Ian Fung, vice-president and portfolio manager at Davis Rea
Focus: North American large caps

MARKET OUTLOOK

The global economic slowdown continues, though it’s not as severe as feared last December. Recession risk increased in late 2018, but hasn’t increased any further. Global manufacturing continues to downshift, with the automotive sector still the main source of weakness. We’re seeing some tentative signs that manufacturing activity is starting to stabilize, helped along by easier financial conditions and Chinese policy stimulus. Manufacturing activity should pick up in the second half of this year, boosting the overall global economy and underpinning rebounds in earnings growth and commodity prices. That being said, some of the recent developments surrounding trade and tariffs could push this back further.

The extreme pessimism among investors in December has given way to optimism. The key ingredient to the improved mood was the shift away from planned interest rate increases by central bankers, but especially the U.S. Fed, which has stated they’re open to cuts if trade tensions continue. As with corporate bonds, we worry that sentiment has gone too far. Earnings are slowing and will slow further along with the global economy, with more downward revisions to earnings estimates. However, with economic activity expected to rebound later this year, equity markets are expected to end the year on a positive note.

Our base case view is for manufacturing activity to bottom this summer and strengthen in later 2019. The outlook for equities, corporate bonds, commodities, and the Canadian dollar is expected to improve in tandem with global manufacturing.

Several U.S. industries look attractive on valuation, macroeconomic and longer-term thematic considerations: defence, industrials, transportation, technology and banks. In most markets, commodity industries have been beaten down and should get a lift from the rebound in manufacturing and commodity prices. Aside from problems in small economies like Canada, the global consumer is in very good shape and this will benefit large, non-automotive and consumer-oriented companies.

Downside risks are still based on U.S. interest rates, trade and geopolitical frictions. The slowdown could yet morph into recession with greater weakness in asset prices, commodities and the loonie. Alternatively, higher equity and corporate bond prices, Chinese policy stimulus, and hopefully productive U.S.-China discussions could boost confidence and bring the slowdown to an end before summer.

TOP PICKS

ACCENTURE (ACN.N)

Accenture is the world’s largest consulting firm. It provides management and technology consulting services and solutions to clients globally. The company has been pivoting since 2014 to focus their consulting business on newer areas such as digital experience, data analytics, cybersecurity and cloud services, which now collectively comprise around 60 per cent of their revenues and 65 per cent of their future bookings. They have achieved this through organic growth and tuck-in acquisitions.  It carries a pristine balance sheet with almost zero debt and generates an abundance of free cash, in which about 50 per cent is allocated to organic growth and 25 per cent each for acquisitions to grow the business and to shareholder return through a dividend (currently yielding 1.6 per cent) and share repurchases. As the world focuses more on digital channels, Accenture is well positioned to benefit from the continued shift to cloud computing, and greater focus on data-driven digital insights and experiences.

SYNOPSYS (SNPS.N)

Synopsys is a leader in electronic design automation solutions for the global electronics market. It provides tools and intellectual property to assist in the design of semiconductors primarily through a subscription model. These include design software, consulting services, and solutions to check code for errors. Semiconductor designs have been increasing in complexity as the demand for increased computing power grows.  Synopsys provides the foundation for companies to design more complicated chips and integrates design between hardware and software. The company has a clean balance sheet, with recurring revenue of over 90 per cent that generates strong free cash flow. It’s been growing organically after purchasing Black Duck Software in 2017, a company specializing in securing and managing open source software. It continues to grow as global demand for chip design increases.

SS&C TECHNOLOGIES (SSNC.N)

SS&C is a developer of computer software for financial service providers for functions such as trading, portfolio management, accounting and reporting. It develops software for both traditional and alternative asset managers. The company has historically been acquisitive as they roll up a fragmented industry, but SS&C has a great track record of integrating lower-margin businesses and increasing their profitability, over-delivering on synergy targets while paying down debt. The company has moved into offering additional services such as fund administration and is currently looking to grow in the Asia-Pacific region. The revenue is extremely sticky as switching costs are very high for clients, with 97 per cent of it recurring. It has a 95 per cent retention rates with clients. The company pays a modest dividend, yielding 0.70 per cent. It continues to reinvest capital into organic growth.

WEBSITE: davisrea.com
TWITTER: @DavisRealtd