May 9, 2018

Cameron Hurst's Top Picks: May 9, 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

There was a trading comment this morning that noted the VIX index has traded in a 2-point range for the last three days. We suggest this wildly understates underlying volatility in the market and how easy it’s to get it wrong right now.

Take consumer staples as an example, a traditionally defensive sector with good yield support. Compared to the S&P 500 year-to-date (YTD) return of 1 per cent, staples are down 13 per cent, including the hefty dividend. Total return for Proctor & Gamble is -21 per cent and Altria -22 per cent YTD, demonstrating the dangers of investing in the wrong neighbourhood right now.

Energy yesterday was clearly volatile on U.S.-Iran news and experienced significant volatility in both the commodity and related equities. An equal-weighted ETF reflecting energy exploration and production companies dropped 5.4 per cent yesterday from the previous day’s high only to then lift 4.8 per cent and close on strength.

Comparing oil to the VIX index comment, the commodity is up about 1.5 per cent from three days ago, but that masks the cliff drop yesterday before the Iran news and subsequent 5.2 per cent rally. This is absolutely not a low-volatility market and it requires much greater selectivity.

We started talking about a more volatile and challenging investing environment last fall, pointing to a number of countervailing factors that continue to play out: strong corporate earnings on the back of synchronized global growth are being offset by declining monetary policy accommodation, rising interest rates and increasing policy uncertainty from Washington.

Notwithstanding 9 per cent revenue growth so far this earnings season (a multi-year high) and earnings per share (EPS) growth trending towards 18 per cent for the S&P 500 excluding tax reduction, expectations were so high that stock performance has been the worst in recent memory. Companies that beat on both revenue and EPS were up less than 1 per cent, while any other combination of revenue and/or EPS misses result in a punishing stock performance following the earnings report.

We don’t expect things to improve near-term and we continue to recommend a tactical approach as best fit to this environment. Being unemotional and open to the reality of rising interest rates is critical to protecting and growing capital now.

Fixed income is not your friend. TLT, the U.S. government long bond ETF, is down 6 per cent YTD while staples and telecom are down more than two times that. The days of riding the secular trend of declining interest rates are over. Using a total return approach to your portfolio and generating mid-to-high single digit returns will enable you to harvest some of that each year if need be. Investors can’t look to yield and dividends for the same income and return they’ve experienced over the last 20 or more years.

Our Global Tactical Allocation Fund went modestly overweight equities again in April, but remains focused in leading areas of the market: rate-sensitive U.S. financials, medical devices, technology and consumer discretionary. The fund has been underweight fixed income for well over a year and focused in short-duration exposure to protect against rising rates while still diversifying the portfolio. Cash remains elevated on a cautiously optimistic view until equities can break out of the present range (about 2,600 to 2,800 points on the S&P 500).

TOP PICKS:

ISHARES US MEDICAL SERVICES ETF (IHI.US)

Stable end-market fundamentals and new product launches (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 reaccelerate this year to 5.1 per cent from 4.4 per cent in 2017. 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.
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.
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.

MICROSOFT (MSFT.O)

Technology continues to lead in the market with a 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 (93 per year-over-year) driving revenue up 13 per cent and the operating leverage due to well controlled expense growth and tax reform lifting EPS 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 more than $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 in the next three years, pointing to significant market growth ahead. 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.
Microsoft is also 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 sustain in order to continue to grow overall revenue and earnings and justify peak multiples.
It’s well positioned to take advantage of huge structural opportunities, while expense discipline and cash returns ensure solid returns for shareholders.

UTILITIES SELECT SECTOR SPDR FUND (XLU.US)

This is our insurance policy: Utilities offer defensive protection in a volatile market.

Allocation to utilities creates a barbell strategy within the portfolio, offering downside protection in a volatile market.
The group offers income security, with a dividend yield of 3.4 per cent.
Operating within a regulatory framework gives utilities a clearer growth trajectory and means that they have less business risk and more earnings visibility than many other defensive sectors.
Strategic activity remains a key focus across the group, with many large players currently exploring potential transactions (Dynegy, NRG Energy, Calpine). Historical M&A in the sector has resulted in substantial synergies equal to 15 to 75 per cent of the acquired company's operating and maintenance costs.
The economics of renewables are improving at a rapid rate and we’re beginning to see significant deployment plans being laid out by some major players in the XLU (NextEra Energy, Duke Energy, Southern Co). These plans should drive above-average EPS growth due to the large number of incremental investment opportunities.
Utilities trade close to in-line with the market.