Oct 31, 2016

Brian Madden's Top Picks: October 31, 2016

BNN Bloomberg

Brian Madden , BNN

Brian Madden, senior vice president and portfolio manager at Goodreid Investment Counsel

Focus: Canadian equities and fixed income
_______________________________________________________________

MARKET OUTLOOK
Brexit? What Brexit? While capital markets trembled and wavered in June as Brexit came to pass, markets gave sober second thoughts to the impact of Britain’s unexpected exit from the European Union, and eventually came to shrug it off as a political event more so than an economic event — basically in line with our own thinking on the subject. Stocks fared well accordingly, with the TSX Composite notching a total return of 5.5 per cent during the quarter, followed closely by the S&P 500 which gained 3.9 per cent in USD terms. These would be the returns enjoyed by owners of an index fund, but perhaps more important for managers like ourselves who carry out extensive research in the quest to build a portfolio of undervalued stocks, is the fact that participation in this quarter’s rally was broad-based, unlike during the first half of the year where leadership was narrow and, in Canada particularly, was led by poor-quality issues within the resource sectors. This quarter, by contrast, conditions were ripe for stock pickers in Canada especially, with nine of eleven TSX subsectors making gains and 67 per cent of issues within the TSX Composite rising. In the United States, seven of eleven S&P 500 subsectors and 60 per cent of the S&P 500 stocks made gains. In simple terms, this means stock pickers had a 67 per cent and 60 per cent chance of making money this quarter in Canada and the U.S., respectively, and these are good odds by historical standards. Leadership in both markets was in the pro-cyclical segments of the market, whereas the laggards were interest-rate-sensitive stocks, as fear of the Fed was once again prominent in the minds of investors. The U.S. central bank remains locked in a tug-of-war on the one hand with a domestic economy that is approaching full employment and is moving away from the risk of a downward deflationary spiral, and on the other hand with a global economy that remains mired in subpar growth. Expectations for the Fed to raise rates at its September meeting were low, and the Fed ratified those expectations by keeping overnight rates at 0.25 per cent to 0.5 per cent. Investors remain very evenly split on the prospects for a rate hike in December, and of course the overwhelming consensus is that the Fed, as a politically-neutral entity by long historical tradition, neither tightens nor loosens monetary policy on the eve of a federal election, so a rate hike in November is off the table. In Canada, on the other hand, the case for a rate hike is extremely remote, with our own economy currently very weak, although recovering; this is most notable in the western, resource-rich provinces. Accordingly, upward pressure on interest rates is nowhere to be found, and bonds, as measured by the FTSE TMX Canadian Universe index, eked out a decent gain of 1.2 per cent as rates continued to grind down to fresh lows, with Canadian 10-year government bond yields closing the quarter just below one per cent.

Shaping the outlook for the balance of the year and the early part of 2017 are a few interesting recent developments and upcoming events. First, as for recent developments, we watch with interest as concerns mount over perceived speculative excesses in certain regional Canadian housing markets, and as governments increasingly are called to action to counter the systemic risks posed by these imbalances. We don’t know what the final effect will be of British Columbia`s tax on non-resident investors in Vancouver housing, nor do we know whether the allure of more tax revenues will prove too difficult to pass up for other provincial governments. We do know that the federal government immediately subsequent to the end of the quarter enacted a further series of administrative and tax measures intended to cool off overheated housing markets. We also know that housing is the single largest asset on household balance sheets, so a disorderly collapse in housing would surely have negative ripple effects on the economy, and so we continue to watch this space closely. Secondly, OPEC surprised the world late in the quarter by announcing an informal agreement to effect a six per cent production cut in November, to help draw down the glut of global oil inventory and to restore prices to more comfortable levels. To the extent this initiative is put into action (and there is some skepticism about this, as the cartel has a history of cheating on production quotas), the effect would be favourable to Canada as a net exporter of oil, and negative, although not dramatically so for the United States, as a net consumer of oil. Finally, of course, the elephant in the room is the upcoming U.S. election which is causing investors and citizens at large much consternation, on both sides of the border. Elections, though, much like Brexit, are best understood as political events more so than economic events, at least in the long term. Presidents come and go, and the U.S. system of government is designed with checks and balances, such as the House of Representatives and the Senate, which exist to force some degree of consensus building in policy, rather than leaving the country beholden to the whims of a single official. America has a long and proud history of being the most dynamic capitalist nation to have ever existed, and the unstoppable inevitability of its economic growth is the reason we see fit to invest there. In a nutshell, the economy grows over time, under all manner of political leadership, and shareholders own the profits in the economy — period.

