Jun 27, 2018

Don Lato's Top Picks: June 27, 2018

BNN Bloomberg

Don Lato , BNN Bloomberg

Don Lato, president of Padlock Investment Management
Focus: North American equities

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MARKET OUTLOOK

As trade war rhetoric has intensified, markets have reacted negatively, trimming the solid returns that had been achieved during the second quarter. Although no portfolios can be totally immune, a well-diversified portfolio that has holdings across many industries can help soften the blow while the current uncertainty dissipates. Companies negatively impacted by reduced trade and a curtailment of the global economic expansion will be hurt, but those whose business is more domestic and/or less dependent on a strong economy, should fare relatively better.

Overall market valuations continue to be reasonable. The strong reported earnings in the first quarter are expected to continue as companies begin to report second-quarter results three weeks from now. Padlock continues to be constructive over the medium- to long-term as increased reported earnings should help to limit significant further downside. Should the current volatility continue on the downside, valuations could move from “reasonable” to “attractive,” with the possibility of a price-to-earnings (P/E) multiple expansion coming into play. Investors should be looking at the current market environment as one that’s presenting opportunities to enter as opposed to one which suggest exiting equities.

TOP PICKS

ROOTS CORPORATION (ROOT.TO)

After a solid fourth-quarter report, the company’s seasonably strongest and most important quarter of the year, Roots missed estimates in their second-quarter release in early June and the stock has sold off dramatically. A significant factor in the earnings miss was the April ice storm occurring during their annual four-day promotional event.

Backing out the impact of the ice storm, same-store sales (SSS) would have grown over 8 per cent, but still came in at a very respectable 6.2 per cent, including double-digit SSS in their U.S. operation. The growth in SSS was the ninth consecutive quarter of SSS growth. Impressively, gross margin expanded during the quarter as the company’s United Brand Range (UBR) strategy continues to have a positive impact.

The stock trades at a very reasonable P/E multiple of 11.3 times next year’s earnings. As investors begin to appreciate the growth and operational improvement in UBR, the stock should be rewarded with a more appropriate multiple and higher prices.

GILEAD SCIENCES (GILD.O)

In general, valuations in the large-cap biotechnology group have retreated to levels not seen in years. A recent study done by Jefferies Financial shows that, for only the second time in the last 15 years, forward P/E multiples for the group are lower than both the S&P 500 and the pharmaceutical group. Those multiples are also at ten year lows on an absolute basis.

Gilead is no exception as it trades at a P/E of 10.7 times next year’s consensus earnings. The company has seen earnings flatten over the last couple of years as sales of its very successful Hepatitis C franchise have fallen. To offset the decline, Gilead has made recent advances in the oncology area through the purchase of Kite Pharmaceuticals late last year and through its own research in the NASH or fatty liver area. Major product releases are expected in this area early next year.

In the interim, the company has ample free cash flow to support its 3.3 per cent yield and hefty buyback program. Gilead also offers diversification away from more economically and trade-sensitive groups.

EQUITABLE GROUP (EQB.TO)

Equitable Group is the leading player in the Canadian alternative mortgage market. Its share price and business model came under attack last spring as problems surfaced concerning its major competitor, Home Capital. In order to assure a continued supply of funding, Equitable chose to fortify it by taking on a sizable and expensive standby facility.

Changes to lending laws have also had an impact on Equitable’s growth, but the company has continued to produce solid earnings through this period. With a more stable funding environment and greater assurance of the company’s long-term growth, Equitable announced last week that it would be retiring a significant portion of that standby facility.

The increased earnings in 2019 resulting from the cost savings of retiring the facility have brought the P/E multiple down to just 5.5 times next year’s earnings. A very significant short position in the stock, estimated to be 15 to 20 per cent of the share float, can become a catalyst for an upward move in the stock. A modest move from its current Price to Book (P/B) of 0.85 times back to January 2017 levels of 1.1 times would imply a return of approximately 25 per cent.