Cameron Hurst, chief investment officer at Equium Capital Management

Focus: U.S. equities
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MARKET OUTLOOK

• Volatility in FX has picked up substantially, not least because of all the moving parts in monetary policy around the globe.
  • CAD spike was primarily driven by a speech yesterday from Sr. Deputy Governor Carolyn Wilkens, noting that if growth continues at this elevated pace the bank would revisit whether all of the (quite considerable) monetary policy stimulus is still required.
  • This comes at a time when major central banks like the Fed and ECB are ratcheting up rhetoric on reduced policy accommodation, which adds significant complexity.
  • Domestically, we could point to multiple negative headwinds for the loonie, e.g. weak oil prices, comparatively dovish policy, Home Capital and questions surrounding housing, and even threats to NAFTA from the Trump administration — there’s been a lot to worry about.
  • All this negativity led to the most bearish futures positioning in CAD in over 25 years, making the loonie highly susceptible to a snap-back rally.
• Remember, there is a significant time gap between policy signals and actual changes.
  • For example, tomorrow afternoon we’ll hear from the Fed and expect a 25bps rate hike.
  • More importantly, however, will be language in the release and discussion that follows pertaining to the Fed balance sheet and asset purchases.
  • Bearing in mind it’s highly unlikely we see changes to the asset purchase program this year, it should provide some comfort the BoC is similarly unlikely to do anything rash, particularly with major changes unfolding in the housing market.
• Auto is another segment where we’re waiting to see more substantial cracks from rising rates.
  • Particularly in the U.S. post-financial crisis, banks ran toward a perceived safer area of credit after the housing fallout.
  • The U.S. auto fleet had become very aged with the average car over 11 years old, so low rates drove people to update their cars.
  • Additionally, the proportion of cars being leased versus financed doubled to about over 30 per cent last year from 15 per cent in 2010.
  • So now a glut of used cars coming off leases is driving down residual values.
  • Adding insult to injury, higher rates reduce the actual asset valuation, so there’s a compounding effect at play in this asset class.
  • Ally Financial and Santander Consumer USA are the two pure plays to watch here, but Capital One also has a substantial auto loan book.
• This also highlights why we feel so strongly about employing a hybrid investment strategy.
  • We have to underpin our technical views with fundamental research because they typically speak to different catalysts and horizons.
  • We don’t invest in a sector, country or theme unless we can check both boxes.
• Financials in both Canada and the U.S. might be good for a trade here on the rate-related bounce, but there are significant questions and headwinds to be resolved before we would lean into them.

TOP PICKS

UNITEDHEALTH GROUP (UNH.N)

• Sector: Health care
• Market cap: $174.2 billion
• Performance:
  • 1 year absolute: +35.9% 
  • 1 year versus health care: +27.0%
  • 1 year versus S&P 500: +18.3%
• Valuation:
  • Top-line growth: FY17 8%; FY18 8%
  • Bottom-line growth: FY17 +22%; FY18 +10%
  • P/E multiple: FY17 18.7x; FY18 16.9x
     
• Positive: We like managed care fundamentals generally, given the changing health-care model.
• Dominant managed care company (commercial, Medicare and Medicaid) and pharmacy benefit manager.
• Large diversified enterprise both in terms of breadth of services and geographical reach, and is a market leader in virtually every business segment that it operates.
• Supported by secular trends in Medicare and Medicaid, i.e. aging population and lifestyle diseases; the company has significant demographic tailwinds for years to come.
• Changes in health-care delivery and payment models (fee for services to value-based) favours entities positioned to reduce per capita health-care spending; puts managed care in good position.
• Minimal impact and exposure of ACA repeal/replace on large diversified managed care companies.
• Returns about 50 per cent of annual cash flow to shareholders as dividends and share buybacks.
• A risk to the company is the Department of Justice is looking into case alleging UNH made efforts to identify sicker members in its Medicare Advantage plans in order to code for their health status and receive commensurate higher-risk payments from the government.
  • Little evidence to substantiate fraud claims and DOJ intervention in past has not guaranteed material finding.
• Very consistent beat and raise story; excellent management.
  • Trading at 18.7x 2017 EPS — slight premium to peer group (18.1x) warranted as company continues to execute operationally leading to earnings estimates beat and raises.
• Look for buying opportunities on further DOJ case noise.

RAYTHEON (RTN.N)

• Sector: Industrials
• Market cap: $46.5 billion
• Performance:
  • 1 year absolute: +22% 
  • 1 year versus industrials: +2.0%
  • 1 year versus S&P 500: +4.4%
• Valuation:
  • Top-line growth: FY17 5%; FY18 4%
  • Bottom-line growth: FY17 10%; FY18 12% 
  • P/E multiple: FY17 21.4x; FY18 19.2x
     
• Positive: We like RTN’s specific defence market exposures (missiles, missile defence and cyber) and its higher-margin international exposure.
• Diversified business mix: 1. Integrated Defense Systems (Missile Defense) 2. Missile Systems 3. Intelligence Information Services 3. Space & Airborne Systems 4. Forcepoint (cybersecurity).
• Positive on the defence space – DoD budget pivoted towards growth and heightened threat environment globally and RTN is geared towards current defence market priorities (missiles, missile defense and cyber) — DoD focus on missile spending versus ISIS.
• Platform “agnostic” — RTN subcontract into major defence programs but are not main supplier, therefore mitigates risk of Trump interference (as seen with LMT (F35) and BA (Air Force One).
• Leader in international defence sales (31 per cent of revenue) which are higher-margin sales.
• Top and bottom line beat in Q1, raised guidance and have significant balance sheet capacity, therefore room for dividend increases and share buybacks.
• Trading at slights premium to peer group average 21.0x.

MCDONALD’S (MCD.N)

• Sector: Discretionary
• Market cap: $123 billion
• Performance:
  • 1 year absolute: +24% 
  • 1 year versus discretionary: +7% 
  • 1 year versus S&P 500: +7% 
• Valuation:
  • Top-line growth: CY16 -3%; CY17 -9%; CY18 -12% 
  • Bottom-line growth: CY16 +15%; CY17 +12%; CY18 +7% 
  • P/E multiple: CY17 23.8x; CY18 22.2x
     
• Discretionary is neutral but consumer services sub-sector is trending very positively
• MCD is a high-quality large cap defensive undergoing significant structural changes across its menu, workflow and restaurant ownership.
• Global restaurant sales should expand as wages and consumer sentiment continue to improve across most major economies (55 per cent profit excluding the U.S.).
• Food inflation expected to drive higher comp sales as beef prices recover and MCD presses its value advantage to take share. Also, stepped-up innovation, all-day breakfast and customization efforts helping to drive traffic.
• Refranchising efforts (will be 93 per cent by end of 2017 up from 80 per cent in 2015) driving significant gross margin gains (up 10 percentage points since 2015) and free cash flow conversion (72 per cent to 90 per cent).
• MCD undergoing significant front-to-back technology overhaul from mobile ordering (to be launched in 20,000 restaurants by year end 2017) to improved drive-thru/curbside pick-up. These efforts are expected to reduce labour, increase throughput and improve loyalty/service levels with very high return on investments in test stores.
• Cash returns to shareholders expected to be approximately $8 billion per year through to 2019.
• 15x EV/EBITDA high relative to market but actually in-line with restaurant peers and at a discount to comparable highly franchised peer set. High ROIC and stability of global franchise cash flow model justify the premium. Significant potential upside from technology improvements not well reflected in estimates, either (see SBUX).