Jun 28, 2018

John Zechner's Top Picks: June 28, 2018

BNN Bloomberg

John Zechner , BNN Bloomberg

John Zechner, chairman and founder of J. Zechner Associates
Focus: North American large caps

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MARKET OUTLOOK

The bullish case for stocks is that continued economic buoyancy, exceptionally strong earnings reporting season and a recent reduction in excess stock valuations could set up the market for a re-test of the January highs. But we take issue with that view and see the headwinds of early signs of slower global growth, a continually rising interest rates and a potential peak in earnings growth in 2018 as the bigger risks. These have all combined to put in a larger rollover in stock prices and we may have probably already seen the peak. We don’t think the “synchronous global economic recovery” story that seems to be the accepted consensus of investors is quite as solid as it was in 2017.

The rising U.S. dollar is putting pressure on emerging market currencies in much the same way as during the Asian currency crisis in 1997. This has led to capital outflows and rising interest rates in key emerging economies in Europe, Asia and South America. The Chinese stock market recently entered official bear market territory, with the index now down more than 20 per cent from the January highs and off more than 12 per cent since trade tensions with the U.S. became headline news in May. Global debt is at record levels and monetary stimulus has been exhausted, so the central bankers of the world have basically run out of ammunition to further stimulate economic growth without lighting up inflationary fears.

More importantly for stocks though, the liquidity that’s been the greatest source of financial market strength over the past five years is being withdrawn. While the U.S. is the only one taking interest rates higher for now, we expect the EU to start reducing their quantitative easing programs later this year. Rising oil prices, rising labour costs and a higher U.S. dollar are also starting to raise input costs and reduce overseas sales for most of the large multinational companies that make up the S&P 500 Index. This will begin to impact profit growth just as the benefits of the tax cuts are starting to wear off. We expect profit growth to slow down to under 5 per cent by year end. Higher inflation will also keep upward pressure on interest rates, which should also reduce the earnings multiple for the stock market.

While stocks may continue to trade in the current range, the volatility seen since early February is a warning shot that the period of complacency for stocks is over with. We’re very late in the economic cycle, with wage and inflationary pressures starting to rise and capacity constraints in labour markets squeezing corporate profits. The “near-zero” interest rate environment had been the reason for both the expansion in stock valuations and the massive increase in corporate borrowings to fund stock buybacks in the past five years. Now that stimulus is being withdrawn. Risk in markets remains at an elevated level.

Within our managed portfolios, we’ve increased slightly our exposure to short-term bonds as a hedge against potentially slower economic growth and overall more attractive yields than seen over the past few years. We’ve taken some profits in preferred shares after a very strong two-year run in that group. We still have a slight overweight in preferred shares, though, due to the very attractive gross dividend yields. Stock weights remain at below-average levels, as we’ve recently reduced positions in U.S financial and technology stocks. One area where we do feel more bullish is the energy space. The TSX energy sector has rallied more than 20 per cent from the March lows, but is still almost 40 per cent below the peak seen in 2014 when oil prices were above US$100 per barrel. While we don’t expect to see prices recover to those levels, with the inventory glut now removed and the market in balance we do expect prices to stabilize in this US$65-75 range.

We also expect the CWS/WTI spread to narrow, which should favour Canadian producers along with a lower Canadian dollar. On that basis, we still see extremely good value in the energy sector in Canada after the mass exodus of capital that we’ve seen since 2015.

TOP PICKS

MAXAR TECHNOLOGIES (MAXR.TO)
Most recent purchase at $58 in March, 2018.

With the closing of the DigitalGlobe (DGI) acquisition, Maxar is set for new round of growth at a valuation discount to aerospace peers. DGI provides Maxar with increased exposure to the data and services part of satellite earth observation market, which has higher growth than their traditional satellite manufacturing business due to the growing need for data and mapping for all types of companies as well as governments. DGI and new management also gives them better U.S. market access and more exposure to growing U.S. government spending in their service offerings. Strong free cash flow generation will allow them to pay down acquisition debt relatively quickly. The valuation is very reasonable at under 10 times forward earnings and 8 times forward EV/EBITDA. We should also see increased interest from U.S. investors. The risk is a gradual shift away from the geo-satellite market in favour of other monitoring instruments such as drones.

TRINIDAD DRILLING (TDG.TO)
Most recent purchase at $1.65 in May 2018.

You don’t have to be an energy bull to like Trinidad here. Stronger oil prices will increase the capital budgets for the major oil producers. While the rig count has been flat recently, Trinity has been shifting rigs to U.S. (Permian Basin) from Canada and making tuck-in acquisitions to round out/expand their product offering. All of this should improve margins and growth. Also, the company still has a joint venture with Haliburton for foreign drilling rigs. Rising free cash flow has been used to reduce debt to a much more manageable level. The best reason to own the stock, though, is that it’s trading at about 35 per cent of the replacement value of their assets which, in the past, has always been the low point for energy services companies

OPEN TEXT (OTEX.TO)
Most recent purchase at $39 in September 2017.

Open Texy has done excellent transition over past five years from a licence-based document management software company to a cloud-based EIM (enterprise information management) company by making numerous strategic acquisitions (most recent ones include Magellan and Documentum) and strategic marketing partnerships with the like of SAP, CapGemini, Accenture and CGI. Strong free cash flow has allowed the company to quickly pay down acquisition debts as well as increasing the profit margins of the acquired businesses. Recurring revenue base from cloud-based businesses should also allow the company to get a higher valuation, which remains low at only about 12 times forward EPS and under 10 times forward EV/EBITDA. A “blue sky” upside could come from AI capabilities on either a stand-alone or integrated basis coming from the recent Magellan acquisition.