MARKET OUTLOOK

This may be the shortest comment we have produced in a while because we feel the market setup is more straight forward at present. Of all the conditional factors we look at to gauge sentiment and market risks, virtually none suggest now is the time to be adding exposure.

To name a few of the higher-efficacy macro/conditional factors we watch, the relative strength of asset managers, semis, transports and small caps are all at or near lows. For background, odds of success increase when positive price action is confirmed by new highs in relative strength. Accordingly, new RS lows is a warning sign that now is NOT the time to be adding exposure.

Credit, long a market indicator we’ve flagged, continues to demonstrate weakness as peak issuance was met with widening corporate credit spreads. Indeed, late October saw new recent wides in both high yield and investment grade credit, so it’s not isolated.

On earnings, the U.S. dollar is getting stronger which is a headwind for earnings. While it appears S&P 500 EPS growth will be comfortably in the mid-20 per cent range this year, it appears the implied margin expansion baked into consensus 2019 and 2020 numbers is overly ambitious. Goldman Sachs recently revised their forward numbers down for exactly this reason and we expect others to do so over the coming 3 months. 5-6 per cent EPS growth in 2019 isn’t terrible, but it’s hard to justify a higher market on that basis, particularly when global PMIs are almost all decelerating.

Also telling, our process-driven tactical allocation strategy added 20 per cent points in fixed income over the last quarter, all short-dated North American government bond exposure, while equity weight declined by about 35 per cent points, leaving cash higher. The equity exposure, heavily tilted toward U.S. Health Care, holds the least Canadian and international exposure as at any point in the fund’s history. While some markets outside the U.S. still look attractive, e.g. Norway, they are few and far between.

Unfortunately, Canada is technically weak and fundamentally challenged by rising rates pressuring an over-leverage consumer. Canadian banks have quietly been draining liquidity from the system and now the growth in total household credit is BELOW the level experienced during the financial crisis (See Chart). We suspect this is being done in anticipation of coming credit challenges, mostly related to consumer and mortgage credit strain, but nonetheless it will ultimately contribute to the problem. In short, be very careful investing in Canadian equities for the foreseeable future.
 

TOP PICKS

iShares US Medical Devices ETF - (IHI.O)

• POSITIVE – Stable end market fundamentals and new product launches (cardio & diabetes) should boost revenues & support the sector.
• Group exposed to positive secular trends: aging population, lifestyle diseases/obesity epidemic, emerging market demand.
• Offers investors defensive, yet, growth tilt - Channel checks demonstrate stable end markets (Cardio, Diagnostics, Surgical, Tools) with respect to volumes and pricing.
  • Quality exposure, with stable earnings. 82 per cent of the top holdings (comprising 75 per cent of IHI weight) beat bottom and top line Q3 consensus estimates. Additionally with an average revenue growth rate of 10 per cent.
• Growth characteristics steaming from diabetes & TMVR (Transcatheter Mitral Vale Replacement) recent positive readouts
  • 29m Americans with Type II diabetes (and an additional estimated 84m adult American prediabetics). Market for medical devices is in the double-digit billions and largely unpenetrated while we are on the cusp of the first large new product cycle (insulin pumps & continuous glucose monitoring (CGM) systems).
  • ABT had a successful COAPT study that surpassed even the most optimistic forecasts on its MitraClip bringing TMVR devices closer to commercialization. TMVR market is expected to be potentially 4x the size of the TAVR market (MDT expects this TAVR market to be US$3B by 2022 growing in mid-teens). 
• After the October pull-back, valuations are very reasonable (top 5 holdings have an average forward PE of 19x).

Utilitie Select Sector SPDR Fund - (XLU.O)
 

• POSITIVE – 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.
• With midterms over, the split house reduces the probability of more fiscal stimulus causing investors to temper down their expectations for yield increases. This increase the attractiveness of the 3.3% forward dividend yield.
• Earnings visibility - 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.
• Economics of renewables are improving at a rapid rate and we are beginning to see significant deployment plans being laid out by some major players in XLU (NextEra Energy, Duke Energy, Southern Co). These plans should drive above-average EPS growth due to the large number of incremental investment opportunities.
• With uncertainty increasing, liquidity declining and cyclical indicators flagging we advocate increasing exposure to defensive areas such as Utilities.

Microsoft Corp - (MSFT.O)
 

• POSITIVE – We are Neutral on Technology however Software continues to perform well and we like MSFT’s defensive business model.
• MSFT has set itself up to be a key beneficiary of many of the critical themes such as cloud (Azure), AI and IoT while still benefiting from the shift of Office users to higher value subscription plans.
• Q1’19 was yet another clean beat for MSFT with strong sales growth (+18 per cent y/y) and improving margins ahead of consensus. Cloud +46 per cent (Azure +76 per cent), LinkedIn +34 per cent, Office 365 seat growth +29 per cent so key categories continue to perform very well. Guidance bracketed the street.
• Office365 now has over 150MM total commercial and consumer users driving mid-teens growth with the help from mix as usage expands and customers trade up to higher value plans. MS believes the O365 commercial business could more than triple by 2023 (to > US$40B) as the installed base increases and pricing averages positive high single digit growth.
• Azure was up +76 per cent y/y 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 (~+17 per cent EBIT CAGR thru 2020). MSFT’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.
• GitHub acquisition (the largest global open source code repository) for $7.5B provides direct access to 27MM developers that should help expand the use of MSFT tools & services.
• MSFT is well positioned in other growth areas such as gaming (+36 per cent in Q1), data centers, machine learning and AI providing further support to the outlook for the stock.
• 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.
• All in, well positioned to take advantage of huge structural opportunities while expense discipline, a strong balance sheet (US$58B net cash) and cash returns ensure solid returns for shareholders.

