Feb 22, 2017

Jerome Hass' Top Picks: February 22, 2017

BNN Bloomberg

Jerome Hass, portfolio manager at Lightwater Partners
Focus: Canadian mid-caps and long-short strategies

___________________________________________________________

MARKET OUTLOOK:

Equity markets continue to soar in the post-election rally. The S&P/TSX composite index has continued to do well in early 2017, but the Canadian stock market is not cheap. The TSX index is currently trading at 16.4 times forward earnings, its highest valuation at this point of the year since 2001. Earnings growth expectations remain relatively aggressive at 24 per cent over the next 12 months. This is twice the growth rate expected in the U.S., so there’s plenty of scope for disappointment. In terms of volatility, the VIX recently closed at 11.45; it has closed below this level only 3.5 per cent of the time over the last two decades. It leads one to ask “how long this Goldilocks period can last?”

We feel there’s a good argument to be made for positioning in alternative assets while the markets continue to hit new all-time highs. We firmly believe the low correlation and downside protection offered by a long-short equity fund are worth adding now. Portfolio insurance, as with any insurance, should be put in place prior to volatile events. You can’t buy fire insurance after the fire.

TOP PICKS:

SPIN MASTER (TOY.TO)

Spin Master is Canada’s only publicly traded toy company after Megabrands was taken out by Mattel in 2014. There are few publicly listed toy companies globally, so we believe Spin Master will get to critical mass in the next few years and become another takeover candidate.

At $3-billion market cap, Spin Master would be an acquisition candidate for Hasbro or Mattel (each with a US$10-billion market cap). In the interim, Spin Master remains a compelling growth company, as the U.S. toy industry is growing 5 to 7 per cent annually.

The company is best-known for this year’s breakout Christmas toy Hatchimals. Headlines about Hatchimals not hatching were overblown during a slow news season and created an opportunity to add to our position. In addition, Hasbro recently reported fourth-quarter earnings well ahead of consensus forecasts indicating Christmas sales were very strong for the sector. The stock trades at about 10 times EBITDA 2017E versus peers at 12-13 times. [We added to our position on Jan. 30, at $32.01]

SHORT: HOME CAPITAL GROUP (HCG.TO)

Home Capital Group is one of the most shorted stocks on the TSX (30 per cent of the float is now sold short). We generally avoid crowded trades – both long and short – but we make an exception for Home Capital.

The stock is a popular short with U.S. hedge funds that have a bearish view on the Canadian housing market, as Home Capital is the largest listed sub-prime lender in Canada. Our short thesis isn’t based on a negative outlook for housing (we’re neutral on housing). Instead, we’re concerned about high run-off rates of its loan book. Specifically, their mortgage originations growth has been much higher of late than their portfolio growth.

In the fourth quarter their main product, traditional single-family residential mortgages originations (that is new mortgages), was up 14 per cent year over year while their mortgage loan book was actually down 5 per cent year over year. That implies Home Capital is having a harder time retaining borrowers – “running to stand still.”

Banks have become much more aware of the potential of new immigrants and have introduced programs to attract this clientele, a traditional sweet spot for Home Capital. The company will also be seeing increased competition for self-employed borrowers. Finally, the Ontario Securities Commission recently served the company with an enforcement notice, which is never a good sign for a stock.

PAIR TRADE: LONG - CINEMARK (CNK.N) / SHORT – CINEPLEX (CGX.TO)

The motivation for this pair trade lies mainly on the short side: we think Cineplex is overvalued relative to U.S. comparables and over-owned by Canadian long-only funds.

When analyzing Cineplex, investors focus on the upcoming film slate. As a hedge fund, we mitigate as much risk as possible. In this instance, the risk is the success of blockbuster movies. To offset this industry risk, we’re long Cinemark in the U.S.

Both companies will basically show the same movies, so the box office risk is eliminated. Cineplex already has 77-per-cent market share in Canada, so it’s difficult to grow seat sales. The company is trying to offset this by adding frills like vibrating seats and 3D or adding “premium” services. To fuel growth, Cineplex is diversifying into non-cinema businesses such as stand-alone casual dining restaurants and hosting e-gaming tournaments, which are driving up operating costs and pushing margins down. Conversely, Cinemark is still growing its market share south of the border and sticking to its core business of exhibiting movies.

Cineplex is currently trading at twice the valuation of Cinemark: The company is at 41 times 2016 price-to-earnings (P/E) and 35 times 2017, while Cinemark is trading at around 21 times current P/E and 17 times 2017 P/E. [We last added to our Cineplex short position 14 months ago at $47.65 on Dec. 31, 2015; we last added to our Cinemark long position 16 months ago on Oct. 16, 2015 at $33.84].

DISCLOSURE	PERSONAL	FAMILY	PORTFOLIO/FUND
TOY	Y	Y	Y
HCG	N	N	Y
CNK	N	N	Y
CGX	N	N	Y

PAST PICKS: FEBRUARY 8, 2016

CURRENCY EXCHANGE INTERNATIONAL (CXI.TO)

After an almost four-year wait, Currency Exchange International was awarded a Canadian Schedule 1 bank license in September, operating as “Exchange Bank of Canada” (EBC). There are two main benefits to this: firstly, EBC can now transact “bank-to-bank” which opens up a lot more doors from marketing and compliance perspectives and reduces client banks’ capital provision requirements. Secondly, it will reduce costs for EBC as it can now source foreign exchange directly from central banks and eliminate the middle man.

We expect EBC to land a number of large Canadian and U.S. banks in the first half of 2017, reviving its multi-year growth path. It also landed a large U.S. national last summer, which should begin to have an impact on its first-quarter earnings. Based on its existing clients, we see 22-per-cent revenue growth and 44-per-cent earnings growth in FY17. Compared to the eight largest Canadian banks, we prefer the simplicity of CXI’s business model and much higher growth trajectory. [We added to our position on Jan. 31 at $26.50].

Then: $22.01
Now: $26.51
Return: +20.45%
TR: +20.45%

SHORT: SHAWCOR (SCL.TO)

Shawcor is a pipeline-coating specialist. It’s a rare Canadian company that’s a world leader in their field. We like the company and its management team — in fact, we’ve had the stock as a top pick as a long. So why did we short the stock? Headwinds. Shawcor is a late-cycle play on the oil and gas sector. Whenever one defines the bottom of the sector, it will usually take four to six quarters for the company to start to see any operational improvement. The market has been overly generous in reflecting potential future improvements. We think the company’s share price is way ahead of its fundamentals but rather than “fight the tape,” we opted to cover our position. [Covered Shawcor on May 18 at $29.75].

Then: $28.78
Now: $36.75
Return: -28.04%
TR: -30.57%

PAIR TRADE: LONG - MYLAN (MYL.N) / SHORT - VALEANT (VRX.TO)

The conviction in this pair trade was our short thesis on Valeant. Our long position in Mylan was a hedge to mitigate market risk and sector-specific risk. Both companies have run afoul of the U.S. Congress for price gouging. We covered our Valeant short on Mar. 15, 2016 at $50.50 and we sold Mylan on Sept. 7 at $40.43.

In pair trading, stocks can rise or stocks can fall. Whether you make money depends on what happens to the spread between the two. In this instance both stocks fell, but the short fell more than the long, so the spread widened and we made money on the pair.

LONG: MYLAN