Robert McWhirter's Top Picks: Oct. 11, 2018

Robert McWhirter, president of Selective Asset Management Inc
Focus: Canadian dividend stocks and small caps

MARKET OUTLOOK

The price of WTI oil rose 19.4 per cent from mid-August, 2018 to $76.90 in early October. Unfortunately, most Canadian oil producers don’t benefit as they receive about US$35 per barrel as American refinery outages, pipeline capacity shortages and new regulations make Canada’s heavy oil with its high Sulphur content less attractive. 10-year U.S bond yields were 2.41 per cent on Dec. 26, 2017 and recently surpassed the 3.15 per cent year high set in mid-May 2018. They closed at a seven-year high of 3.23 per cent on Oct. 10.

Mark Deriet, Cormark’s quantitative and technical analyst, noted that one of his macro indicators recently gave an equity sell signal as only 36 per cent of global equity indexes are above their 80-week moving average.

Rising interest rates, oil prices and wages as well as the IMF’s recent forecast for reduced global economic growth have increased investor caution, causing an intermediate correction in equity markets.

Investors are closely watching the yield curve (the spread between U.S. 10-year and 2-year bond yields). The spread was 51 basis points (bp) on Dec. 28, 2017, narrowed to 18 bp in late August 2018 and closed at 34 bp. on Oct. 10. Historically, when the yield curve inverts (the 2-year yield rises above the 10-year yield), a U.S. recession follows.

John Aitkens, investment strategist at TD Securities, recently noted that “once the yield curve inverts, the S&P 500 typically rises an average of 14.6 per cent over an 11-month period before the bull market ends and a bear market, averaging 34.6 per cent, begins.

“The TSX composite has outperformed the S&P 500 in five of the last seven late-cycle environments, raising an average of 28.1 per cent over a 14-month period from the point at which the U.S. yield curve first inverts until the TSX peaks and a bear market begins, with an average decline of 35.9 per cent. These averages are based on the experience of the last seven U.S. economic recessions.”

 We expect the intermediate correction will be finished by the end of the year, and then equities will continue to rise to the end of 2019. We believe that our consistent, long term, quantitative Canadian Dividend Strategy that looks for above average growth at below average valuations will continue to do well.

TOP PICKS

AECON GROUP (ARE.TO)

A Canada-based construction and infrastructure development company. It operates through four segments: infrastructure, energy, mining and concessions.

Aecon reported July 26: year-over-year sales per share grew 6 per cent, with a 186 per cent increase in earnings per share (EPS). This was an 8 per cent earnings surprise. Earnings estimates have increased 11 per cent in the past 90 days.

Earnings are forecast to grow by 33 per cent in calendar 2019, with further EPS growth of 25 per cent forecast for 2020. The rising earnings drive a 67 per cent increase in return on equity to 9.2 per cent for 2019 versus the trailing 12 month return on equity of 5.5 per cent. ATS is expected to report earnings on Oct. 25. The forecast is $0.50 versus $0.45, a 9 per cent increase.

On Oct. 2, Aecon announced that it had entered into an agreement to sell its contract mining business for $199 million to the North American Construction Group (NOA). Upon closing of the sale, Aecon is expected to be in a net cash position.

Aecon’s backlog stood at $6.4 billion at Q2/18 plus $1.25 billion potential from the Gordie Howe International Bridge project.

On Oct. 2, Joe Farrell, head of research at Velocity Trade Capital noted: “the stock is carving out a decade-long ascending triangle formation. We see minimum technical upside back to the overhead neckline at the $20-plus zone. Much higher, longer-term technical targets are clearly visible.” This implies a potential upside of 23 per cent.

CP RAIL (CP.TO)

CP provides freight transportation services and logistics solutions in North America. This is a repeat of my July 24 top pick.

It has a 1.0 per cent yield, a modest 14 per cent payout ratio of a four-quarter trailing cash flow. CP reported on July 18: year-over-year sales per share grew 9 per cent, while EPS grew 14 per cent. EPS is forecast to grow 16 per cent in 2019, giving a 36 per cent return on equity (ROE), with 12 per cent further EPS growth forecast for 2020.

CP is expected to report earnings on Oct. 16. The forecast: $4.09 (revised up from $3.56 since July 24) versus $2.90, a 401 per cent increase.

On July 18, Farrell noted that CP “has successfully retested the neckline of a three-year rounding base breakout. The base continues to support further measured upside in excess of $360.” This implies potential upside of 41 per cent

Velocity Trade’s Tony Popowich wrote a follow-up: “After reporting Q3 results, the stock continues the dominant uptrend in place since the technical breakout in August. The base continues to support further measured upside in excess of $360..” This implies a 34 per cent upside from the Oct. 10 closing price.

XEBEC ADSORPTION INC (XBC.V)

A global provider of clean energy solutions, Xebec’s equipment cleans up bio-digested gas, removing Co2, nitrogen and oxygen and providing pure methane that sells for $40 in Europe and US$70 in California.

Despite continued working capital issues in Q2/18, sales grew 62 per cent year-over-year from $4 million to $6.6 million.

Management resolved the working capital issues early in Q3/18 through credit facilities with EDC and anticipates that sales in 2018 will increase 50 to 70 per cent, $22 to $25 million.

In the U.S., the EPA has identified over 400 candidate landfills that are suitable for landfill gas to energy or renewable natural gas (RNG) projects. Xebec estimates that approximately 120 to 160 landfills could qualify for the production of RNG, indicating a market for Xebe’s upgrading equipment of US$1.2 to US$1.6 billion.

The order backlog has grown 6.6 times year-over-year to $68 million as of Aug. 6 compared to $8.9 million on Aug. 25, 2017. EPS is expected in the range of $0.02 to $0.05. If five cents per share were achieved, it implies an attractive 14.6 times price-to-earnings multiple for 2018. Recent average daily trading volume for Xebec’s shares is 43,000.

PAST PICKS: OCT. 6, 2017

AVIGILON (AVO.TO)
Taken over on March 2018 at $27.

• Then: $18.46
• Now: $27.00
• Return: 48%
• Total return: 48%

MARTINREA (MRE.TO)
Sold July 5 at $13.84.     

• Then: $12.58
• Now: $12.15
• Return: -3%
• Total return: -2%

NORBORD (OSB.TO)
Sold July 26 at $47.09.     

• Then: $49.85
• Now: $36.86
• Return: -26%
• Total return: -16%

Total return average: 10%

FUND PROFILE

Canadian Dividend Strategy
Performance as of: September 30, 2018

• 1 month: -1.5% fund, -0.7% index
• 1 Year: 3.5% fund, 6.7% index
• 3 Years: 39.2% fund, 33.1% index

Index: S&P/TSX Total Return Index.
Returns include all distributions and are net of all fees.

TOP 5 HOLDINGS AND WEIGHTINGS

1. Waste Connections: 5.5%
2. Enghouse Systems: 4.9%
3. Canadian Pacific Railway: 4.9%
4. MTY Food Group: 4.9%
5. WSP Global: 4.8%

WEBSITE: selectiveasset.com