John Zechner, chairman and founder, J. Zechner Associates
Focus: North American large cap stocks

MARKET OUTLOOK

We continue to try to balance the market risks associated with high valuations against the belief that central banks will continue with extremely low interest rates for an extended period of time, providing stocks a continued tailwind. There is no lack of risks for all investors, including the upcoming U.S. election, the developing second wave of COVID-19, the lack of any new stimulus spending, the massive global debt and growth valuations that are stretched to the upside. However, we see only minimal returns in cash and potential losses in bonds and as such continue to have slightly overweight positions in very defensive sectors with low valuations and high dividend yields. Recent buys have been focused in value sectors such as industrials, financials and basic materials. Core overweight positions include the pipeline and telecom sectors, with dividend yields over 6 per cent and low relative valuations on operating cash flows. Earnings in both of those sectors are recurring and resilient, but have been ignored as investors have been chasing the high-growth sectors of the market. We also added to financial sector holdings in both the U.S. and Canada as the valuations are attractive, loss reserves are sufficient and dividend yields are above 5 per cent. Additionally, we bought more preferred shares, particularly those with strong credit ratings and little risk of lower rate resets. While technology remains the area of best earnings growth for the next few years, we still struggle with the record valuations that are unduly supported by the low rate environment. If growth resumes as we expect, the record money creation could lead to inflationary pressures which would put some upward pressure on interest rates and remove that support for the growth sectors of stocks.

TOP PICKS

Rogers Communications (RCI/B TSX) Latest purchase: $52 on September.

In the current slower growth environment the telecom sector provides the best risk/reward combinations, with low volatility, attractive valuation, continued cash flow growth and a strong dividend growth model. These companies continue to benefit as the “highways” for massive growth in high bandwidth data flow and their ability to bundle those services for consumers. Less appreciated are the benefits of owning all the long-life spectrum and other communications and infrastructure assets at a significant discount to other long-term capital assets. Rogers trades at seven times EV/EBITDA and generates significant free cash flow. It’s been under pressure due to regulatory concerns and a temporary absence of sports media, while “unlimited data” plans and other pricing pressures have reduced the average revenue per user. This weakness provides a great buying opportunity as the growth of 5G and streaming will increase usage dramatically and lead to continued cash flow growth.

Martinrea International (MRE TSX) Last purchase: $9.80 on September.

Martinrea has an exceptionally low valuation and some earnings cyclicality, allowing it to outperform strongly as the global economic recovery continues. It has a strong balance sheet and positive free cash flow; they withstood the steep downturn in auto sales earlier this year and are positioned to participate in the recovery of the sector. The auto parts companies are also able to shift production to supply growing demand for electric vehicles without the associated valuation risks. The heavily discounted valuation on a quality business provides an opportunity similar to market lows in 2009 and 2016. We see a continued avoidance of air travel and low gasoline prices leading to a further rebound in auto miles driven in North America. This, in turn, is highly correlated to stronger auto sales.

Enbridge (ENB TSX) Latest purchase: $39 on September.

With a dividend yield of 8 per cent, an improved balance sheet from assets sales and single digit cash flow multiple, we see Enbridge as a safe, high-yield play on further growth in the North American energy infrastructure market. Enbridge moves 25 per cent of North America’s crude oil and 20 per cent of natural gas, with a safer earnings profile than its peers given its reliance on volumes rather than prices. Enbridge is largely insulated from swings in commodity prices, as it sets prices for transporting oil and gas in long-term contracts. Moreover, the huge dividend yield in an environment of continued low interest rates will give investors a solid return even if stock market recovery takes longer than expected. Excessive debt from the $37-billion Spectra acquisition has been reduced substantially. The deal also added a growing natural gas business to Enbridge’s portfolio and allowed for a dividend hike, with average increases of 11 per cent annually over the past 15 years.

PAST PICKS: OCT. 19, 2019

Maxar Technologies (MAXR TSX)

• Then: $10.10
• Now: $37.73
• Return: 274%
• Total Return: 275%

Crescent Point Energy (CPG TSX)

• Then: $4.98
• Now: $1.77
• Return: -64%
• Total Return: -64%

Rogers Communications (RCI/B TSX)

• Then: $65.28
• Now: $54.23
• Return: -17%
• Total Return: -14%

Twitter: @jzechner56
Website: www.jzechner.com