Jan 18, 2018

Jason Mann's Top Picks: January 18, 2018

BNN Bloomberg

Jason Mann , BNN

Jason Mann, chief investment officer at EdgeHill Partners
FOCUS: North American equities
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MARKET OUTLOOK

The Trump Trade lives. Cyclical value stocks which were weak most of 2017 picked back up in the last quarter on the back of tax cuts becoming a reality.
Can see the results in U.S. smallcaps, financials, materials, industrials.
Underlying commodities are strong, and inflation expectations are rising again.
Last year was all about owning “beta," while generating “alpha” was hard – simply owning mega-cap growth stocks without regard for valuation was the best strategy.
The problem is that when markets are this stable with such good returns, people feel the market is getting LESS risky, when in fact the complacency makes the market MORE risky.
The market is already expensive, and certain growth stocks even more so.
Markets are born on pessimism and die on euphoria – we believe we have entered the “euphoria” stage now.
The final stage can last longer than you think, but we do expect volatility to start rising – even if markets keep going up. The likelihood of a market “melt up” is high, and while it can be foolish to try to pick a market top as it will go higher than you expect, melt ups are more likely to end with a bang rather than a whimper.
Certain sectors like cannabis and crypto are in full-blown bubbles in our opinion, and we wouldn’t touch them at this point. They are indicative of the euphoria environment however.
All this said, the divergence between sectors hasn’t been higher in years – while markets overall are expensive, we see lots of opportunity in relative valuations.
Energy is one example: after a multi-year bear market we are seeing opportunities to be long again. Price momentum has turned positive on a medium-term basis, and we actually think there is an economic backdrop that could support the price of crude. When there is strong price momentum and reasonable valuations, that is our sweet spot.

TOP PICKS

MAGNA INTERNATIONAL (MG.TO)

Best-of-breed auto parts company.
Scores in top three per cent on valuation for us with top 15 per cent on price momentum and with reasonable volatility.
Strong ROE at 21 per cent, EV/EBITDA of 6.1x, 10.3 PE
Industry fundamentals are strong given the age of the U.S. vehicle fleet – there is an ongoing need for replacement post lacklustre 2008 crisis
Strong balance sheet despite ongoing acquisitions. Good balance sheet and strong cash flow gives them a lot of options for use of cash.
Could be argued Magna is perpetually cheap. There is an interesting “sum-of-the-parts” argument though. They are now reporting each business segment, and if you were to apply the group multiples for each business line separately (as opposed to a single multiple for the whole business), you can get an extra $10/share in “value.”
Some of their U.S. peers have crystallized this by spinning out divisions (Delphi and Autoliv), and while Magna has said they don’t want to do this, the size of the company actually makes them a potential activist target to help encourage them to maximize shareholder value in this manner.

PAREX RESOURCES (PXT.TO)

Latin America exploration focused, primarily in Columbia.
As an energy stock it has been somewhat unique in that it has scored well versus all other non-energy stocks in the TSX despite a very tough environment.
It is a “safer” way to get exposure to cyclical energy recovery, although it won’t give you the most torque by any stretch.
They have always been focused on maintaining a profitable profile and have been able to grow even in low price environment.
Scores in top 10 per cent of all stocks on both price momentum and valuation. Trades at 20x PE, good ROEs, recently beat on earnings, and has great balance sheet.
Importantly, produces high-quality light oil and gets Brent pricing – not exposed to the transportation problems that are causing the WCS and AECO discounts in Canada.
They have good inventory of drilling targets, and have had good exploration success historically. Could have meaningful production growth in an improving price environment.

CENOVUS ENERGY (CVE.TO)

This would be our “riskiest” pick, but perhaps the one with the most potential upside.
CVE ran into trouble last year when they bought out their partner Conoco on their oil-sands project. The market thought they had overpaid for the asset and levered up at exactly the wrong time, and stock dropped about 40 per cent post-deal.
Since then, they have sold down non-core assets and raised $3.7B which is enough to retire their bridge loan and help delever. Should have another $500M of asset sales in the deep basin.
So looking forward, despite the perceived missteps of the last year, they look reasonably priced now with a 2018 estimated cash flow yield of seven per cent versus four per cent for the group, and 6.6x EV/EBITDA vs peers at 7.9x.
Momentum is turning up as well, as it is for the whole sector – and for us that sweet spot of reasonable price and good momentum is beginning to play out.
The knock against is their fairly big hedge book, which means they’ll have less torque to recovering oil prices, as well as steep WCS discount to WTI. They are also exposed to AECO on their gas production. Also have potential overhang of Conoco’s block of stock.