Zachary Curry, chief operating officer and portfolio manager at Davis Rea

Focus: North American large caps
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MARKET OUTLOOK
The global economy has continued to improve in the early months of 2017, and is evident in most major economies. However, after a year of rising growth rates, it looks like global growth may be starting to plateau. We don’t see this as the beginning of a slowdown, but an end to the cyclical acceleration in the global economy. Moderating growth is evident in the advanced industrial nations, while emerging markets are still accelerating. Both the U.S. and Canadian economies have picked up and 2017 growth rates will be above those recorded in 2016. This economic growth environment is bullish for earnings growth, which is expected to continue increasing this year.

Global inflation increased in the second half of 2016 as rebounding oil prices fed through the system. However, that impact is now dissipating, and inflation is still low. Underlying inflation trends remain extremely well behaved, and this is expected to continue. Tight U.S. labour markets suggest slightly higher inflation risks in the U.S. than elsewhere.

A stronger global economy remains a plus for commodity prices — not strong enough to generate another big boom, but sufficient to push prices higher over the balance of 2017. Rising commodity prices are supportive for the Canadian dollar, and we expect that to play out over the balance of this year. Most investors are very bullish on the U.S. dollar, but we believe that there has already been a major adjustment in currency markets, and that the strong greenback is a major impediment to reducing the U.S. trade deficit.

Sustained, low short-term interest rates remain our base case scenario. U.S. rates are expected to increase another 50 basis points in 2017. We could see euro area rates increase slightly, back to zero from their current negative setting. The Bank of Canada has kept rates steady at 0.5 per cent. Our bias is for ten-year government bond yields to rise to the upper ends of their recent ranges, hence our preference for shorter-term bonds. The economic and earnings outlook is supportive for corporate bonds, but corporate yield spreads have narrowed sharply, which has made corporate bonds less attractive.

Equity markets are likely to rise over the remainder of 2017, though some choppiness is likely in the near-term. Valuations are stretched, suggesting that investors are very optimistic, maybe too much so. Our economic outlook suggests that valuations (notably price-to-earnings ratios) may drift lower this year, but that the pickup in earnings growth will be an offset. Global defence spending is a new theme for us, especially cyber warfare, although market valuations are rich and vulnerable to correction. Sector valuations remain favourable for U.S. information technology and health care, notably medical devices and biotech. Our cyclical outlook is supportive for energy stocks, which are very cheap at present. However, there are some longer-term considerations that must be considered when investing in this sector.

TOP PICKS

STANLEY BLACK & DECKER (SWK.N) – Most recent purchase: October 16, 2013 at US$77.98
Stanley Black & Decker is a diversified global provider of industrial tools and security that provides exposure to the U.S. home building, renovation and industrial markets. In addition to the acquisition of Newell Brand’s Tools (Irwin and Lenox) and the Craftsman businesses, the company recently sold their mechanical lock business, and continues to work towards driving further organic growth while integrating new businesses. Management has a great track record with the integration of acquisitions, and we should see synergies come in nicely this year. The company continues to fire on all cylinders, with new products such as the DeWalt Flex Volt battery driving sales worldwide, helping the company to continue generating both free cash flow and dividend growth.

ALTAGAS LTD. (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. in a deal worth $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).

GOLDMAN SACHS GROUP (GS.N) – Most recent purchase: May 18, 2017 at US$216.31
Goldman Sachs is a global investment banking and securities firm specializing in investment banking, trading and principal investments, asset management and securities services. With all the headlines regarding tax and financial reform in the U.S., Goldman is poised to benefit from both if they were to pass. Repeals of Dodd-Frank or the Volcker rule would lead to lower capital requirements, and as an investment bank, lower corporate tax rates would potentially spur increased mergers and acquisition and financing and trading through the capital markets. However, even if reforms are stuck in transition for the near future, Goldman Sachs can benefit from increased volatility in the markets. After reporting weaker than expected fixed income, currencies, and commodities trading revenue last quarter, taking the stock down five per cent, we added this position as we believe it to be just a one-time miss. The company is continuing to exhibit double-digit top-line growth while increasing its return on equity, and continues to return capital to shareholders through both a share repurchase program (for 70 million shares), and the 1.4 per cent dividend yield on the stock, while trading relatively cheaply at 11 times 2018 earnings.
 

PAST PICKS: APRIL 5, 2016

FACEBOOK (FB.O)

• Then: $112.22
• Now: $149.28
• Return: +33.02%
• TR: +33.02%

CERNER (CERN.O)

• Then: $54.03
• Now: $64.50
• Return: +19.38%
• TR: +19.38%

TOURMALINE OIL (TOU.TO)

• Then: $24.92
• Now: $28.29
• Return: +13.52%
• TR: +13.52%

TOTAL RETURN AVERAGE: +21.97%
 

FUND PROFILE: DAVIS REA EQUITY FUND

PERFORMANCE AS OF APRIL 30, 2017:

• 1 month: Fund* 0.69%, Index** 0.64%
• 1 year: Fund* 12.85%, Index** 14.06%
• 3 years: Fund* 0.51%, Index** 5.66%

* Returns are gross of fees (we do not calculate net of fee returns) and based on reinvested dividends
** Index: 50% S&P/TSX 60 Index, 50% S&P 500 Index

TOP HOLDINGS AND WEIGHTINGS

1. U.S. dollar cash: 10.8%
2. Kelt Exploration (KEL.TO): 9.2%
3. Tourmaline Oil (TOU.TO): 7.9%
4. AltaGas Ltd. (Sub. Receipts) (ALAr.TO): 7.7%
5. Spartan Energy (SPE.TO): 6.9%

TWITTER: @DavisRea
WEBSITE: www.davisrea.com