John Zechner's Top Picks: Oct. 4, 2018

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

MARKET OUTLOOK

We believe that global economic and profit growth peaked for this cycle in the second quarter. Emerging market economies have been under severe pressure due to high U.S. dollar debts, trade worries and falling currencies. Leading economic indicators from the industrialized (OECD) countries have also lost momentum as Asian and European manufacturing data turned down and Economic Surprise Indices have headed lower. The U.S. remained pretty much the sole source of global strength as second quarter growth exceeded 4 per cent and consumer confidence indicators remained strong. We’re, however, starting to see more inflationary pressure emerge, which will necessitate the continued removal of the extremely easy money conditions that have characterized the last 10 years. Record global debt levels and rising interest rates will lead to retrenchment in consumer and business spending, thus limiting further expansion. Profit margins are expected to peak this year due to rising input costs (wages, basic materials). While the U.S. tax cuts have led to double-digit profit gains this year, those cuts are one-time in nature and will diminish in impact by the fourth quarter. Stock markets outside of the U.S. and Japan have all moved lower this year, with China down 25 per cent from its January highs. Rising U.S. interest rates will reduce stock valuations, which have been responsible for over 75 per cent of global stock market gains in last five years. The U.S. Fed suggests it could raise short-term interest rates above “normal,” since it can’t accurately gauge what that level is right now. Expect them to reach the 3 per cent range in the next year and that the yield curve will invert, which typically occurs before the onset of any recession.

Within our managed portfolios, we maintain a defensive bias due to our continued belief that we’re late in this economic cycle, interest rates are rising, stocks valuations are excessive and there’s more downside than upside potential in stocks over the next two years. Stock weights therefore remain below average levels. One area where we still feel bullish is energy. The TSX Energy Sector 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, the inventory glut that lead to the 2014 price swoon has now been removed and the market is in balance. We expect prices to stabilize in the current US$65-75 range. We also expect the spread between Canadian and international oil prices to narrow which, along with a lower Canadian dollar, should boost earnings. We see good upside potential and little downside risk in the energy sector in Canada as the mass exodus of capital since 2015 created attractive valuations.

TOP PICKS

MAXAR TECHNOLOGIES (MAXR.TO)
Most recent purchase in August at $42.

This satellite and space systems manufacturer and operator has fallen over 40 per cent in 2018 despite the successful acquisition of Digital Globe in 2017, which helped to integrate its total satellite orbit offerings. The biggest problem has been a negative research report by Spruce Point Capital Management, a hedge fund with a track record of launching negative campaigns against North American public companies after taking a short position in their stock. Investors, though, are clearly in “show me” mode and it will take some quarters of earnings growth to convince the skeptics (and short-sellers) that the stock has more upside than downside. Improvement of free cash flow with a priority to pay down debt is of primary importance. Strong free cash flow generation will allow Maxar to pay down acquisition debt relatively quickly. The valuation is exceptionally low at under eight times forward earnings and seven times forward EV/EBITDA. The biggest risk is a gradual shift away from the geo-satellite market in favour of other monitoring instruments, such as drones.

TREVALI MINING (TV.TO)
Latest purchase in August at $0.70.

Trevali is a multi-mine base metals producer focused on the production of zinc, with operating mines in Canada, Namibia, Burkina Faso and Peru. Zinc prices are at their highest levels since 2007, driven by a significant supply squeeze and strong demand. Trevali is one of the only “pure-play” multi-asset Zinc producers listed in North America. It should generate "substantial" free cash flow at current zinc prices over the next two years and could be sitting on a net cash position, which is close to the market value of the entire company today, and then do further accretive acquisitions or buy back a substantial amount of the existing stock. With zinc fundamentals remaining firm, improving operating results and cash generation, we expect Trevali can be re-rated to a much higher level.

BAYTEX ENERGY (BTE.TO)
Latest purchase in October at $3.85

With the acquisition of Raging River, an improvement in its balance sheet and oil prices remaining high, Baytex Energy should be re-rated to a higher valuation. The company should now have the money to expand and continue improving its balance sheet, with the potential to even start rewarding shareholders with a dividend once again. With WTI oil now above $70, the company could generate between $500 million and $700 million in free cash flow. That would push Baytex Energy's leverage ratio down to a more comfortable 1.5 while giving it the financial flexibility to drill more wells, pay off additional debt, pursue another acquisition, or reinstate a dividend.

PAST PICKS: MARCH 27, 2018

MAXAR TECHNOLOGIES (MAXR.TO)

• Then: $57.82
• Now: $42.01
• Return: -27%
• Total return: -26%

VANECK VECTORS OIL SERVICES ETF (OIH.O)

• Then: $23.83
• Now: $25.59
• Return: 7%
• Total return: 7%

QUALCOMM (QCOM.O)

• Then: $54.84
• Now: $72.38
• Return: 31%
• Total return: 34%

Total return average: 5%

FUND PROFILE

J. Zechner & Associates Global Hedged Growth Fund
Performance as of: June 30, 2018

• 3 Months: 2.3% fund, 1.8% index
• 3 Years: 3.3% fund, 3.1% index
• 5 Years: 6.6% fund, 4.6% index

Index: Fundata Alternative Strategies Index.
Returns are after fees.

TOP 5 HOLDINGS AND WEIGHTINGS

1. Short: SPDR Trust Unit S&P500 (SPY): 8.16%
2. Short: iShares Russell 2000 ETF: 7.87%
3. Short: NASDAQ 100 Powershares (QQQ): 6.93%
4. Long: iPath VIX Short-Term Futures ETF: 5.96%
5. Short: Vaneck Vectors Semiconductor ETF: 5.95%

WEBSITE: www.jzechner.com