Oct 29, 2018

Don Lato's Top Picks: Oct. 29, 2018

BNN Bloomberg

Don Lato , BNN Bloomberg

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

MARKET OUTLOOK

Markets across North America have entered correction territory. Corrections are fairly normal occurrences within ongoing bull markets and Padlock believes that we’re still in the midst of one. In fact, 58 per cent of the times the S&P 500 has fallen by 10 per cent since 1928, the declines stopped before the index could fall by another 10 per cent.

Most times when a 10 per cent correction has been followed by an additional decline of 10 per cent or more, the move is accompanied by a recession. There’s some interesting work done by a service that I use called SentimenTrader, which examined 10 per cent declines in the S&P against their proprietary recession indicator. Said indicator, which has an above-average record of forecasting the probabilities of a recession, is currently indicating a 0 per cent chance of one happening in the U.S. Over the last 50 years, with the recent parameters of a 10 per cent correction and a 0 per cent chance of a recession in the next 12 months, there have been two declines of less than 5 per cent, two years of gains between 6 and 11 per cent and four years of 12 month returns greater than 20 per cent, with an average return for all eight occurrences of just under 16 per cent.

The other historical aspect that equities have in their favour is that a president’s third year in office has the highest average return in their four-year term. The average third-year return is 16 per cent, while under a Republican that return rises to 21 per cent, with all of them being positive. Obviously, when dealing with future market returns, unforeseen events can be very impactful, but historical precedents can be used as a guide. Taking into account the above precedents, people should stay invested in sound, long-term businesses whose outlooks are under or fairly valued.

TOP PICKS

PAREX RESOURCES (PXT.TO)
Last purchased in August at $19.10.

After being the best-performing energy stock in Canada this year, Parex’s share price has come under pressure since its July 17 announcement it’s examining the sale of their development properties in Colombia and a return to their roots as an exploration company. The initial weakness was exacerbated by the company’s last earnings release in early August, with the news it abandoned two wildcat wells. This news accompanied an otherwise solid second quarter earnings release that included guidance for an increase in overall production this year.

Following that earnings release, Parex announced two additional exploration successes, which were well received for a very short time. The stock, however, was again driven down with the overall market decline. Nonetheless, investors have clearly overreacted to this combination of news and are overlooking the tremendous cash flow (estimated at $5.77 per share for 2020) that Parex continues to generate. The company should be of great interest to a variety of potential acquirers.

My overall investment view is that stocks are generally priced rationally, but have periods of irrationality that must be taken advantage of. The current irrationality around Parex, now trading at a price to cash flow multiple of 3.4 times 2020 cash flow, is presenting a tremendous buying opportunity that must be acted upon.

APPLE (AAPL.O)
Last purchased on Oct. 29.

In times of uncertainty, having a solid foundation for your portfolio is of paramount importance. Since Apple is the largest holding in Padlock’s, the tech giant should act as your portfolio’s foundation if you’re building one today.

In the current market turmoil, Apple has held up better than the rest of its FAANG counterparts, but is still down almost 7 per cent from its all-time high earlier this month. Apple reports their fiscal fourth quarter results this Thursday after the close and if the past two quarters are any precedent, a positive earnings report from Apple could act as the catalyst for a rebound in the overall technology group.

I’m anticipating a strong quarter based on a higher average selling price for the iPhone along with continued strong growth in the services sector. The current consensus estimate for the next fiscal year (Sep. 30, 2019) is $13.52 per share, which projects a still low 16 times earnings, or less than 14 times minus the company’s net cash.

BORGWARNER INC (BWA.N)
Last purchased on Oct. 29.

In spite of rallying over 6 per cent since its earnings release last Thursday, BorgWarner is down 35 per cent from its high earlier this year. Auto stocks, which are particularly hurt by the tariff wars, are among the weakest groups in the S&P this year. In spite of declines in industry revenues and profits during the year and particularly the last quarter, BorgWarner exceeded expectations by growing revenues and earnings 2.6 per cent and 5.3 per cent respectively.

As discussed during the earnings conference call, BorgWarner has had significant contracts recently awarded that continue its growth in the hybrid and electric vehicle markets. Although industry growth in the fourth quarter is expected to be negative, BorgWarner is still guiding toward modest revenue and earnings growth for the quarter. The company is currently trading at a price-to-earnings multiple of 8.2 times 2019 earnings, which is 60 per cent of its average multiple for the last five years. This valuation represents a great long-term entry point.