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


MARKET OUTLOOK

The global, U.S. and Canadian economies remain on a solid footing as we head toward 2019.

Rising U.S. short-term interest rates, trade frictions and weaknesses in some emerging market economies suggest a slower pace of expansion ahead, but a recession is unlikely in the next twelve months. Higher U.S. rates are the main risk to growth, but that’s more of an issue for late 2019. This growth backdrop is a plus for corporate earnings and commodity prices. Underlying inflation remains low both globally and in North America though low unemployment rates have tilted the risks upward. U.S. and Canadian short-term interest rates have been rising in response, and will likely edge higher in the months ahead. NAFTA risks will keep the Bank of Canada on a more cautious path than the Federal Reserve and weigh on the Canadian dollar in spite of expected gains in commodity prices.

Equity prices have been caught in a tug-of-war between rising U.S. short-term interest rates and escalating trade tensions, which are negative and growing earnings, which are a plus. However, valuations have declined considerably this year as markets have digested the risks associated with higher rates and trade tensions, implying a more favourable risk/reward profile in equity markets over the next six to nine months.

Valuations have improved across all sectors in 2018 and several areas of the market are attractive. The two areas that really stand out are Canadian energy and U.S. banks. Energy companies will continue to benefit from higher oil prices, especially if there’s a major supply disruption in the Middle East. The backdrop is positive for U.S. banks as the global economy and American consumers releverage themselves and U.S. regulations are scaled back.

TOP PICKS

John O'Connell's Top Picks

John O'Connell of Davis Rea shares his top picks: Kelt Exploration, Scotiabank and Stanley Black & Decker.

KELT EXPLORATION (KEL.TO)

Kelt is an oil and gas company that focuses on exploration, development and production of crude oil and natural gas, primarily in Northwestern Alberta and Northeastern B.C. The company’s year-end reserve report showed proven and probable reserves (P&P) growing at 20 per cent year-over-year, with a proved developed producing (PDP) reserve life index of four years and a P&P reserve life index of more than 25 years. Kelt recently disposed of its Karr assets and is positioned very well financially, with forecasted debt-to-cash flow below 1 times in 2019, lower than its industry peers. Production per share increased 26 per cent year-over-year in Q2/18, with production and cash flow coming in line with estimates. Recent well results at Fireweed were promising and will be key in derisking the northern portion of its land holdings with more well locations. The company also recently increased its 2018 capital spending budget, with more than half of the increase going towards its own infrastructure projects, where greater synergies are realized. Kelt maintains a high exposure to oil prices, as they maintain the drilling program to target Montney wells that are rich in oil and condensate. Despite oil comprising 45 per cent of their 2018 revenue, it provides 91 per cent of their operating income. Kelt has recently signed a deal with AltaGas to process gas and sell propane through that company’s Townsend facility. This allows Kelt to market their gas and natural gas liquids, allowing for export through the Ridley Island facility. Valuation remains attractive, as it is similarly valued to peers despite its lower leverage ratios and higher production per share growth.

SCOTIABANK (BNS.TO)

The Bank of Nova Scotia is one of the Big Six banks in Canada. It has a larger international exposure than its peers, with a larger Latin American presence. The bank has recently focused on increasing its presence in the asset management business, completing the acquisition of Jarislowsky Fraser in May and announcing the acquisition of MD Financial Management, which is expected to close in October. We like this move, as it increases the diversification of the bank’s revenue streams and the exposure to fee-based income.  After the recent pick-up in acquisitive activity, the bank is now focused on integration and is also working through some internal realignments of its capital markets business unit. Loan growth has been strong both locally and in its international banking units, while cost containment remains a priority. Scotiabank has underperformed the peer group year-to-date, as the market remains concerned about execution and integration risk. This has driven the valuation down to attractive levels and we feel that it is especially attractive given the 4.5 per cent yield. As the execution risk clears and the recent acquisitions begin showing positive contributions to earnings, the stock should rerate.

STANLEY BLACK & DECKER (SWK.N)

Stanley Black & Decker is a diversified global provider of industrial tools and security which provides exposure to the U.S. home building, renovation and industrial markets. The company continues to see strength across all its geographies, with double-digit growth in North America, the emerging markets and mid-single digit growth in Europe. The stock has been under pressure as tariff uncertainty and commodity price inflation continues to weigh on it. However, Stanley has been successful at passing price on to its customers. The company continues to focus on generating free cash, deploying it on both organic investments and mergers and acquisitions. Stanley has recently purchased International Equipment Solutions’ attachment tool producer for heavy equipment and a 20 per cent interest in MTD Products, a manufacturer of outdoor power equipment, with an option to acquire the rest of the company in the future. These acquisitions will bolster the organic earnings growth that Stanley is known for. Stanley also has a great reputation for integration success with acquisitions. Craftsman, acquired from Sears in 2017, is in the midst of its initial rollout and all signs are positive for a strong launch. The stock has been beat up, and we feel that a 16 times forward price-to-earnings is unjustified for a company that has been able to generate high single-digit to low double-digit organic growth consistently.

 

DISCLOSURE PERSONAL FAMILY PORTFOLIO/FUND
KEL Y Y Y
BNS Y Y Y
SWK Y Y Y

 

PAST PICKS: JUNE 14, 2017

John O'Connell's Past Picks

John O'Connell of Davis Rea reviews his past picks: Apple, Goldman Sachs and AltaGas sub. receipts.

APPLE (AAPL.O)

  • Then: $145.16
  • Now: $218.24
  • Return: 50%
  • Total return: 53%

GOLDMAN SACHS (GS.N)

  • Then: $226.51
  • Now: $228.89
  • Return: 1%
  • Total return: 3%

ALTAGAS SUB. RECEIPTS (ALAr.TO)
Expired on July 9, 2018 and converted into AltaGas shares.

  • Then: $29.85
  • Now: $22.38
  • Return: -25%
  • Total return: -17%

Total return average: 13%

 

DISCLOSURE PERSONAL FAMILY PORTFOLIO/FUND
APPL Y Y Y
GS Y Y Y
ALA Y Y Y

 

FUND PROFILE

Davis Rea Equity Fund
Performance as of: August 31, 2018

  • 1 Month: -1.84% fund, 0.99% index*
  • 1 Year: 17.69% fund, 12.15% index
  • 3 Years: 5.05% fund, 9.61% index

* Index: 50% S&P/TSX60 Index, 50% S&P 500 Index.
* Returns are gross of fees.

TOP 5 HOLDINGS AND WEIGHTINGS

  1. Gear Energy Ltd: 10.33%
  2. Kelt Exploration Ltd: 8.04%
  3. Brookfield Infrastructure Partners: 5.70%
  4. Vermilion Energy Inc: 5.32%
  5. Altagas Ltd: 4.85%

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WEBSITE:  www.davisrea.com