Jan 8, 2018

James Telfser's Top Picks: January 8, 2018

BNN Bloomberg

James Telfser , BNN

James Telfser, partner and portfolio manager at Aventine Asset Management
Focus: Canadian equities
_______________________________________________________________

MARKET OUTLOOK

In 2017 we delivered industry-leading performance for investors in the Aventine Canadian Equity Fund (“ACE Fund”), returning +17 per cent after all fees versus the TSX Total Return Index at +9 per cent. This marks the second year of the past three where the ACE Fund has been in the 99th percentile of Canadian Equity funds tracked by Morningstar. As we enter 2018, we see strong momentum in the global economy, continued growth in corporate profits and the persistence of easy financial conditions. In short, we are in an environment where global equities should produce above average returns for investors.

The chorus of pundits calling for a market top is louder than ever and indeed markets are top on good news, not bad. However, a disciplined model-based approach to managing the long, short and net investment exposures in our portfolios has kept us near fully invested since mid-2016, with great results. Like many other managers, we monitor the common recession indicators closely during the later stages of a bull market, but given near-zero recession risk over the next 12 months, we are nowhere near throwing in the towel. We are interested in seeing how inflation performs this year and the impact that anticipated monetary tightening may have on financial conditions. We believe that these — along with weaker than expected earnings — are the major risks to the bull trend in 2018.

Canadian equities were a significant laggard in 2017 and we see strong potential for a catch-up in the coming year. In our view, industrials, non-bank financials, energy and materials will be the best ways to participate. Traditionally we prefer to invest in non-resource industries, but from time to time we see risk/reward opportunities in these sectors that are too compelling to ignore. For this reason we have over 20 per cent invested in what we believe are the best ways to take advantage of the move higher in energy/materials in early 2018. We continue to find excellent catalyst rich opportunities in financials and industrials, which is where we have concentrated the bulk of our investment portfolio.

New followers of the ACE Fund should learn that we are concentrated value investors (20 stocks) and that our investment process requires portfolio companies to possess one or more clearly defined event catalysts, such as earnings, M&A, a divestiture, etc. 2017 was so successful for us in part because we had several portfolio positions acquired by U.S. private equity (RDM Corp, Halogen Software, and Napec Inc.). In a recent meeting of our investment committee we discussed the M&A outlook for 2018, concluding that high levels of profitability, financial health and CEO optimism, combined with low borrowing costs and the still weak loonie, should keep mid-size Canadian firms in the acquisition crosshairs of global consolidators.

TOP PICKS

IBI GROUP (IBG.TO)
We continue to view IBI Group as an underfollowed and undervalued architecture/engineering company with significant catalyst potential. Not only do they have attractive exposure to the growing global infrastructure/urban development theme, but they have been working on unlocking the hidden value embedded in their proprietary technology platform that manages transit networks, building systems and other large infrastructure projects. After bringing on a new management team and significantly improving the balance sheet, IBI is hitting their stride The underlying business is healthy, and we really like the fact that a competing firm recently spun out their own technology platform at a significantly higher multiple than what is currently priced into IBI’s valuation. Focusing the market on their “smart city” intelligence platform helped drive the stock higher in 2017, and we believe this trend will continue through 2018 as the company (1) formally launches their technology platform, (2) further improves the health of the balance sheet, and (3) capture new project wins from increased government infrastructure spending. We think the intelligence business with its recurring revenue and margin characteristics really has the potential to drive multiple expansion in the stock, which at 8x our forecasted EBITDA, does not represent the true value of this business.

WINPAK (WPK.TO)
Winpak has been a winner in our ACE Fund portfolio for a long period of time, but has recently struggled to regain its momentum. As a packaging company that uses inputs whose costs are derived from the price of oil, we are not overly surprised by this given current spot pricing and recent disruptions from hurricanes in the U.S. There has also been a shift in customer tastes towards more environmentally-friendly packaging, which has impacted short-term sentiment as they pivot some manufacturing (at a lower margin initially). Winpak is a conservatively-managed company with a significant cash position (10 per cent of market cap) and very attractive characteristics as a takeover candidate. Notwithstanding recent trends in the industry, we remain bullish on their packaging business and continue to believe organic growth will be present given their ever-increasing customer base and product placement/marketing trends in the consumer goods sector. With the shares off 25 per cent from the high we believe the risk/reward is skewed to the upside given extreme negative sentiment and M&A chatter in the industry (Amcor, Bemis, Berry Plastics). At 11x EBITDA, valuation risk is low and we would be very comfortable adding to our position here.

EVERTZ TECHNOLOGIES (ET.TO)
Evertz is a recent addition to the portfolio and comes after scouring the Canadian equity market for attractively valued technology companies (with real businesses) that were poised to outperform or attract interest as an acquisition target. Evertz is a very healthy business that operates in the audio/video equipment space with an increasing focus on software-defined video networking ("SDVN"). We believe Evertz should outperform expectations in 2018 as they capitalize on the strength of their backlog and momentum in their SDVN business. Interestingly, Evertz products started to be included in sales presentations made by Amazon AWS/Discovery towards the end of 2017, which could be a huge tailwind for the business. We like the fact that very few of our investors or colleagues have heard about this company, which creates a natural opportunity for multiple expansion as sell side analysts begin to cover the company and institutional investors start to notice it. Overall, we believe that Evertz offers a great combination of value (11.5x EBITDA), growth (10 per cent revenue growth), income (4.1 per cent yield) and catalyst optionality given the attractiveness of their technology platform to a strategic buyer. There is a nice buffer built into 2018 as Evertz generally realizes surges in activity around events such as the Olympics, elections and other major sporting events (FIFA World Cup), of which there are plenty this year.