John Zechner, chairman and founder of J. Zechner Associates
Focus: North American large caps

MARKET OUTLOOK

While the stock market seems once again to be in a state of bliss, particularly in the U.S., we continue to see substantial risks due to slowing global growth, lofty earnings expectations and stock valuations that are only supported by the extremely low interest rate environment. In our view, the majority of market indicators are setting up for higher volatility for the balance of the year. While investors are celebrating expected easier money conditions, we would point out that the impact of low rates has hit the point of diminishing returns. Is it any coincidence that over the past 10 years we’ve seen the most aggressive period of monetary stimulus ever combined with one of the weakest economic recoveries ever? Low interest rates have only fueled increasing stock market multiples and high levels of risk-taking as investors use a lower discount rate on long-term earnings, which leads to higher valuations. Economic numbers and second quarter earnings are not expected to bring any good news, so markets will clearly be dependent on a lessening of trade tensions between the U.S. and China (amongst many U.S. trade battles) as well as continued conciliatory talk from key global central banks such as the Fed, ECB and Bank of Japan. Maybe that’s why gold and gold stocks have been shining a bit more brightly lately.

In addition to continued global economic concerns, we’re expecting further reductions in earnings estimates as companies struggle with higher costs and reduced demand. While we’ve been surprised by the strength of the current stock market recovery so far, investors seem overly optimistic about the economic outlook while also believing the Fed is no longer a risk for stock markets. The monetary reality is that financial conditions have already tightened due to the rate increases enacted over the past three years such that economic growth has peaked for this cycle. The bottom line is that we don’t see the risk-reward trade-off as being favourable enough for us to have a strategy that would include an overweight position in stocks. We continue to have overweight positions in mid-term bonds, preferred shares and cash. While we’re underweight U.S. stocks, we retain some resource exposure in Canada, particularly in energy, where we’ve watched a mass exodus of capital for much of the past four years. We expect a lower U.S. dollar to provide some strength to this commodity group and are seeing better technical action in gold stocks in particular, having added positions.

TOP PICKS

VANECK VECTORS GOLD ETF (GDX.N)
Position added inMay 2019 at $23.70.

Zero/negative interest rates have dramatically reduced the opportunity cost of holding “non-yield” gold. Competitive global currency depreciation also should shift funds towards gold as the anti-paper currency. Gold stocks are trading at decade-low valuations relative to bullion and are a better way to lever its upward move. We prefer the large-cap oriented GDX ETF with its diversity of major gold stocks in order to reduce specific mine risk as well as gaining geographical diversification.

DISNEY (DIS.N)
Position added in April 2019 at $132.

Content continues to be king in the world of media and no company has greater content than Disney, with the Marvel, Star Wars and Pixar franchises as well as the old Disney library and the recently-acquired Fox assets. Disney also cross-sells its content better than any of its competitors, with ABC television, movies, merchandise, theme parks and its new streaming service as outlets for product distribution. Growth continues at only a slight premium to market multiple.

BAYTEX ENERGY (BTE.TO)
Position added June 2019 at $2.

One doesn’t need to be a raging energy bull to be positive on Baytex at current levels. The company has reduced financial leverage dramatically in the past three years as it generates free cash flow at current strip prices. There’s the misconception that the majority of its production is priced at WCS, but the reality now is that Baytex sells a large amount of oil from the Permian Basin and therefore receives market prices. With current WTI prices averaging around US$60, the company could generate between C$500 million and C$700 million in free cash flow. That would push Baytex’s leverage ratio down to a more comfortable 1.5 times, giving it the financial flexibility to continue drilling, pay off additional debt, pursue another acquisition or reinstate a dividend. The stock trades at discount to net asset value and only about three times operating cash flow.

PAST PICKS: JUNE 28, 2018

TRINIDAD DRILLING (TDG.TO)
Acquired by Ensign Energy on Feb. 20, 2019.

• Then: $1.77
• Acquired at: $1.68
• Return: -5%
• Total return: -5%

ALPHABET (GOOG.O)

• Then: $1,114.22
• Now: $1,150.34
• Return: 3%
• Total return: 3%

HUDSON’S BAY CO. (HBC.TO)

• Then: $11.57
• Now: $10.08
• Return: -13%
• Total return: -12%

Total return average: -5%

WEBSITE: jzechner.com
TWITTER: @jzechner56