Dec 21, 2018

Don Lato's Top Picks: Dec. 21, 2018

BNN Bloomberg

Don Lato , BNN Bloomberg

Don Lato, president of Padlock Investment Management

Focus: North American equities

MARKET OUTLOOK

For several months, North American equity markets successfully climbed the proverbial “Wall of worry”. The last three months however have told a different picture as the old worries intensified and were joined by a new batch including the progression of the Mueller probe, quantitative tightening by the Fed decreasing liquidity, a potential government shutdown in the U.S. and the latest worry of increased turmoil within the U.S. administration. All of these concerns increase uncertainty and if there is one thing that markets do not like, it is uncertainty.

The added uncertainty combined with year-end tax-loss selling, hedge fund redemption and worrisome corporate reports (Micron and FedEx) have all tipped the scales leading to the substantial declines during the quarter and particularly this month(on pace for the worst December for U.S. equities since 1931). The irony is that one of the recent negative catalysts was this week’s statement from Fed Chairman Jerome Powell that the Fed remains committed to further interest rate hikes because of the underlying strength of the economy.

The current environment has brought many quality companies down to valuations that they not seen in years, if ever. There is always the possibility that the some of the current concerns will create economic issues down the road that could indeed cause further deceleration in earnings growth. Under that scenario, even those lower multiples won’t be enough to stop further price declines. The upcoming earnings season starting in mid-January will be crucial in helping set the tone for next year. In the interim, long-term investors will be re-examining their asset allocations with an eye toward bringing their equity weightings back up to their desired level. Any re-allocation to equities could provide the fuel that will be needed to stop the decline and move markets past this short-term cyclical bear market and into the next stage of a bull market.

TOP PICKS

PAREX RESOURCES (PXT.TO)

Latest purchase was last week at $15.46.

Parex, a Top Pick in my last appearance, was in the news earlier this week when they announced that the strategic review that began in July did not find an acceptable bid for their developed properties in Columbia. As mentioned during their last earnings call in November, plan B was to return cash to shareholders and plan B was enacted with an issuer bid of 10 per cent of the float that starts today.

In this week’s release, Parex highlighted that the issuer bid should be easily funded with their 2019 free cash flow (after planned 2019 capex) thus leaving the bulk of their $200M of current cash position untouched. The company also increased production guidance for the fourth quarter and for 2019. Production in 2019 is now expected to grow to 52,000 to 54,000 barrels of oil equivalent per day or 20 per cent growth over 2018. At current consensus estimates Parex is trading at 2.6 times 2019 cash flow which is a ludicrously low level for an energy company that receives Brent pricing. It is not encumbered by the restrictions that Canadian producers encounter, is debt free with $1.15 per share of cash and is projected to grow production and cash flow by almost 20 per cent per year.

GREENSKY (GSKY.O)

Latest purchase was last week at $9.20.

GreenSky is a rapidly growing fintech company that has largely disappointed investors since its IPO in May. The stock fell precipitously following its latest earnings release in early November but appears to be building a solid base around the $9.00 mark helped by a recently authorized buyback of 10 per cent of the company’s shares.

The company has a proprietary technology that interfaces with consumers, select national and regional banks and service providers to automate loans for the consumer to acquire the services of their desired vendor. After operating exclusively in the home renovation and repair market, the company now also serves the elective healthcare market.

Consensus earnings estimates for 2019 are 68 cents per share providing a price-earnings multiple of just over 13.0 times. The company remains confident that they can produce the 20 per cent plus growth rate that has been highlighted in their investor presentations. Should GreenSky deliver on its forecast, its earnings growth combined with an upward multiple revision should translate into above average returns.

NFI GROUP (NFI.TO)

Latest purchase was last week at $34.94.

After being a market darling for several years, NFI Group has fallen distinctly out-of-favour by dropping over 45 per cent from its all-time highs in April. Trade and tariff concerns surrounding aluminum and steel served as the initial catalyst for the decline. Other concerns that have arisen include the sustainability of NFI’s earnings in an economic slowdown, the growth of its more economically sensitive motor coach division and new competition entering the market.

Those concerns were addressed last week in an excellent report by Cameron Doerksen of National Bank Financial Markets who argued that NFI’s fundamentals remain solid and the stock is now trading well below its historical valuation range. Using Doerksen’s estimates, NFI is trading at 6.1 times 2019 enterprise value to earnings before interest, taxes, depreciation and amortization compared to its average multiple of 9.0 times. At a 9.0 times multiple the stock could reach his $55 target.