MARKET OUTLOOK:

Markets continue to rally as economies reopen, with low interest rates, and ongoing fiscal stimulus from the Biden administration. Earnings have also been stellar, doing their best to catch up to some historically high valuations.

The last year or so has been much about the “growth to value” trade and an aggressive rotation into cyclicals as we reaccelerated off the COVID-induced lows. That rotation has taken a bit of a pause since March as investors have become concerned about two things: the rise of the Delta variant slowing the recovery, and the U.S. Fed looking to taper their asset purchases which would logically be followed by rate increases.

We think Delta won’t slow re-openings much, particularly in large economies like the U.S., which continue to take a “plough forward” approach overall. The other reality is that case counts are the less important measure than hospitalizations, an in particular hospitalizations among the vaccinated.

The Fed has made it clear that tapering does not equal rate hikes, and we think they will be accommodative for longer than currently expected. That, coupled with fiscal stimulus, is leading to a “transitory for longer” environment for inflation. So much so, in our view, that the real risk currently is “stagflation” where inflation increases as growth slows from its peak. 

In a stagflation environment, you want a barbell approach of stocks that benefit directly from inflation: commodities and related businesses, as well as high-quality, larger-cap, low volatility stocks with strong earnings growth (as opposed to speculative top-line growth)

That has us maintaining weights to high-quality cyclicals in materials (lumber, copper, steel) as well as related construction and transportation businesses, and then exposure to larger financial and technology businesses. We’ve moved to a net long on REITs as well while utilities are still underweight.


TOP PICKS:

Legato Merger (LEGO NASD) 
This one is a bit of a different type of pick for us, as it’s a SPAC currently, and there has been endless press both good and bad about SPACs over the last year. In this case we aren’t speculating on a high-flyer growth company where most of the SPAC attention has been focused, rather, Legato will become Algoma Steel if this deal goes through likely in October.

Algoma is certainly not new, having been around since 1902, went bankrupt in 2004, and was bought by Essar in 2007. Legato is merging with them, which will provide them cash, along with a US$400M loan on very good terms from the federal government to convert their blast furnace into an efficient “green” electric arc furnace. 

When the deal was struck, it was at a very cheap valuation of 1.9x EV/EBITDA using their 2021 numbers.  Subsequently, steel prices have continued to rally, up another 25 per cent, so this will come out at an even cheaper multiple.

The SPAC is trading at $11.50/share, but has deal risk in it – if they can’t close the transaction for some reason, you get your $10 back, so that’s your maximum downside. If they do close it, and the SPAC arbs are out of the way, we think the stock has a major re-rate higher to catch up to industry peers. It would need to rally about 50 per cent to trade in-line with Stelco (which we also own), and 100 per cent trade in-line with Nucor in the U.S.

We think it is really good risk/reward at this price which is artificially low given the dynamics described above.

GreenFirst Forest Products (GFP TSXV)
This one is another special situation that we’ve played in our merger arbitrage fund. [It’s] small cap, trades on the venture, but quite interesting. Management is ex-Fairfax, well regarded. 

GFP is now one of the top 10 lumber producers in Canada following the just completed purchase of eastern Canadian mills from Rayonier. These were actually Tembec mills and have been around for decades.

What made it a special situation is they funded this purchase with a massive rights offering (relative to their market cap) to buy shares at $1.50. These rights couldn’t be exercised by U.S. holders, which caused a lot of forced selling in the market. Stock went from $5 to $1.80 as a result. Senvest back-stopped the offering – you might remember them from their massive win on GME this year.

These mills were bought cheaply around 2.2x EBITDA at $500 lumber (lumber is moving back up, last above $600). Stock is 3-4x EBITDA currently, in-line with comps. The key is they believe they can improve utilization and make these numbers look meaningfully cheaper, which should provide a re-rate higher.

So, an emerging way to play lumber with a team that we expect we’ll hear from again as they grow this business.

Power Corp (POW TSX)
This pick is more of a “slow and steady” one in contrast to the last two that carry higher risk, and one that benefits from rising interest rates.

Power Corp is the holding company for a number of assets in insurance and asset management including Great West Life, Investors Group, and a host of other non-public interests.

“Holdcos” tend to trade at a meaningful discount to net-asset-value (POWs is about 22 per cent discount currently), and Power has been restructuring over the last few years to start to optimize their structure and minimize the discount. Eliminated the Power Financial (PWF) multi-vote structure for example.

They’ve been growing their alternative investment platform, as well as have had very strong inflows at their Investor Group fund level. 

Had big earnings beat recently as they monetized their Lion Electric holdings (went public). Hits all the metrics for us. Good price momentum, low volatility stock with cheap valuation at 1.3x book, P/E just over 10x, great balance sheet with no meaningful net debt, and a solid 4.2 per cent yield with a payout ratio that gives them lots of room to increase over time.

PAST PICKS: August 12, 2020

Labrador Iron Ore (LIF TSX)

• Then: $27.52
• Now: $42.93
• Return: 56%
• Total Return: 78%

Canfor (CFP TSX)

• Then: $16.05
• Now: $28.73
• Return: 79%
• Total Return: 79%

North American Construction Group (NOA NYSE)

• Then: $10.27
• Now: $18.07
• Return: 76%
• Total Return: 79%

Total Return Average: 79%