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

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MARKET OUTLOOK

Little has changed since the last time I joined BNN’s Market Call back on Feb. 8. That was the second significant down day in early February that kicked off this market consolidation, which we believe to be a multi-month process. For better or for worse, investors have not yet been given a clear signal on which way the market is likely to break in coming months. Consolidations like this, healthy though they may be, are a test of patience, resolve and process.

Having a robust and clearly defined investment process should carry investors through such periods, helping them avoid the emotional rollercoaster and its associated untimely buying and selling. Through Equium Capital’s multi-lens process:

Positive signals:

+ Capitalization performance turning positive: small caps outperforming large caps and equal-weighted large caps, which in turn outperform capital-weighted large caps.

+ Very robust corporate earnings picture likely to continue (consensus expects 18 to 19 per cent earnings growth next quarter and for the full 2018 year).

+ Asset management performing in-line with the S&P 500 (neutral to positive, considering market weakness).

+ Semis outperforming the S&P 500.

+ Advance/decline line setting up for confirmation of new high (when or if we have one).

Cautionary signals:

- Credit spreads, notably BBB spread, at recent wides and up to summer 2017 levels.

- Financial conditions index remains well off peak, with credit growth dropping sharply.

- Yield curve has flattened, e.g. two year-five year and three month-ten year, and spreads sit near lows.

Qualitatively, if we were headed for a more notable breakdown in equities and rally in bonds, you would expect to see more notable sector rotation than what’s transpired over the last couple months. In fact, utilities are the only bond-proxy sector to have stable relative strength, with consumer staples, telecom and real estate all weaker than the market as a whole.

Further, leadership sectors and industry groups have maintained their strength throughout this consolidation. You see the IAI ETF, reflecting capital markets and exchange stocks, returned 29 per cent over the last year, but is still up 7.5 per cent year-to-date (YTD). Compare that resilience to consumer staples, -1.4 per cent for the last year, but even worse at -7.5 per cent YTD.

Our technical lens, which guides asset allocation for our Global Tactical Allocation Fund, has yet to confirm a positive likely outcome on volume and breadth, so we remain in a holding pattern, sticking with our winners and trimming positions that have broken down. Over the last two months, this process has caused the sale of our focused German and Indian equity exposure as well as U.S. materials sector and U.S. transports exposures. Our cash is now over 20 per cent and we’re comfortable holding there until we have more definitive signals from our unemotional process.

TOP PICKS

ALPHABET (GOOGL.O)

• POSITIVE– We remain neutral technology as relative performance has flattened out and risks have increased, but we are overweight the Internet subsector.
• Google continues to execute against multiple compelling opportunity sets that are driving significant 20 per cent plus revenue growth (Q4/17 32nd straight quarter with more than 20 per cent), though TAC (traffic acquisition costs) and “other bet” investments continue to modestly weigh on earnings growth.
• Core advertising business continues to be strong (up 21 per cent year-over-year in Q4/17; 66 per cent of ad spend still offline). Google Sites up 24 per cent. Secular digital ad growth and mobile usage highly likely to continue driving superior earnings growth on their own and Google has about 70 per cent market share of global search ad revenue.
• Beyond the core, cloud services are growing rapidly with significant opportunity ahead (and within an oligopoly with Amazon and Microsoft). Q4/17 was the first disclosure of cloud financial metrics, with management stating that it’s currently a $4-billion annual revenue run rate business, which is higher than street expectations and growing faster than peers.
• Machine learning, AI and autonomous driving are also significant initiatives for Alphabet, but with uncertain future. Waymo is over four million miles of real driving time. Google Assistant is on 400 million devices. Lots of high-level commentary, but investors are getting tired of the lack of financial details.
• YouTube up to 1.5 billion monthly users and 60 minutes per day average. Critically, ad viewability rate is 95 per cent compared with 66 per cent average for video ads.
• Management attempting to get “other bet” spending under control (paused Google Fiber expansion), which should reduce the current $4-billion drag on operating income (around 10 per cent of total). Fiscal year 2017 was down to a still sizable $3.6-billion loss so progress is directionally positive, but not really in magnitude.
• Significant international exposure (53 per cent of sales) could be helped by tax repatriation holiday ($96 billion cash, 13 per cent of cap).
• Valuation of 21 times is in-line with long-term averages and remains below historical relative premium to the S&P (current 137 per cent vs. average 153 per cent).
• $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 trading at a reasonable price. Further “other bet” disclosures could be a material positive catalyst. But margin weakness (TAC) and increased anti-trust attention will need to be watched carefully.

EDWARDS LIFESCIENCES (EW.N)

• POSITIVE – one of the best growth stories in the medtech space, with new product launches and expansion into new markets expected in 2019.
• Like the medtech space generally, it escapes the drug pricing debate and is exposed to positive secular trends: aging population, obesity epidemic and emerging market demand.
• Edwards Lifesciences is a leader (60 per cent revenue) in the TAVR (transcatheter aortic valve replacement) market.
  • Worldwide TAVR market expected to reach $5 billion by 2020 from $2.5 billion last year. This creates a huge opportunity for growth and should lead to at least DD sales compound annual growth rate (CAGR) for this business line to 2021.
  • Among the growth drivers within TAVR are low-risk indications, next generation valves and expansion into emerging markets.
  • TAVR revenues up 20 per cent Q4/17, seeing rising demand for TAVR at hospitals that are acknowledging the superior outcomes relative to surgical valves.
  • Expect a number of key product approvals in TAVR both within the U.S. and Europe in the coming months (CENTERA and SAPIEN).
  • Positive readout at the American College of Cardiology’s recent meeting for NOTION trail. which demonstrated TAVR-SAVR (surgical aortic valve replacement) equivalence on low risk patients bodes well for the company’s upcoming low-risk trial of SAPIEN.

• The company is also a key player in the TMVR (transcatheter mitral valve) market.
  • Mitral valve disease is the most common type of heart valve condition in the U.S., suggesting TMVR market could be four to five times TAVR in future.
  • The company forecast $1b worlwide TMVR by 2021 - implies 25 per cent CAGR between 2018 and 2021.
• Trades at a premium to peer group average 22.8 times (2018 price-to-earnings) – reasonable, given its leadership position in high-growth markets (TAVR, TMVR).

E*TRADE FINANCIAL (ETFC.O)

• POSITIVE – strong cyclical tailwinds and multiple drivers of organic growth with optionality from potential merger with TD Ameritrade.
• 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 eight 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.
  • 25bps rate hike would increase revenue by $60 million, which translates to 22 cents earnings-per-share on a 2017 base of about $2.32 per share earnings, that is, 9 per cent accretive.
• Announced a $1 billion 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 20s.
• 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 24 per cent cheaper than Schwab on P/E and a much cleaner story vs. past.
• Risk is another round of price competition and/or JPMorgan moving aggressively into the industry most likely with low prices.
  • External risks like these increase the chance of a merger between TD Ameritrade and E*Trade Financial , which should be significantly accretive.