PAST PICKS: November 7, 2017

Becton Dickinson & Co - (BDX.N)

• POSITIVE – BDX is a diversified leader in drug delivery products benefiting from strong end-market fundamentals and cost synergies resulting from the CareFusion & C.R. Bard acquisitions.
• Ongoing solid worldwide hospital capital spending environment - a positive for hospital CAPEX names like BDX.
• The company is exposed to positive demographic trends with aging populations needing greater amounts of drug delivery equipment.
• Messy FYQ4 combined with the October sell-off leaves BDX trading at a reasonable 17x forward earnings.
  • FYQ4 earnings miss and weak guide were due to a number of factors: stronger USD (~45% of revenues are OUS), tariffs (though management is working with suppliers to offset cost increases), resin input cost (owing to capacity constraints due to the hurricanes in the US & a supplier bankruptcy).
  • Nothing fundamental has changed, core business remains strong & showing momentum. These are viewed as transitory as management sees FY19 revenue +8.5-9.5%. Consensus EPS to grow in mid/low DD.
• C.R. Bard acquisition provided BD with a strong non-overlapping consumables portfolio, growing faster than BD, with cost synergies amounting to $300M annually by FY20.
   
• Then: US$221.27
• Now: US$240.33
• Return: 9%
• Total Return: 10%

DowDuPont - (DWDP.N)

• NEGATIVE – Although typically a late cycle outperformer, Materials screen negatively on our process. We turned negative on Dow in March 2018 when the relative price trend broke down and increased trade war rhetoric and weakening global growth muddied the fundamental outlook.
• DWDP recently hosted an analyst day outlining longer-term management focus on capital allocation, cost savings and efficiencies. Along with more shareholder friendly compensation targets this new focus should help increase the earnings outlook and drive longer-term value for shareholders.
• Q318 was a strong quarter with both pricing and volume +5 per cent and up across almost all segments and regions. Despite higher raw material costs and FX headwinds, EBITDA was still ahead of consensus and guidance was inline, which was a positive surprise. The company also upped their cost synergy targets to US$3.6B and introduced a US$3B accelerated buyback.
• The more efficient corporate structure, which will help crystalize the SOTP argument, is expected to be realized April 2019 (Ag, Materials, and Specialty have their own cycles and drivers and thus multiples, which have been depressed by the conglomerate structure).
• DOW is a key beneficiary of the US shale gas boom, which provides it with a cost advantage relative to global peers (specialty plastics).
• However, DWDP is a cyclical and the macro picture has deteriorated for key end markets such as housing and autos as well as global growth, which in turn will likely weigh on the multiple and the organic earnings outlook.
• 8x ’19 EV/EBITDA and 12.5x P/E is optically cheap given the double digit EPS outlook but it is a premium to peers and the cyclical risks to earnings are real.

• Then: US$71.14
• Now: US$58.16
• Return: -18%
• Total Return: -16%

E*trade Financial - (ETFX.O)

• NEGATIVE – cyclical tailwinds have largely run their course or be priced in, but optionality from potential merger remains
• New management committed to growing top line or realizing value other ways; to date this hasn’t been a problem but the last quarter was the first in 10 quarters when revenue growth didn’t accelerate (although 23 per cent YoY growth really isn’t weak)
• Higher rates are a natural revenue tailwind; management has been clear on interest rate sensitivity, but net interest margin was a little disappointing last quarter
• Deposit beta is becoming a headline issue now because deposit gathering is becoming competitive and banks are starting to pay-up for deposit balances; this reduces the benefit of higher rates
• Share count expected to fall by 10 per cent in 2018 
• Risks include: 1) stalling short-term interest rates, 2) aggressive deposit pricing across banking industry, and 3) pricing, either through competition with existing players 
  • External risks like these increase the chance of a takeover by AMTD or another player, particularly given the valuation discount vis-à-vis pe ers

• Then: US$43.62
• Now: US$52.21
• Return: 20%
• Total Return: 20%

Total Average Return: 5%

Fund Profile

Equium Global Tactical Allocation Fund
Equium Capital’s tactical strategy combines the best elements of traditional and alternative investing. The investment team views markets and investments through the unemotional lens of technical analysis and then supports those findings with bottom-up fundamental research.  This conservative investment process minimizes risk by allocating capital only when and where managers find compelling risk-return opportunities. Accordingly, portfolios should be better protected during market declines while still participating during market upswings.

Performance as of Nov. 8, 2017
 

• 3 Month: -4.2% Fund. -5.2% Index*
• 1 Year: 1.2% Fund, 1.4% Index*

Inception: 0.3% Fund, 1.9% Index*

* Index: TSX Comp
* Returns are net of fees
**Inception: Apr 3/17 on an annualizated basis

5b. Include the top 5 holdings and weightings.

1. Cash & Cash Equivalents -16.7%
2. iShares 1-3 Year Treasury Bond -12.5%
3. iShares Canadian Short Term Bond Index ETF - 9.2%
4. SPDR S&P Aerospace & Defense ETF - 8.0%
5. Vanguard Cdn Short-Term Bond Index ETF - 6.2%