John Zechner's Top Picks: March 27, 2018

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

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MARKET OUTLOOK

We believe that economic and profit growth will peak for this cycle in 2018. Leading economic indicators from the industrialized (OECD) countries have already started to roll over. Record global debt levels and rising interest rates will lead to retrenchment in consumer, business and government spending that will limit expansion. Profit margins are expected to peak this year as rising input costs (wages, basic materials) offset further cost restructuring. While the U.S. tax cuts will lead to double-digit profit gains this year, those are one-time in nature.  Moreover, most of the excess profits have thus far been directed to share buybacks rather than direct investment in growth, making this more of a “stock market event” than an “economic event.” 

Stocks have been in a nine-year bull market, with the bulk of the upside generated by higher earnings multiples due to record-low interest rates.  With the U.S. economy running at full capacity, inflationary and wage pressures are starting to grow, which will necessitate a period of rising interest rates, thereby turning a major tailwind for stocks into a headwind.  We have also not been impressed by the technical quality of the recovery in stocks off the February 8 lows. The advance has been exceptionally narrow, driven largely by the FANG, financial and large industrial stocks. New lows have exceeded new highs, “down volume” has been much higher than “up volume” and the new flow into ETFs has been negative and offset only by record levels of share buybacks.

Bottom line is that we’re very late in this economic cycle and the usual cyclical pressures are starting to build. The increased volatility in stocks this year is a clear sign that the unabated bullishness of investors over the past few years is being challenged at a time when valuation levels are still excessive and the backdrop of generational lows in interest rates is ending. We remain cautious on the outlook and are carrying higher-than-normal levels of cash in all of our accounts.

TOP PICKS

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

With closing of the DigitalGlobe (DGI) acquisition, Maxar is set for new round of growth at a valuation discount to its 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.  It also gives them better U.S. market access and therefore more exposure to growing U.S. government spending in this area. Strong free cash flow generation will allow them to pay down acquisition debt relatively quickly. The valuation is reasonable at about 10 times forward earnings and 8 times forward EV/EBITDA.  We should also see increased interest from U.S. investors.

VANECK VECTORS OIL SERVICES ETF (OIH.US)
Most recent purchase at US$24.50 on February 2018.

The biggest beneficiaries of oil prices holding above US$60 per barrel should be the U.S. energy service stocks and this ETF contains a diversified basket of the largest names in the industry, with Halliburton and Schlumberger accounting for over 35 per cent of the fund. Fourth quarter earnings reports from both of those companies beat expectations and project  strong growth this year as U.S. and global producers put excess cash generation from recovering oil prices into spending on existing and new projects.  Energy service stocks continue to trade well below replacement value, a historically good metric for identifying buy and sell points in this industry. Technical picture on this ETF also looks attractive as it bounces off multi-year lows at US$22, but remains well below cycle high of over US$56 in 2014.

QUALCOMM (QCOM.O)
Most recent buy at US$56 on March 2018.

We see upside earnings potential from multiple sources as the leader in the telecommunications industry readies for a global wave of spending on the rollout of 5G. While the Broadcomm bid of US$82 has been withdrawn, we see earnings upside from the NXP Semi acquisition. Also, there are currently no earnings from various parts of the QTL business as Chinese manufacturers hold back royalty payments and disputes with Apple continue. Any resolution of either issue would lead to earnings upside. Also, Qualcomm remains positioned as undisputed leader in the smartphone market for further gains as the world moves to 5G. The stock is trading at only about 15 times next year’s earnings, even assuming none of these issues are resolved.

PAST PICKS: OCT. 6, 2017

TRINIDAD DRILLING (TDG.TO)

• Then: $1.77
• Now: $1.75
• Return: -1.12%
• Total return: -1.12%

MAXAR TECHNOLOGIES (MAXR.TO)

• Then: $70.73
• Now: $57.82
• Return: -18.25%
• Total return: -17.38%

OPEN TEXT (OTEX.TO)

• Then: $41.70
• Now: $43.91
• Return: 5.29%
• Total return: 6.12%

Total return average: -4.12%

FUND PROFILE

JZ Canadian Union Partnership Fund
Performance as of:  Dec. 31, 2017 (provided by GlobeFund)

• 3 Month: 3.25% fund, 2.77% index
• 1 Year: 12.92% fund, 5.60% index
• 2 Year: 14.05% fund, 6.26% index

* Index: Globefund Neutral Balanced Index
* Returns provided are net of fees

TOP 5 HOLDINGS AND WEIGHTINGS

1. Canadian Pacific Rail: 4.44%
2. Martinrea International: 4.01%
3. Suncor Energy: 3.62%
4. SNC Lavalin Group: 3.01%
5. Maxar Technologies: 2.73%

TWITTER: @johnzechner
WEBSITE: www.jzechner.com