Cameron Hurst's Top Picks: July 11, 2018

Cameron Hurst, chief investment officer at Equium Capital Management
Focus: U.S. equities

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MARKET OUTLOOK

We look at the world through a multitude of lenses because we run a global multi-asset strategy. Notwithstanding the burden that puts on our research team, the myriad perspectives offer tells of different kinds at turning points in the cycle, often tipping us off when indicators diverge from each other or from historical patterns in either a positive or negative fashion.

Last month on The Street, we talked about liquidity and how the massive policy tide that lifted all asset prices and economies has reversed and started to flow out. Apart from the obvious reduction in central bank balance sheets and higher interest rates, a few notable tells for this are widening corporate credit spreads and weakening financial conditions indices.

There’s a pretty clear set of requirements for the cycle to continue, namely ramping productivity from accelerating capital investment, which should drive real growth and foster the synchronized global growth dynamic. Realistically, we need China to stop monkeying with the yuan and it would help if they pushed through a little stimulus too. Against this backdrop, you would likely see Europe reaccelerate, emerging markets play catch up and off we go to the races for another one or two years.

Wouldn’t that be wonderful? Unfortunately, we worry the slow train wreck of trade wars is undermining the benefits from years of global stimulus and the significant recent boost from U.S. tax reform. Sharply rising uncertainty is causing corporate managements to hold back on investment and lower earnings guidance, as witnessed in recent commentary from European auto manufacturers.

Without question, U.S. equities have been the standout performer year-to-date and earnings revisions have been nothing but stellar. But if you look at credit indicators and listen to non-U.S. corporate commentary, it seems more likely than not this U.S. earnings season will see negative revisions and cautious commentary. Replacing higher capital investment with greater operating uncertainty leads us to believe we’re approaching the end of the second-longest bull market in history.

Accordingly, we exited our overweights in tech and financials, replaced some of the exposure with real estate and late-stage global commodity exposure, modestly closing our underweight in fixed income and raising cash to double-digits. This should be understood as just the first step of many toward a cyclical repositioning of the portfolio for a more notable corrective period in the future.

TOP PICKS

ISHARES US MEDICAL DEVICES ETF (IHI.N)

• Stable end-market fundamentals, with new product launches boosting the ETF.
• Best performing sector in health-care YTD (IHI is up 18 per cent versus next best market cap up 10 per cent).
• The group is exposed to positive secular trends: aging population, lifestyle diseases/obesity epidemic and emerging market demand.
• Medtech revenue growth will likely accelerate in 2018 driven by new product launches on the back of strong new device approvals (especially in the U.S) and easy comparables, given hurricane disruption in the second half of 2017.
• It offers investors stability or a defensive tilt. Channel checks demonstrate stable end-markets (in cardio, diagnostics, surgical, tools) with respect to volumes and pricing.
• World-wide hospital capital spending trends are strong, as political uncertainty around the Affordable Care Act in the U.S. has decreased and private capital spending in China picks up.
• Tax reform provides access to cash outside the U.S. (77 per cent of large cap cash is outside America) and flexibility to undertake M&A, with management showing a preference for tuck-ins.
• A U.S. medical device tax overhang is removed, with the tax suspended for further two years until 2020.
• Little to no Amazon risk as it isn't likely that the tech giant can penetrate the medical device market because of the complex, value-added service these companies offer.
• The group trades at premium to the market (15.8 per cent 2019 price-to-earnings). Medtech offers stability in a volatile market. Given investors’ less favorable view of most other health-care subsectors, this premium could be maintained or even increase.

CME GROUP (CME.O)

• The exchange and data business is a high-margin, strong cash flow business where CME’s scale and competitive position are defining advantages.
• While we like the steadiness and good growth of the high-margin data business, CME is principally a derivatives exchange focused in interest rate, energy, equity and ag commodity options, where clearing and transaction fees drive revenue.
• The volume-oriented nature of the business means there are significant advantages to scale, best seen in CME’s incremental operating margin of over 90 per cent.
• At this point in the cycle, with us believing we’re in the late innings of this bull market, we further appreciate the stabilizing effect of a having two-thirds of revenue tied to equities and interest rate contracts, whose volumes naturally spike in volatile and risk-off markets. Exchanges were one of the best hiding places in equities right up until the end of the 2008-2009 bear market.
• Integration of the U.K.'s NEX Group, a foreign exchange and fixed income-focused electronic trading platform, is expected to be completed in the second half of 2018. It continues to demonstrate CME’s scale and technology advantages.
• The company pays a nice quarterly dividend and tops it up with a special at year-end that typically aggregates to nearly a 4 per cent yield. But this year, it could be larger due to tax reform windfall.
• Free cash flow yield over 4 per cent and growing enables a competent management to continue fishing for accretive bolt on acquisitions.

REAL ESTATE SELECT SECTOR SPDR ETF (XLRE.N)

• We believe it’s time to balance portfolios with incremental defensive exposure. Real estate’s modestly pro-cyclical tilt versus other bond proxy sectors make it a favourable first step.
• We prefer broad-basket sector ETF exposure through XLRE over the industry-standard IYR owing to lower cost and preferential industry weightings towards secular growth themes, namely data centres, storage and towers.
• “Growing slower” is good for REITs. Trade war rhetoric is more significantly impacting equity volatility and economic indicators around the globe. It now appears economic momentum could be slower than expected in the rest of 2018 and 2019 — altough still positive — which caps longer-term interest rates and staves off cap rate compression from what we previously expected. Secular growth in industrial (think fulfilment centre for Amazon), health care and tech-centric REITs maintains growth in the group despite slower than expected marcoeconomic tailwinds
• If we’re too optimistic and growth slows more precipitously, rate compression will support low cap rates in the sector for the early stages of the slowdown, allowing time for more defensive tactical repositioning

PAST PICKS: JULY 7, 2017

ISHARES US MEDICAL DEVICES ETF (IHI.N)

• Then: $166.84
• Now: $205.42
• Return: 23%
• Total return: 24%

E*TRADE FINANCIAL (ETFC.N)

• Then: $38.69
• Now: $61.27
• Return: 58%
• Total return: 58%

FEDEX (FDX.N)

• Then: $218.51
• Now: $231.35
• Return: 6%
• Total return: 7%

Total return average: 30%

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