Market Call Tonight for Wednesday, February 15, 2017
Brian Madden, senior vice president and portfolio manager at Goodreid Investment Counsel
Focus: Canadian equities and fixed income
The fourth quarter earnings season is well underway, with about 20 per cent of S&P TSX Index constituents having reported their results thus far. Broadly, results have been good with roughly two companies exceeding analysts’ earnings forecasts for every one falling below estimates. The most impressive sector this earnings season has been the energy sector, with all six companies thus far having exceeded consensus earnings forecasts.
Oddly enough though, energy has in fact been the worst performing sector in Canada year to date, as investors have been fixated on oil and gas inventories, which are drawing down more slowly than first anticipated given warmer-than-normal weather, as well as on looming changes and uncertainties in continental energy flows, pipeline infrastructure and Canada/U.S. tax policy.
Our view is that the sector is indeed healing after the spectacular plunge it took in the wake of the 2014 OPEC cartel breakdown, albeit in a choppy fashion, which suggests that a focus on quality producers with above-average financial strength remains the prudent way to approach investing in the sector.
Elsewhere, stock market leadership is evident in the banks and insurance companies as well as in the industrial and consumer discretionary sectors, and remarkable signs of strength have emerged more recently in some of the industrial and precious metals companies.
Most of these leadership trends are bona fide hallmarks of an ongoing cyclical recovery in the economy. Real economic data bears this out as well: Canada created a net 48,300 new jobs last month, and the six months ended January 31 were in fact the strongest six months for job creation in at least a decade — a reality that is, in our view, not well appreciated by most observers.
In some ways, this is a Goldilocks economic environment: strong job creation, but given existing slack in labour markets, inflationary pressures are not yet problematic domestically and thus the risk of the Bank of Canada hiking interest rates this year is low, with markets pricing in only a 1/3 chance of a rate hike.
Nevertheless, our view is that the very long secular bull market in bonds drew to a close last summer. As such, we expect bond yields to rise in sympathy with other global bond markets, including the United States. We advocate keeping fixed income maturities short, seeking out the right balance between capital preservation and safe income via high quality corporate bonds and select Canadian preferred shares and avoiding bond proxy sectors like real estate investment trusts, utilities, telcos and pipelines in equity portfolios.
While some observers will note that price-to-earnings ratios are slightly elevated, our experience tells us that this is not the correct metric to use in assessing value in Canada due to the fact that earnings are highly cyclical, and thus high P/E ratios tend to occur immediately in advance of strong cyclical recoveries in earnings — periods of time which are usually very investor friendly.
Instead, we would note that valuations within the Canadian market are comfortably below longer-term averages, with the S&P TSX Composite index trading at 1.93x its book value (an accounting measure of shareholders equity, which is much more stable and less cyclical than earnings are) versus its 30-year average of 2.1x.
With a benign macroeconomic backdrop and stock market valuations not stretched, the most proximate risk to the rally Canadian stocks have been enjoying is likely a geopolitical or foreign/trade policy flare-up originating south of the border. With our Prime Minster having skillfully and diplomatically navigated his first meeting with the new American president earlier in the week, some of the most dire or draconian fears about American trade protectionism vis-a-vis Canada have been quelled for now, but we remain attuned to the ongoing risk that surrounds this important policy file, especially as it relates to the energy and manufacturing sectors.
Finally, we note with some enthusiasm the increasing media coverage on what we have been calling an “active investment management renaissance” — we have written about this topic ourselves (see for instance "In Defence of Active Management") and are seeing more and more experts whose views align with our own in exploring this topic, including this piece “Not Dead Yet” published just last month.
MAGNA INTERNATIONAL (MG.TO) – Last purchased February 13, 2017
Magna, Canada’s largest auto parts company, offers exposure to the auto cycle, which is still going strong and may extend further from the current run rate of around 18 million cars per year in the U.S. The business is geographically well balanced between North America, Europe, and Asia and Magna is outgrowing the industry in each region as their innovations in “light-weighting” for fuel efficiency, electronic transmissions, and advanced driver assistance breakthroughs have resonated well in the marketplace. A recent change in financial governance is driving higher return of capital to shareholders via buybacks and the shares are inexpensive at 7.8x earnings versus peers at 11.5x and relative to its own historic average, which is closer to 9.8x.
SHOPIFY INC. (SHOP.N) – Last purchased February 13, 2017 at $73.15
Shopify is Canada’s largest e-commerce enablement company, and is growing at a torrid pace with sales up 89 per cent compared to the prior year in their latest quarter. While not yet profitable, this company, which went public in 2015, expects to hit the breakeven mark later this year. We are drawn to their comprehensive “retailer/e-tailer-in-a-box” open platform solutions for small- and mid-sized businesses with functionality spanning sales promotion management, inventory management, shipping and order management, point-of-sale solutions/retail hardware, payments, and receivables financing. Shopify offers connectivity to all major sales channels and payment methodologies whether they are web-based (Amazon), mobile (Apple Pay), social-media based (Facebook) or bricks and mortar. The company is investing back into enriching their user experience and their platform functionality, creating high switching costs via greater integration into all aspects of their clients’ businesses. This has been restraining short-term profitability, but in our view is cementing loyalty, which should lead to higher lifetime revenue and, ultimately, profit per client.
GLUSKIN SHEFF + ASSOCIATES (GS.TO) – Last purchased February 13, 2017 at $19.25
Gluskin Sheff is a mid-sized independent asset manager catering to high net worth private clients. The firm operates in an attractive market niche because assets are growing more quickly among wealthy families versus lower net worth households and because client relationships tend to be sticky and long term in nature, and finally, because high net worth investment management has long been more fee transparent and price competitive relative to transactional brokerage models and mutual funds and where an escalating price war pitting banks against independents is pressuring profitability. Gluskin Sheff, however, is highly profitable with returns on invested capital above 25 per cent and returns on equity above 40 per cent. With an asset-light business model, the company returns a tremendous amount of capital to shareholders via regular and special dividends. Concerns about a legal arbitration with its two founders have been overhanging the stock and any settlement or alleviation of these concerns could prompt a significant upward re-rating in the shares.
PAST PICKS: AUGUST 29, 2016
ALIMENTATION COUCHE-TARD (ATDb.TO)
- Then: $67.63
- Now: $62.20
- Return: -8.02%
- TR: -7.79%
MAGNA INTERNATIONAL (MG.TO)
- Then: $52.29
- Now: $59.14
- Return: +12.45%
- TR: +13.13%
CCL INDUSTRIES (CCLb.TO)
- Then: $240.35
- Now: $268.51
- Return: +11.71%
- TR: +12.19%
TOTAL RETURN AVERAGE: +5.84%
FUND PROFILE: GOODREID NORTH AMERICAN BALANCED
Goodreid’s balanced approach allows investors to participate in the potential growth of equity holdings while mitigating risk through ownership of quality fixed income instruments.
PERFORMANCE AS OF DECEMBER 30, 2016:
- 1 year: Fund 7.3%, Index* 10.2%
- 3 years: Fund 8.0%, Index* 5.5%
- 5 years: Fund 10.3%, Index* 7.1%
* Figures included reinvested income and are net of fees
* Index: Globe Canadian Equity balanced peer average
TOP HOLDINGS AND WEIGHTINGS
- Canadian equities: 34%
- U.S. equities: 37%
- Canadian fixed income: 24%
- Cash: 5%