Full episode: Market Call for Monday, September 17, 2018
Jason Mann, chief investment officer at EdgeHill Partners
Focus: North American equities
- Global markets remain in a funk after the volatility bomb this past winter. The only trend for most of the world is that there’s no trend. Most markets seem trapped in a technical range, unable to break out to new highs, but also not cracking to the downside.
- The U.S. is the main source of strength. American markets have shown signs of strength on the back of good earnings, but they’re increasingly becoming the last man standing.
- Sector leadership has been inconsistent as well. It seems like every month there’s a shift in what sectors are working.
- One thing that has been consistent until recently is the performance of growth stocks over value stocks: Growth has trounced value, with the FAANG stocks in the U.S. and cannabis stocks in Canada being poster children for this phenomenon.
- Playing defence has been tough as well. Ironically, one of the best strategies year-to-date would have been buying a basket of the “most shorted stocks.” Even on days where the market has sold off, we’ve noticed that lower-quality stocks that hedge funds use as shorts have tended to outperform. It’s not unprecedented, but it’s unusual and it reminds of us 1999.
- High-priced growth isn’t confined to the tech sector and not all tech stocks are expensive, but overall the valuations are back to the highs reached in 1999-2000. As a per cent of the index, the tech sector is back to levels of the dot-com era.
- We think that the growth investing style, which dominated last year’s returns as well, is at most risk. Investors should be looking to rotate to higher quality, lower valuation stocks found in materials, industrials and discretionary sectors. For yield, REITs have the best risk/reward in our view.
- Net-net, earnings are still good and overall growth in North American is fine. International markets are under more pressure on that front and a full-blown trade war will be a problem, but it’s possible a good portion of that risk is already priced in the market.
- We believe we remain late-cycle, but perhaps not end-of-cycle just yet.
HYDRO ONE RECEIPTS (Hir.TO)
This one is a little unusual. Let’s start with Hydro itself, which has had quite a ride since going public, doing some large M&A purchases and then having the entire management team essentially fired by the Doug Ford’s government. It’s probably not a surprise the stock has suffered and that it’s become cheap enough that it’s interesting to us now. They have a high-quality regulated business, strong growth profile, solid balance sheet and a reasonable payout ratio supporting their 4.6 per cent yield.
Hydro One trades at 11 times EBITDA and 15 times price-to-earnings, both reasonable relative to its utility peers. We don’t mind Hydro on a stand-alone basis, but there is another way to own it that is much more attractive.
Hydro issued “installment receipts” as a way to fund their pending purchase of Avista (AVA.N) in the U.S. With the receipts trading at $28, they have a few interesting outcomes: If the Avista deal closes, you’ll end up owning shares in Hydro, which we like at these levels. If the deal breaks, you’ll get $33.33 back, or a 20 per cent return from here. In addition, you get a 16 per cent yield on the receipts while you wait for one of these outcomes, so the total return is higher.
The deal could break as soon as the end of the month, but more likely next April which is when the receipts expire assuming no deal gets done. We think there’s quite a good chance that it does break, since the various approvals are going to be tough to get after the turmoil at the top for Hydro. Given that it’s no longer accretive to Hydro at these prices, they may well be better paying a break fee and moving on.
One thing to note: The receipt trades as a 3-to-1 levered version of Hydro shares, so consider this if you buy it. It will be three times more volatile (up and down) than the shares of Hydro.
We’re playing defence with this pick, and it’s the first time in a while that we have started to add anything in the pipeline or utility sectors. Our beef with the sector for a long time now was they were overpriced, but valuations have improved.
TransCanada is a pipeline and gas transmission company, and a power producer with North American infrastructure. It has a healthy backlog of projects that would support growth through the end of the decade, including optionality on Keystone XL, Bruce Power and Canadian LNG, any of which could be a catalyst. It’s been working through higher spend and funding and has done some asset sales as a part of this, but results have been good in the context.
The company sits at 16 times earnings with an attractive 5 per cent yield. It’s also a stable, defensive stock, which we like. Momentum and valuation overall are decent, and the stock has held up better than most despite rising rates.
Cineplex has been pummeled over the last year as it missed on earnings and its premium valuation was repriced as investors reconciled its slowing growth profile. But now, it’s fallen far enough that its valuation has improved materially and more recently its share price has found support with momentum improving.
It currently sits at about 10 times EBIDTA, 24 times price-to-earnings and 12 per cent return on equity, so it’s not the cheapest on those measures. They do pay a healthy yield at 5.4 per cent and the balance sheet is fine. Overall, it scores in the top 20 per cent of TSX companies on relative valuation.
Momentum has begun to turn as well: Cineplex had a big beat most recent quarter and that has taken the pressure off. This was actually a short position for us through 2017, but has gotten cheap enough and with a stabilizing trend has moved to a long.
While not a reason to own the stock, there’s interesting optionality for the company in terms of potential M&A. National Bank recently upgraded the stock on the possibility that BCE might be interested in buying Cineplex. While on the surface it seems like an odd fit, it would add to diversification in BCE’s media division as well as give them ability to control how content is distributed across platforms. There would be good synergies, and if they took Cineplex down to core businesses, there’s good cash generation.
PAST PICKS: JUNE 28, 2017
GENWORTH FINANCIAL (MIC.TO)
- Then: 35.91
- Now: $44.03
- Return: 23%
- Total return: 30%
COGECO COMMUNICATIONS (CCA.TO)
- Then: $80.12
- Now: $65.03
- Return: -19%
- Total return: -16%
*SHORT* FIRST QUANTUM (FM.TO)
- Then: $10.88
- Now: $15.39
- Return: -41%
- Total return: -42%
Total return average: -9%
EHP Select Fund
Performance as of: Aug 31, 2018
- 1 Month: 1.4% fund, -0.8% index *
- 1 Year: 11.1% fund, 10.1% index
- 3 Year: 9.1% fund, 8.7% index
* Index: S&P TSX Composite Total Return.
* Funds returns based on reinvested dividends.
TOP 5 HOLDINGS AND WEIGHTINGS
- Canfor Corp: 5.8%
- BRP Inc: 5.4%
- Interfor Corp: 5.1%
- Transcontinental Inc: 4.9%
- Methanex Corp: 4.8%