Jason Mann's top picks: Apr. 6, 2016

- Market weakness to start the year was based largely on the fear of a U.S. led recession, and in Canada the ongoing recession in the “resource economy”
- U.S. earnings have been weaker, but largely because of currency (strong US dollar hurts), energy, and stronger wages (hurts profit margins).  Stronger wages is a good thing for the bulk of the economy and should lead to stronger discretionary spending eventually.
- The U.S. services sector which is far more important remains strong, and employment remains strong.  Absent services showing weakness we think probability of recession is low.
- Canada had reached what we believe is a cyclical low from a valuation perspective, and we have “geared up” risk as a part of our process in the last month or so.  There were a number of things that suggested Canada had become “too cheap”:

1. 1/3 of the TSX was trading at or below book value.  that has only happened a few times and always near market bottoms (1982, 1990, 2008)
2. From a U.S perspective (who are the marginal buyers of our market) the TSX had fallen 45% from peak to trough, in-line with the 40% average decline that has marked bottoms over the last 50 years
3. We are in month 22 of a bear market in Canada, the second longest in 60 years and well in excess of the average 11 months

- It’s been a challenging environment for long/short hedge funds.  Hedge funds typically have exposure to the “momentum” factor where they own stocks that have been winning and short those that have been losing.  This strategy “crashed” in March with last year’s losers materially outperforming (think Energy stocks), and last year’s winners (think the “FANG” stocks) materially underperforming.
- We think that the emerging trend is a shift away from “momentum” or growth stocks, and a rotation to “value” stocks.  This is a good thing for Canadian equities as these stocks tend to be cyclical or resource stocks.  We are finding lots to buy in the energy, materials, and industrial sectors.

TOP PICKS:

Turquoise Hill Resources (TRO.TO) 

- Emerging copper producer in Mongolia, majority owned by Rio Tinto
- Owns one of the best underdeveloped copper assets in the world
- Currently cash-flowing from its low grade, low cost, open pit mine.  40+ yr life for the asset with underground expansion starting in July of this year
- The company is cheap given the asset they have: 6x EV/EBITDA, 0.6x book value, has cash of $1.34 Billion and is fully funded for their portion of the expansion cost.  It has improving price momentum as well.
- Rio Tinto has effectively managed to do a creeping takeover of the company over the past number of years, and the “bonus” scenario is a take-in of the minority by them
- If you are Rio, the logical time to do that is at the bottom of the cycle, and if we are there now, then could be an event in the next 6-12 months.  There have been rumours in the press that Rio has hired advisors for a bid, and while it’s never a reason for us to own a stock, the companies that tend to get bought are those that are of strategic value, cash flowing, and cheap.

Westshore Terminals (WTE.TO)

- Leading coal export terminal on west coast with approximately 75% to Asia, 10% to Rest of World (South America and Europe)
- Both thermal and met coal markets – and both have been poor
- Have seen volume weakness and announcements of further production and shipment curtailments, and we’re going to see more volume declines in the near term - calling for declines in volumes of 16% in ‘16
- Cheapest valuation since ’09, half of its longer run average.  Trades at 5.3x EV/EBITDA, 8.2x PE, 10x FCF.  Solid balance sheet with no net debt.
- Post their dividend cut last year the stock has moved up and now has good price momentum – the selling pressure has come off considerably
- Jim Pattison owns 24% of company so the float is not that big
- They are well-positioned when markets rebound, and you won’t go broke owning them while you wait, the dividend is sustainable, and as a strategic asset that can’t be replicated you have optionality owning it

TransAlta (TA.TO)

- Has been a bit of a “broken” story as a coal-based utility that now needs to transition to a renewable business, but they are now well on their way to doing that
- But, we think most of the bad news is behind them – they cut their dividend recently to shore up liquidity for the transition to renewable.
- 3.8x CF, 0.7x book value, 7.3x EV/EBITDA.  Stock price momentum has materially improved recently as well so the “redemption cycle” appears to be behind them
- Stock is cheap given premium asset and mgmt. team: trades at 7.1x CF, 8x EV/EBITDA
- What is perhaps most interesting is that the press reported that they were in talks that broke down in the fall.  We suspect the buyer was Brookfield, who filed that they own a 4.6% stake in the company.  Brookfield made the filing last year, but asked for a special exemption so that the filing was private for 6 months.  You only do that if you either want to acquire more of the stock which we think they may be doing, or if you want to buy the company and not have your purchases move the price
- Bottom line, we think it’s a cheap company that again has a free “option” of a take-out event as it comes off the bottom of the cycle

Past Picks: May 25, 2015

Badger Daylighting (BAD.TO)

Black Diamond Group (BDI.TO)

*Short* Algonquin Power (AQN.TO)

Total Return Average : -36.40%