payer to mid-20 per cents
- Stock has had a great run as investors got wise to the story, but although valuation is closer highs of the historical range it is still 20 to 25 per cent lower than Schwab and a much cleaner story than in the past
SPDR S&P TRANSPORTATION ETF (XTN.US)
- Transportation benefiting from strong economic growth. Names within the industry benefit from a number of positive secular trends (e-commerce, air travel etc.)
- XTN industry exposure: 45 per cent road and rails, 26 per cent airlines, 22 per cent airfreight and logistics
- Trucking: Volumes remain robust driven by strong consumer demand, expanding industrial demand and benefit from hurricane effects due to rebuilding projects and re-establishing disrupted supply chains. Expect to see an inflection higher in truckload rates +5.5 per cent due to capacity tightness
- Rails: Positive volume dynamics esp. in intermodal driven by strong consumer demand and solid housing starts (expected to grow five per cent in 2018 and six per cent in 2019)
- Airfreight and logistics: Secular support from (i) outsourced logistics trend - higher transport expenses, tighter delivery windows and regulatory compliance hurdles (ii) growth of e-commerce
- Airlines: Robust demand trends in 2017 will likely continue in 2018 given the uplift to GDP and corporate profits from tax reform. PRASM was stable to improving in 2H17 and this has continued into 1Q18 with the competitive environment more disciplined and management intending to pass fuel cost increases on
- Tax reform is a positive for the space. Transportation businesses are U.S.-centric and so the group are higher cash tax rate payers. The reduction in the corporate tax rate should therefore result in a reduction in effective rates across the group.
- Risks across the group:
- Trucking: Wages rising due to driver shortage - low unemployment rate, autonomous tech dissuading entrants starting driving career
- Rails seeing volume pressure in coal (shift to Nat. Gas) and autos (slowing growth)
- Airfreight and logistics: Amazon disintermediation a tail risk
- Airlines: Margin pressure due to higher unit costs (fuel and wages)
- US Transports trading below its 10-year average relative P/E to S&P (0.89x versus 1.04x)
- Materials sector has broken out as base metals have performed well and chemicals names benefit from strong industrial growth
- DWDP positively pre-announced their first quarter (Q317) as a merged company although underlying details were more mixed, guidance slightly below consensus and the corporate breakup was delayed by several months. Given the hurricanes and restructuring efforts however near-term estimates are not a good guide and we do not view the delay as material to the thesis
- Underlying volume trends have been positive as key end markets continue to post solid growth (plastics, housing, auto, construction) and pricing should be supported by increasing commodity prices. Effective tax rate 25 per cent so modest gainer on lower tax and full CAPEX expensing
- DOW/Dupont merger will result in significant cost synergies ($3B target could be conservative) and more efficient corporate structure (will be broken into three parts: Ag, Materials, and Specialty that have their own cycles and drivers), which will help crystalize the SOTP argument
- DOW is a key beneficiary of the U.S. shale gas boom, which provides it with a cost advantage relative to global peers (specialty plastics)
- DOW has pushed significantly more towards higher quality consumer facing verticals and away from cyclical industrial and commoditized businesses driving up margins and cash flow in turn resulting in peer & market leading shareholder performance over the last five years
- 10.6x ’18 EV/EBITDA is close to prior peak (DOW) however economic growth and commodity inflation will likely sustain earnings growth while the strategic shift up the value chain, cost savings and break-up of the company into a more efficient structure should lift both estimates and multiple
- All in, as long as the economy and inflation show progress and management continues to execute their strategic plan we would expect the stock to benefit from its later cycle positioning and self-help and move steadily higher over time
PAST PICKS: JULY 7, 2017
ISHARES US MEDICAL DEVICES ETF (IHI.US)
- Then: $166.84
- Now: $182.30
- Return: 9.26%
- Total return: 9.55%
E*TRADE FINANCIAL (ETFC.O)
- Then: $38.69
- Now: $52.84
- Return: 36.57%
- Total return: 36.57%
- Then: $218.51
- Now: $268.92
- Return: 23.06%
- Total return: 23.61%
TOTAL RETURN AVERAGE: 23.24%