For our part, we navigate changing economic and political realities by trying to anticipate changes and at times, when necessary, by reacting to unanticipated changes, which can sometimes tilt the playing field in favour of certain companies or sectors over others. We also build, using multiple uncorrelated asset classes as the basic building blocks, well-diversified (but still high active share, high conviction) portfolios. We do this by researching and digging deep into companies to understand their unique competitive advantages and to develop an edge over other investors. The result is a portfolio that reflects our steadfast belief that stocks with better growth prospects, higher profitability, sound financial strength measures and which trade at attractive valuations will outperform passive alternatives (index funds). We are pleased with the progress made in each of our major asset classes this quarter, and fully expect that by keeping our eyes on this dashboard of portfolio health, we will drive deliberately and mindfully towards our clients’ goals and objectives on the horizon, outperforming index funds and the majority of our rivals along the way.

TOP PICKS

ALIMENTATION COUCHE-TARD (ATDb.TO) – Last purchased October 27, 2016 at $67.09
Alimentation Couche-Tard is the largest convenience store operator in North America. The company has a 20-year+ record of growing earnings and enjoys high and rising profitability as measured by return on shareholder’s equity. Their increasing size and scale are driving procurement advantages relative to rivals, so they can price sharply on fuel to draw traffic. Shoppers are then enticed into attractive, modern and well-merchandised stores to buy chocolate bars, coffee, cigarettes, prepared foods, etc., which carry 34 per cent gross margins versus the five to six per cent margins on gasoline. Those in management are extremely capable acquirers and integrators of businesses, which is important in this still-fragmented industry where there are more motivated sellers than qualified buyers. The company is in the process of acquiring CST Brands in their largest deal yet for $4.4 billion, which should be about 15 per cent accretive to earnings.

PEYTO EXPLORATION & DEVELOPMENT (PEY.TO) – Last purchased October 27, 2016 at $34.44
Peyto is a mid-sized natural gas producer operating in Alberta’s Deep Basin and is currently producing about 110,000 barrels of oil equivalent per day — a figure that has more than quadrupled since 2010. The company is the lowest-cost natural gas operator in the region, an advantage which accrues partly from their strategy of operating all of their own assets and owning their own gas-processing facilities. The company also has an excellent land bank offering them 10+ years of drilling inventory to support future growth in the “sweet spot” of this formation where well economics are particularly good. Peyto’s record of shareholder value creation is unsurpassed…not only by any other energy company but by any other TSX Composite index constituent in any sector. From 1998 through 2015, Peyto shares outperformed every other stock in the TSX, with a compound annual rate of return of nearly 45 per cent, which took the share price from 11 cents to nearly $25.

AGT FOOD & INGREDIENTS (AGT.TO) – Last purchased October 27, 2016 at $37.61
AGT is a leading global supplier of pulses, lentils, peas, beans and other food ingredients. With consumer diets in the West increasingly focused on “clean” labels, and with more and more people turning to vegetarian diets, gluten-free diets and GMO-free foods, pulses are an important source of both fibre and protein to meet key nutritional needs while respecting these evolving consumer preferences. In the rapidly-growing emerging markets, these crops have always been traditional staples in people’s diets given their nutritional benefits and low costs. AGT Food & Ingredients is well positioned to capitalize on these secular growth opportunities, and indeed has grown mightily with earnings per share growing at a 60 per cent compound rate since 2012. Their relatively newer food ingredients division, which formulates flours, starches and proteins used by mainstream-branded “Big Food” companies seeking to swap out synthetic ingredients, has been leading their growth thrust in recent years. Their legacy pulse-and-grain-processing segment and their trading and distribution segments have also benefitted from record-sized pulse crops in Canada in recent periods.