Apr 2, 2018

John O'Connell's Top Picks: April 2, 2018

BNN Bloomberg

John O'Connell , BNN

John O'Connell, chairman and CEO of Davis Rea
Focus: North American large caps

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MARKET OUTLOOK

We continue to see good global growth and earnings momentum through 2018 into 2019. Global growth is broadly based, positive for earnings and commodity prices, and it will take a big shock to knock it off track. As a result, recession risk is low for the next twelve months.

The global economy is back into releveraging mode, with private sector credit rising faster than GDP. Global government debt continues to increase relative to GDP and that will intensify, given growth in U.S. budget deficit. The elevated debt-to-GDP level will make all economies, earnings, commodity prices and asset prices considerably more sensitive to interest rates than in the past. Despite this, global inflation remains relatively low.

Inflation risks have increased as labour markets tighten and economies bump up against capacity in many of the advanced economies, notably the U.S. But a shifting relationship between unemployment rates and inflation and the disruption being caused by technological advances suggests that inflation risks are low for 2018 and into 2019.

The U.S. dollar is likely entering a multi-year declining phase after rising between 2011 and 2016. There is currently unanimous agreement that the greenback is going to fall, which is a cautionary sign. In early 2017, everyone expected to U.S. dollar to rise as America cut taxes and increased interest rates. It fell instead. With the U.S. having cut taxes and now raising interest rates, everyone expects the dollar to decline. There’s a good chance, therefore, that the dollar surprises a bit on the upside in 2018, before turning downward.

The Canadian dollar is subject the vagaries of U.S. trade policy, specifically the ongoing NAFTA negotiations. Monetary policy considerations and trade tensions argue for a weaker loonie. Commodity prices have been a plus, but they’re likely to face headwinds if we’re correct and the American dollar strengthens. Net-net, the risks are that the loonie loses ground this year.

U.S. short-term interest rates are expected to rise by another 50 to 75 basis points this year as the Federal Reserve tries to limit inflation risks. International trade uncertainty, mainly the NAFTA negotiations, will limit what the Bank of Canada will do with short-term rates. We expect one 25-basis-point increase in Canada’s overnight interest rate. Rising short-term interest rates and government bond yields are negative for equity and corporate bonds, but earnings strength is a plus. The remainder of 2018 and early 2019 are likely to see a continued tug-of-war between these factors, creating a more volatile environment for investors than they have been used to for the past few years, but especially 2017.

Equity market weakness in 2018 has seen prices fall in relation to earnings, making valuations more attractive and creating opportunities for investors. We continue to view the current weakness in equity prices as a correction in the midst of ongoing economic expansion and earnings growth. Our long-term themes still favour financials and technology. However, many of the tech companies face some government/regulatory headwinds globally and we are being cautious as a result despite favourable valuations.

Global releveraging is a plus for the banks, especially in the U.S. where valuations are reasonable, taxes have been cut and deregulation is in full swing. In spite of lower equity prices, many sectors and industries remain expensive. Alongside U.S. banks and technology, the only other area that shows good value is the energy sector. However, the risk of a stronger U.S. dollar will create some temporary headwinds.

TOP PICKS

ACCENTURE (ACN.N)

Accenture is the world’s largest consulting firm, and 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 about 50 per cent of their revenues. They have achieved this through organic growth and a combination of tuck-in acquisitions, which have been funded through free cash flow generation.

The firm carries a pristine balance sheet with almost zero debt, and generates an abundance of free cash, which is allocated to acquisitions to grow the business and to shareholder return through a dividend (currently yielding 1.9 per cent) and share repurchases. Despite posting great results in the second quarter, shares have recently sold off due to concerns regarding operating margins (which were flat instead of up slightly), but we feel that operating margin expansion should resume in the second half of the year.

Accenture continues to gain market share in newer technology areas (digital, security, cloud, etc.), while posting double-digit earnings and revenue growth. As the world focuses more on digital channels, Accenture is well positioned to benefit from the ongoing shift to cloud computing and focus on data-driven digital insights and experience. They have a great track record with integrating their acquisitions into their consulting practice, and continue to win market share.

FACEBOOK (FB.O)

Facebook is one of the largest social media companies in the world, with a user base of one-in-seven people globally. Despite the recent controversy over the data breach to Cambridge Analytica and the furor of users regarding privacy concerns, we feel that this will pass for the company.

Facebook remains one of the best and largest advertising platforms for companies. We view the concerns about advertisers pulling their marketing spend as very similar to what Alphabet’s YouTube went through when advertisers were talking about pulling their ad spend last year. They ultimately either did not leave the platform, or left temporarily just to return.

Before the breach came to light, Facebook had been working to revamp the user experience to promote better user engagement on the platform, focusing on security. They also released updated privacy tools for the user base soon after the Cambridge Analytica news broke. We view these data issues as transitory, and feel the company can continue to grow its advertising presence through monetization of Instagram, WhatsApp, Facebook Messenger, and newer products like Facebook Watch (for videos). They can also maintain strong double-digit growth in earnings and revenue, despite trading cheaper than the market multiple today. Regulatory headwinds continue to be an overhang on the story, but new regulations like the General Data Protection Regulation (GDPR) in Europe should ultimately be a positive for the company, as it will help entrench their position as a leading social network.

ALPHABET (GOOGL.O)

Alphabet is the parent company of Google Inc., which provides web-based services to consumers and enterprises such as search, advertisements and software. As the undisputed leader in desktop web search, the company continues to improve its foothold in mobile search and advertisements and has a number of other high-growth assets such as video offerings (YouTube) and mobile assets (Android and Google Play).

On the mobile side, Alphabet has always been known as a software and advertising company, but has recently entered the hardware arena as well with the release of their new phone. Google continues to impress in its dominance of advertising and search in multiple venues and, with ongoing cost controls, we expect to see margin expansion contribute to the bottom line.

We’re encouraged by the progress of some of their ancillary businesses, such as the cloud business (which as of last quarter, was a $1 billion revenue/quarter business) and the hardware unit (responsible for products like the Google Home and Chromecast). In the longer term, Alphabet also has its “Other Bets” segment, with some exciting businesses such as Waymo, their autonomous driving unit, and Nest, a manufacturer of connected home devices.

Alphabet has diverse revenue streams, and the current valuation is not giving enough credit to some of the other businesses outside of the core Google search and advertising business. Additionally, Alphabet should be a beneficiary of regulatory changes, like GDPR mentioned above.