Zachary Curry's Top Picks: June 5, 2018

Zachary Curry, president and portfolio manager at Davis Rea
Focus: North American large caps

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MARKET OUTLOOK

We expect good global growth and earnings through 2018 and into 2019. Global growth is broadly based and it will take a big shock to knock it off-track. Recession risk is low for the next twelve months as a result. This outlook is positive for earnings and commodity prices.

The global economy is back into releveraging mode, with private sector debt rising faster than GDP. Global government debt continues to increase relative to GDP and that will intensify given growth in U.S. budget deficits. Elevated debt and GDP will make all economies, earnings, commodity prices and asset prices considerably more sensitive to interest rates than in the past.

Global inflation remains relatively low. Inflation risks have increased as labour markets tighten and economies bump up against capacity in many of the advanced economies, notably the U.S. However, a shifting relationship between unemployment rates and inflation and the disruption being caused by technological advances suggests that inflation risks are low for 2018 and into 2019.

The Canadian dollar is subject the vagaries of U.S. trade policy, which will likely remain a source of uncertainty well into 2019. Monetary policy considerations and trade tensions argue for a weaker loonie. Rising commodity prices are a plus for the Canadian dollar. Net-net, the risks are that the Canadian dollar trade between 77 and 80 U.S. cents, but loses ground this year. International trade uncertainty, mainly the NAFTA negotiations, will limit what the Bank of Canada will do with short-term rates. We expect one 25 basis point increase in Canada’s overnight interest rate. The Fed will raise rates further in 2019 until it’s convinced to stop by a softer economy or serious financial strains. The Bank of Canada will boost rates a little in 2019, but by less than the Fed.

Rising short-term interest rates and government bond yields are negative for equities and corporate bonds, but earnings are a plus. The remainder of 2018 and early 2019 are likely to see a continued tug-of-war between these factors, creating a more volatile environment for investors than they’ve been used to for the past few years, but especially 2017.

Global releveraging is a plus for the banks, especially the U.S. banks where valuations are reasonable, taxes have been cut and deregulation is in full swing. Valuations, rising oil prices and tensions in the Middle East are supportive for energy stocks. Technology and consumer discretionary stocks are also attractive, though government tax and regulatory actions are an issue for some tech companies.

Rising U.S. interest rates, uncertain U.S. trade policies, and geopolitical tensions are key risks to the economic and investment outlook.

TOP PICKS

JPMORGAN CHASE (JPM.N)
Most recent purchase: May 29, 2018 at US$105.59.

JPMorgan is the largest bank holding company in the U.S. and the third-largest bank in the world by assets. It’s one of the best all-around banking franchises as a leader in consumer and commercial lending, asset and wealth management, and in investment banking. Despite the recent volatility in fixed income trading that have negatively affected investment banks over the last year, JPMorgan’s investment bank remains well positioned in both equity and debt underwriting and advisory. As one of the most diversified banks, it’s able to benefit from an improving U.S. economy. Rising interest rates should help net interest margins, while the commercial bank should benefit from greater economic activity from corporations. U.S. consumers have improved balance sheets and are looking to relever through consumer credit. JPMorgan has been invested heavily into technology, spending US$9.5 billion to increase efficiency in legacy operations and into new investments and innovations, which should position them well for the future. Due to tax reform, its effective tax rate has dropped by 10 per cent. We anticipate increased shareholder returns coming through the form of buybacks or increased dividends (JPMorgan currently yields 2 per cent).

KELT EXPLORATION (KEL.TO)
Most recent purchase: April 10, 2018 at $7.75.

Kelt is an oil and gas company that focuses on exploration, development and production of crude oil and natural gas, primarily in Northwestern Alberta and Northeastern B.C. The company’s year-end reserve report showed proven and probable reserves (P&P) growing at 20 per cent year-over-year with a proved developed producing (PDP) reserve life index of four years and a P&P reserve life index of more than 25 years. Production per share increased 24 per cent year-over-year in Q1/18 and production and cash flow coming in above estimates. Kelt recently disposed of its Karr assets and is positioned very well financially, with forecasted debt-to-cash flow below 1.0 times in 2019, lower than its industry peers. Recent well results at Fireweed were promising and will be key in de-risking the northern portion of its land holdings with more well locations. The company also recently increased its 2018 capital spending budget, with more than half of the increase going towards its own infrastructure projects, where greater synergies are realized.

APPLE (AAPL.O)
Most recent purchase: March 12, 2018 at US$179.64.

The iPhone 8 and iPhone X introduction have been positive given the refresh cycle, with Apple’s higher-end products traditionally performing well. The iPhone X was the top-selling Apple device every week in the last quarter. The addition of augmented reality (AR) capabilities will position the iPhone lineup (iPhone 6S and higher) well for the continuing shift to mobile data consumption. The addition of a cellular-enabled watch should increase uptake on what is already the world’s best-selling watch. Apple recently announced that it will be investing US$1 billion in original video content over the next year, and while late to the online programming game, we think it will continue to keep users in the Apple ecosystem resulting in increased revenue for the company. Additionally, Apple has been building out its services business, well on their way to doubling their services revenue from 2016 to 2020 (it’s currently the size of a Fortune 100 company on its own). A very healthy cash position allows for financial flexibility, including a recent 16 per cent increase in the dividend (to yield 1.6 per cent currently) and $100 billion share buyback.

PAST PICKS: MAY 24, 2017

STANLEY BLACK & DECKER (SWK.N)

• Then: $136.18
• Now: $142.06    
• Return: 4%
• Total return: 7%

ALTAGAS SUBSCRIPTION RECEIPTS (ALAr.TO)

• Then: $30.15
• Now: $25.06
• Return: -17%
• Total return: -10%

GOLDMAN SACHS (GS.N)

• Then: $223.83
• Now: $228.15
• Return: 2%
• Total return: 4%

Total return average: 0.3%