Jun 8, 2018

Cameron Hurst's Top Picks: June 8, 2018

BNN Bloomberg

Cameron Hurst , BNN Bloomberg

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

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MARKET OUTLOOK

This continues to be a more complex investing environment with multiple horizons and myriad catalysts, foremost among them rates. To quickly summarize Equium Capital’s top-down views:

Interest rates are going higher;
The yield curve is flattening, led by short rates;
North American inflation is in something of a Goldilocks zone;
Credit quality is not yet a problem;
Global growth is good, although best in the U.S. and less robust elsewhere;
Emerging market risks are real and rising.

Under the surface, we see global equity breadth narrowing and credit indicators flagging increased stress, both of which cause our process and positioning be more conservative and invest in fewer neighbourhoods around the world.

The tricky part in this cycle is the secular reversal of interest rates. No longer can investors flock to bonds and bond proxy equities like consumer staples when things get rocky. More to the point, a significant part of our fund’s outperformance year-to-date came from avoiding pain, not chasing return. Being underweight bonds and focused in short-duration exposures actually protected capital even though equities have had a bumpy year.

Avoiding interest rate-sensitive sectors like telecom and staples (the latter shockingly down 12 per cent through June 7) significantly helped returns YTD and demonstrates the importance of resisting multi-decade muscle memory of declining interest rates.

While we see lots of concerning trends, there remain many attractive and investable neighbourhoods in which to place capital. We remain very comfortable with medical equipment, U.S. financials, especially those exposed to short-term rates, and software and services. On a more tactical basis, we maintain exposure to U.S. exploration and production companies, consumer discretionary and the U.S. and European small cap, the latter in small, liquid scale.

U.S. credit spreads and sovereign credit-default swaps (CDS) trends suggest risks are rising, but in a gradual, orderly manner that hasn’t yet choked off the broader bull market. Market tops are made over time with gradual, observable breakdowns of more and more stocks and industry groups. Remaining focused in leadership and exiting failing positions throughout this process protects capital and enables higher highs until we reach the actual market top. Conversely, the worst thing investors can do at this stage of the cycle is buy weakness and hold on to failing positions.

TOP PICKS

ISHARES U.S. MEDICAL DEVICES ETF (IHI)

Stable end-market fundamentals and new product launches (like in cardio and diabetes) in 2018 should boost revenues for the group.

The group is exposed to positive secular trends: an aging population, an obesity epidemic and emerging market demand.
Medical technology revenue growth will likely accelerate in 2018. The growth is going to be driven by new product launches on the back of a strong 2017 for new device approvals (especially in the U.S), and easy comparables given hurricane disruption the second half of last year.
Channel checks and strong Q1/18 earnings season demonstrate stable end-markets (cardio, diagnostics, surgical and tools) with respect to volumes and pricing. Innovation also remains healthy. Only area of weakness appears to be in spine.
Worldwide 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 has been removed, with the tax suspended for two years until 2020.
Little to no Amazon risk as isn’t likely the Internet giant can penetrate the medical device market due to the complex, value-added service these companies offer.
The group trades at premium to the market. Medtech offers stability in a volatile market and, given investors’ less-favourable views om most other health care subsectors, this premium could be maintained or even increase.

RAYTHEON (RTN.N)

We like Raytheon's specific defence market exposures (in missiles and missile defence) and its higher margin international exposure.

We're positive on the defence sector generally. The heightened threat environment globally is driving both the U.S. Defence Department's budget and foreign defence budgets higher.
Raytheon is geared towards the current defence market priorities of missiles and missile defence (30 per cent the company's revenue). The Defence Department's newly launched "Great Power Competition" strategy, which is meant to address peer competition from China and Russia, focuses on high-end programs and specifically missiles and missile defence.
It's "platform-agnostic": Raytheon subcontracts into major defence programs, but they aren't a primary contractor on any large one. This mitigates risk of a Trump interference as seen with Lockheed Martin's F-35s and with Boeing and the Air Force One.
Raytheon is a leader in international defence sales (31 per cent of revenue), which are higher-margin sales because they're typically mature programs and fixed-price contracts. The current U.S. administration has advocated increase of foreign military sales (FMS), with approvals more than doubling in the 2017 fiscal year.
Raytheon made a discretionary pension contribution in 2017, taking advantage of the higher 35 per cent deduction before tax rates dropping in 2018 to 21 per cent. This lowers the 2018-2020 required pension contributions and therefore provides a boost to free cash flow those years.
It trades at slight premium to the peer group average of 19.5 times (2018 price to earnings). The valuation looks reasonable given Raytheon’s exposure to defence programs of critical near-term importance and its higher-margin international exposure.

MICROSOFT (MSFT.O)

Technology continues to lead in the market, with strong relative price performance and benefiting from a myriad of structural tailwinds.

Microsoft has set itself up to be a key beneficiary of many of the critical themes such as cloud (Azure), AI and the Internet of Things while still benefiting from the shift of Office users to higher-value subscription plans.
Q3/18 was a clean beat across the board, with strong cloud growth (up 93 per cent year-over-year) driving a 13 per cent revenue gain. The operating leverage due to well controlled expense growth and tax reform also lifted earnings per share by 31 per cent YOY.
Office365 now has over 150 million total commercial and consumer users driving mid-teens growth with the help from this mix as usage expands and customers trade up to higher-value plans. Microsoft believes the Office365 commercial business could more than triple by 2023 (to upwards of $40 billion) as the installed base increases and pricing averages positive high-single digit growth.
Azure was up 93 per cent YOY in the quarter and expectations are for public cloud workloads to increase from 21 per cent to 44 per cent per cent in the next three years, pointing to significant market growth ahead (about 17 per cent EBIT CAGR through 2020). Microsoft's hybrid structure (some local, some cloud) seems uniquely suited to where the market is headed. likely meaning share gains on top of end-market growth.
The GitHub acquisition (which is the largest global open source code repository) for $7.5 billion provides direct access to 27 million developers that should help expand the use of Microsoft tools and services.
The company is well positioned in other growth areas such as gaming, data centers, machine learning and AI, providing further support to the outlook for the stock.
It's still exposed to some legacy areas such as PCs and servers so high-growth needs to be sustained in order to continue to grow overall revenue and earnings and justify peak multiples.
All in, Microsoft is well positioned to take advantage of huge structural opportunities while expense discipline and cash returns ensure solid returns for shareholders.