Market Call for Thursday, March 16, 2017
Zachary Curry, chief operating officer and portfolio manager at Davis Rea
Focus: North American large caps
The global economic environment is improving as evidence of acceleration in activity builds. We see this in various surveys, notably in the purchasing managers’ indexes, but also in hard data such as industrial production, steel production and semi-conductor sales. This improvement is broadly based across countries. Canadian and U.S. economies are also improving as 2017 gets underway. Recent job creation figures are particularly noteworthy in this regard.
Improving economic growth implies stronger corporate earnings ahead. The pick-up in economic growth is expected to be a plus for commodity prices over the remainder of 2017 and into 2018. This is a plus for the Canadian dollar, though shifting monetary policy expectations (Fed rate hikes and steady Bank of Canada) have been an offset, weighing on the loonie. Markets are very close to fully pricing in the Fed’s likely interest rate path through 2019 and seem comfortable with steady short-term rates in Canada. This negative impact should fade in the months ahead, and open the door for higher commodity prices to give the Canadian dollar a lift. While we expect some cyclical strengthening in the loonie this year, we remain quite negative on the Canadian dollar over the long-run, given Canada’s competitiveness challenges and its large household debt burden.
The increase in energy prices in 2016 is boosting headline inflation measures, but core inflation measures that attempt to smooth out short-term volatility remain low for most major economies. U.S. inflation trends remain somewhat higher than other countries, reflecting the fact that the U.S. economy is bumping up against capacity constraints. The U.S. Federal Reserve has signalled that short-term U.S. interest rates will rise further this year, but will remain quite low by historical standards. In Canada, Japan and Europe, short-term interest rates are expected to remain very low.
Economic and earnings growth are constructive for equity markets over the coming year. However, markets have rallied strongly since last November and most measures of valuation have become even more stretched. Equity returns over the remainder of this year will likely be driven by a tug-of-war between earnings pulling prices higher, and ebbing valuations providing an offset. With interest rates and bond yields likely to remain relatively low, the decline in various price-to-earnings ratios will only partially offset improved earnings, leaving us with single-digit gains over the remainder of this year. However, valuation measures like price/earnings ratios can be quite volatile over shorter periods, and with investors in a very optimistic mood there is room for some volatility in equity prices in the next few months. Most major markets are richly valued, as are most sectors of these markets. Finding good value for investors in the current market environment is challenging. Our valuation measures still show that U.S. information technology and health-care stocks are favourably valued at the moment, and both are supported by our longer-term economic and investment themes. The improving economy argues for a bias toward the cyclical (or economically-sensitive) areas of equity markets, but many sectors — notably industrials — have discounted a lot of good news on the economic outlook. Energy stocks in both Canada and the U.S. are notable for their favourable valuations.
There are a range of risks that require our attention, notably upcoming elections in France and the details on U.S. fiscal policy and international trade under the new administration.
FACEBOOK (FB.O) – Most recent purchase: November 15, 2016 at US$117.20
Facebook is one of the largest social-media companies in the world, with a user base of one in seven people globally. User growth continues to impress, as four of their platforms have reported monthly active user counts of over one billion, and have crossed the one-billion-user mark for daily active users on Facebook (desktop and mobile). With the continued expansion of their user base and the high engagement level of its users, the rate of monetization per user continues to increase, as advertisers continue moving their advertising dollars to Facebook’s social networks. Alongside the growth in users and advertising revenue, Facebook continues to improve their video offerings with products like “Facebook Live,” continues to add functionality to their messaging platforms for both payments and business-to-consumer engagement, and continues to integrate machine learning and artificial intelligence into all of their products. These offerings and functionality contributed to revenue growth of more than 50 per cent in 2016. We expect year-over-year revenue and earnings per share growth of more than 30 per cent in 2017.
STRYKER (SYK.N) – Most recent purchase: November 9, 2016 at US$116.24
Stryker is one of the world's leading medical technology companies and is active is more than 100 countries around the world. Stryker has a diverse array of innovative products and services in orthopaedics, medical and surgical, and neurotechnology and spine that help improve patient and hospital outcomes. We expect the company will be able to grow revenue by five per cent organically in 2017, with earnings per share growth of around 10 per cent year-over-year. The company will also have synergies come online this year from the acquisitions of Sage Products and Physio-Control Inc. last year, which should continue to bolster growth. Stryker has a number of new product launches that we expect will add to this growth, along with the increased use of robotics to drive greater efficiencies for the company.
ALTAGAS – SUBSCRIPTION RECEIPTS (ALAr.TO) – Most recent purchase: February 3, 2017 at $31.00
AltaGas is an energy infrastructure company with operations that include natural gas gathering and processing, extraction of ethane and natural gas liquids, transmission, power generation and rate-regulated utilities. The company's operations are primarily based in Western Canada with select businesses throughout North America. Earlier this year, AltaGas announced an agreement to acquire WGL Holdings Inc. for $8.4 billion. WGL is a diversified energy infrastructure company with headquarters in Washington, D.C. WGL has regulated utility assets as well as midstream, power and energy marketing businesses throughout the United States. The company expects the acquisition to be accretive in its first year, and expects the transaction to close by Q2/2018. In 2016, the company grew EBITDA by 20 per cent year-over-year, and for 2017 we expect high single-digit EBITDA growth compared to 2016 across all three of the company’s business lines (gas, power and utilities). We favour the subscription receipts as they trade at a discount to the common shares, yet receive the same dividend as the common shares. Also, in the unlikely event that the WGL transaction does not go through, holders of the subscription receipts will have their initial capital returned to them (at the purchase price of $31).
PAST PICKS: JANUARY 13, 2016
AUTOMOTIVE PROPERTIES REIT (APR_u.TO)
- Then: $9.00
- Now: $10.65
- Return: +18.33%
- TR: +29.75%
CERNER CORPORATION (CERN.O)
- Then: $58.33
- Now: $55.79
- Return: -4.35%
- TR: -4.35%
- Then: $95.44
- Now: $139.99
- Return: +46.67%
- TR: +46.67%
TOTAL RETURN AVERAGE: +24.02%
FUND PROFILE: DAVIS REA EQUITY FUND
PERFORMANCE AS OF FEBRUARY 28, 2017:
- 1 month: Fund -0.6%, Index* 1.8%
- 1 year: Fund 12.9%, Index* 21.2%
- 3 years: Fund 2.7%, Index* 6.0%
* Index: 50% S&P/TSX 60 Index, 50% S&P 500 Index
* Our returns are only gross of fees
TOP HOLDINGS AND WEIGHTINGS
- U.S. Dollar cash: 9.8%
- Tourmaline Oil Corp.: 8.5%
- Alphabet Inc. (Cl. A): 8.2%
- AltaGas Ltd. (Sub. Receipts): 7.9%
- Kelt Exploration Ltd.: 7.7%